Is FAA Ready To Take Off?

by on May 24, 2010 | ETFs Mentioned:

The airline industry is notorious for its cyclical booms and busts, fluctuating with the level of consumer and business discretionary spending and often functioning as a leveraged play on the broader global economy. So far, 2010 has been an interesting year for airlines; the rumor mill has churned out hint after hint at a wave of consolidation, while a volcano in Iceland brought the sector to its knees for a few days in March. These events have made for some big price swings, and have made the Claymore/NYSE Arca Airline ETF (FAA) an increasingly popular option among investors looking to time the markets (see Why The Airline ETF Is A Value Buy).

FAA follows the NYSE Arca Global Airline Index, a benchmark measuring the performance of highly capitalized and liquid airline companies listed on developed and emerging market exchanges.  It is not uncommon for the airline ETF to experience big swings in price over a relatively short period of time; in 2009, FAA rose by 67% between June 23 and September 21. With a beta of 1.97, FAA is significantly more volatile than the overall market, and during the recovery, this volatility has translated into impressive returns. Since bottoming out on March 6, 2009, FAA has gained more than 130%, making it one of the top performing equity ETFs over that period.

As recent months have shown, the airline ETF carries a unique risk and return profile; volcanic eruptions, the United-Continental merger, and changing business and personal travel habits have all had a major impact on FAA’s returns in 2010.

Iceland’s Impact

Since erupting in late March, the Eyjafjallajokull volcano had been a major detriment to airlines operating transatlantic flights. In one the most bizarre stories of the year, the ash spewing from the volcano caused countless cancellations, delays, and even airport closures.  By some estimates, airlines have lost over $1.7 billion in revenue and cancellations have exceeded 100,000.  Although the volcano seems to have finally waned, the ultimate financial impact of the interruptions is yet to be seen.

Merger News: Sign Of Things To Come?

While Eyjafjallajokull dominated the headlines for a few weeks, the biggest development in the airline industry this year has been merger-related; United and Continental have proposed a deal that would form the largest airline in passenger traffic. The president and CEO of Continental, Jeff Smisek, will take over as the new CEO of the merged airline.  “This combination brings together the best of both organizations and cultures to create a world-class airline with tremendous and enduring strengths,” said Smisek. “Together, we will have the financial strength necessary to make critical investments to continue to improve our products and services and to achieve and sustain profitability.”

FAA has been sensitive to the market reaction of the United and Continental merger, due to the weight of its stock holdings: Continental (CAL) makes up about 15% and United parent UAL accounts for another 4% of holdings. But beyond the direct impact, merger chatter has given FAA a boost as some investors see the Continental deal as the beginning of a wave of badly-needed consolidation in the industry. With occupancy rates still relatively low and pricing power relatively weak, there is hope that further combinations would produce a more profitable airline industry.

Major airline consolidation creates the potential for greater growth and substantial savings through the ability to cut overlapping routes. This has the potential to hurt smaller airlines who do not have the destination network of larger airline carriers, but can be a very positive development for the leaders of the industry. In September 2008, Delta and Northwest airlines merged as Delta, giving the combined firm hopes of reversing a cash drain and returning to profitability. This year Delta announced first quarter losses of $256 million, which is a considerable improvement from the year-ago loss of $794 million.

Following the merger announcement on May 3, FAA closed at $35.44, an increase of 2.1% from the previous day.

Brighter Skies Ahead?

FAA has been hammered over the last weeks as investors have sold off risky assets with impressive haste. But there are reasons to be optimistic over the short- and intermediate-term outlook for the industry. Airline travel is expected to increase by 1% this summer, which translates into an additional 202 million passengers according to a forecast issued by the Air Transport Association of America. The recent turmoil in Europe may give FAA an indirect boost; as investors have flocked to safe havens, the dollar has soared higher at the expense of the euro. This has pushed oil prices lower, as crude was recently hovering around $70 per barrel. It has also made European vacations more attractive, a development that could increase demand for lucrative trans-Atlantic flights.

For long-term buy-and-holders, an investment in FAA might not be very appealing. But for those on the hunt for an interesting short-term play, the airline ETF might be worth a closer look (see Three Leveraged ETFs Up 50% During The Correction).

Disclosure: No positions at time of writing.