Why The Airline ETF (FAA) Is A Value Buy

by on April 21, 2010 | ETFs Mentioned:

When Iceland’s Eyjafjallajokull volcano erupted last week, few investors imagined that the ash spewing forth would cause wilting fruit in Kenya, rotting mozzarella in Italy, or flowerless weddings in New York City. The ripples throughout the world from the most recent act of nature served as a reminder of the extent to which global economies are now intertwined.

But while companies in all corners of the global economy were impacted by a most unexpected event, the biggest disruptions was felt closest to the splash. It is estimated that the global airline industry lost more than $1 billion over the past week, the result of more than 60,000 flight cancellations as regulators refused to grant permission to fly anywhere near the potentially hazardous ash cloud. The prolonged service disruption presents yet another hurdle for an industry that has been to the brink of collapse multiple times in recent years.

The Claymore/NYSE Arca Airline ETF (FAA) has been one of the best performing equity ETFs since markets bottomed out last year, gaining more than 250% since March 2009 (see FAA’s historical performance).

But the stubborn ash cloud spurred a sharp pullback. FAA, which tracks the NYSE Arca Global Airline Index, lost almost 5% between the first announcement of travel restrictions on Thursday and the end of trading on Tuesday (despite the turmoil caused by allegations of fraud at Goldman Sachs, the broad markets were generally flat over the same period). It’s worth noting that FAA’s largest holding, Southwest Airlines (LUV), flies mostly domestic routes, and as such hasn’t seen its operations affected significantly by the ash. LUV, which makes up about 15% of FAA’s assets, was actually up about 1.5% during the recent slide in the ETF, meaning that the fund’s other components experienced even greater slides.

The financial impact of the recent flight blackout on the airline industry was both material and adverse, a development that will likely be reflected in second quarter earnings. But the idea that a a few days of canceled flights erased 5% of the airline industry’s value is irrational. The beating taken by FAA over the last five days seems to be a bit overdone, especially when given the momentum airlines were carrying before the recent stumble.

Reasons For Optimism

UAL Corp.’s United Airlines has been active in pursuing a merger partner in recent weeks, flirting aggressively with US Airways before pulling back to consider a tie-up with Continental. While a single merger wouldn’t solve all of the industry’s woes, it could signal a wave of consolidation that most analysts agree would be a positive development in an overcrowded space plagued by consistent excess capacity.

Beyond merger rumors, some airlines are showing concrete signs of improved finances. Delta recently announced a first quarter loss of $256 million, a significant improvement over the prior quarter. Perhaps more importantly, however, Delta said it expects to turn a profit in the second quarter. “It appears that the economy has pretty good legs under it now,” Delta chief executive Richard Anderson said during a conference call. The outlook for smaller airlines is positive as well. Alaska Air is expected to report a first quarter profit after both traffic and occupancy rose materially last month.

Long Term Risks, Short Term Opportunity

Volatility in fuel prices poses a threat to major airlines, a risk cited by Delta executives when explaining hesitance to project a full year profit. Given the significant and omnipresent risks to the airline industries–the volatility of fuel prices, persistent labor disputes, and dependence on business spending to name a few–it’s hard to recommend FAA as a long-term play or significant component of a retirement portfolio. But for bargain hunters looking for a good value and some short-term inefficiencies, the airline ETF presents an interesting option.

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Disclosure: No positions at time of writing.