Airlines will benefit if economy picks up

Investor: The recently reported financial results from Aer Lingus confirmed that the airline has transformed itself into a profitable enterprise. Management has made great strides in reducing the cost base and increasing revenues through the adoption of a low-fares strategy.

There is still scope for Aer Lingus to further cut costs across its operations. For example, it is aiming to sharply increase the proportion of bookings made over the internet - which, if successful, could knock another €40 million off its cost base.

The company has effectively moved towards the low-cost model pioneered by Ryanair in Europe, although Aer Lingus is not planning to completely mimic Ryanair. In particular, Aer Lingus intends to continue to fly into mainstream airports where it already holds valuable slots. Also, unlike Ryanair, it intends to continue to offer customers some frills across most of its services.

If the business model adopted by Aer Lingus shows itself to be sustainable, then it can only be a matter of time before the issue of privatisation is revisited.

Investors in Ryanair shares have had a very good experience, as strong and sustained growth in revenue and profits fed through to a rising share price. Indeed, Ryanair is one of the very few quoted airline stocks to succeed in delivering a sustained rise in shareholder value.

In the United States, Southwest Airlines is the original low-cost airline and it has been able to remain profitable even through the past few difficult years. In contrast, most other US carriers have rarely managed to deliver an adequate return to their respective shareholders.

In Europe, the airline industry has also been singularly inept at developing profitable business models.

The situation in Europe has, historically, been complicated by the fact that most airlines were state-owned companies. This meant that the industry was characterised by national flag-carriers that charged high airfares in order to support bloated cost bases riven with inefficiencies.

A gradual process of privatisation and a more "open-skies" regulatory regime has now changed the landscape. This has led to a much greater focus on improving efficiency and delivering a better value service to customers. Nevertheless, large quoted European airlines such as British Airways and Lufthansa have found it very difficult to produce an adequate level of profitability.

This is reflected in generally depressed share prices amongst the incumbent European airlines. As can be seen from the accompanying table, British Airways now has a market capitalisation of 2.6 billion, which is substantially less than Ryanair's market capitalisation of 4.6 billion.

Germany's national flag carrier, Lufthansa, has a market capitalisation of 4.2 billion, which is also lower than Ryanair's albeit by a narrow margin.

EasyJet, which is Ryanair's main competitor in the low-cost market, is significantly smaller as measured by market capitalisation. EasyJet adopts a model somewhat different to that of Ryanair in that it concentrates on mainstream airports and also targets the cost-conscious business traveller.

Only those private investors with well-diversified portfolios are likely to consider investing in airline stocks.

It is not an attractive sector as measured by the historical volatility of share prices and the generally poor levels of long-term profitability generated by the industry. Southwest Airlines in the US and Ryanair in Europe are the exceptions to the rule.

There are, however, some reasons to be hopeful of a somewhat better share price performance from the sector on a short- to medium-term view.

Since the end of the Iraq war and the SARS crisis, air travel has been steadily recovering throughout the world.

Recent figures from the British Airports Authority (BAA) indicate that July was the second-busiest month on record for its seven UK airports. A total of 13.2 million passengers used the airports, which was a rise of 2.2 per cent compared with July of last year. In the absence of the British Airways (BA) strike, BAA estimates that traffic would have increased by 3 per cent.

European scheduled traffic rose by 6.9 per cent and, despite a setback from the BA strike, long-haul routes showed signs of continued improvement. Stansted was the star performer with a rise of 11.3 per cent in passenger numbers. This is of particular relevance to Ryanair, as Stansted is now one of its most important bases.

If a global economic recovery does indeed gain traction over the next six to 12 months, it is almost certain that there will be growth in the demand for air travel. Airline stocks are particularly sensitive to the economic cycle and, therefore, if the overall economy improves, it is highly likely that the share prices of most airline stocks will also improve.