Even without a runway, airlines set for take-off

BAA’s Sir Nigel Rudd grabbed headlines last week by denouncing the ban on a third runway at Heathrow, claiming it would make the facility a “second-tier airport”. His comments followed an update from the International Air Transport Association (IATA) that forecast a likely 2010 profit of $8.9bn for the global aviation industry – excepting Europe, which is still expected to be in the red.

On the surface, the news suggests bleak prospects for UK airlines. But in fact, contracts for difference (CFD) traders could stand to gain from going long on airline equities in the coming months. Brokers remain almost uniformly positive about the industry and, for many, British Airways (BA) tops the list of favourites.

For one thing, the IATA headline findings disguise what is actually an impressive recovery – in Europe and elsewhere. RBS’s Andrew Lobbenberg says: “IATA emphasizes the weaker European economies, but the key issue is the volcano. Without that, the European industry would be in profit.”

This recovery is driven mostly by yield improvements, in part due to airlines deciding not to add capacity during a period of sluggish growth. But high-margin premium sales (that is, sales of all non-economy seats) have also proved more resilient than expected, such that IATA predicts that revenues will be only $4bn below those achieved during the peak of 2008.

So airlines should be in a good position to capitalise on higher demand until the end of 2010. With September passenger figures due in early October, CFD traders should keep a keen eye out for any surprises. Most brokers favour BA due to its impending merger with Iberia (IB). Iberia’s balance sheet will help as BA tries to plug the huge hole in its pensions fund, while IB’s South American routes add coverage to an area where BA is currently limited.

And despite the markets pricing in some of the good news, analysts at Goldman Sachs say BA and Iberia both still look cheap: “The reason for this is that the extent of change afforded by the two corporate tie-ups has yet to be absorbed and quantified by the market due to the lack of related disclosure from the companies,” they write.

Moreover, the lack of a new runway at Heathrow has a perverse effect on valuations. While it will stymie BA’s ability to grow in its central hub, the airline will instead be able to expand in Madrid through its merger. And as for smaller airlines like British Midlands, Lobbenberg points out: “The prime value of that business is in its slot portfolio. If you created another runway you’d ruin that value.” UBS analysts are similarly hopefully for the industry, recommending a “buy” on almost every major European carrier – except easyJet. With the firm still embroiled in a row over its brand and punctuality failings with easyGroup owner Sir Stelios, its outlook remains highly uncertain.

And over the long-term, the same is true of BAA. Although it still has growth potential on the horizon in the form of terminal improvements, it is unclear how much further the company can expand without a third runway, having been forced to sell off other major assets like Gatwick to rival Global Infrastructure Partners (GIP).

But while CFD traders should stand to make solid gains in the European airline space, the strong recovery this year will not necessarily follow through to 2011 as growth slows further. After a long trade over the next quarter, it might then be time to sell.