Airline stock prices have plunged, and now may be the time to pick up some shares in the sector before signs of a U.S. and global economic recovery push prices up again.

Caution and careful evaluation are needed, however. Airlines are hurting not just because of the U.S. recession and slower growth elsewhere. They are also very negatively affected by continued high oil prices.

Normally, oil prices weaken when economic activity slows; this time around, however, they are remaining stubbornly high, forcing airlines to introduce or increase fuel-cost surcharges to recover some of their energy costs. But this policy tends to discourage people from taking trips that can be postponed, thereby further reducing the volume of passengers.

In this environment, global money managers tend to prefer discount airlines; such companies benefit as customers search for cheaper ways to get where they need to go. As well, discount airlines are generally not unionized, have young air fleets that are more fuel-efficient and usually fly only one kind of plane, which simplifies maintenance. (See Investment Executive’s May issue, page 48.)

There are, however, some regular airlines that managers and analysts say are worth considering. These include Air France-KLM SA, British Airways PLC and Singapore Airlines Ltd.

The greatest enthusiasm is for Singapore Airlines. Its quality of service allows it to charge premium prices and it is ideally located in the heart of Asia.

British Airways has moved into a new terminal at London Heathrow Airport, which is expected to yield cost savings despite a range of embarrassing problems that plagued the terminal’s spring opening. The airline is also increasing its premium travel capacity.

Air France-KLM’s failure to take over bankrupt Alitalia-Linee Aeree Italiane SpA is considered a plus — at least, in the short term.

Here’s a look in greater detail:

> Air France-KLM SA.Air France acquired KLM in 2004 and was able to take costs out of the merged entity, resulting in higher profitability. It was trying to do the same with a takeover of Alitalia, but the bid collapsed because of failure to reach agreements with Alitalia’s unions.

Acquiring Alitalia would have been a good strategy, as it would have provided access to the populous and affluent regions around Milan and Rome, which have the 22nd and 32nd highest gross domestic product per head in the European Union, according to a report by UBS Ltd. in London. However, UBS also feels the collapse of the Alitalia bid is positive for Air France-KLM’s stock in the short term because of the “significant increase in the complexity” of Air France-KLM should the deal have gone through.

In the meantime, the merger of Atlanta-based Delta Air Lines Inc. and Eagan, Minn.-based Northwest Airlines Corp. is a plus for Air France-KLM, which is confident that it can quickly build a global partnership with that newly merged company by “offering a network of extremely attractive, multiple hubs.”

Air France-KLM had been concerned that Delta or Northwest would join forces with an airline that would not have been open to an alliance; so worried that it had offered financial help to ensure that the Delta/Northwest merger occurred. The funds weren’t needed.

Air France-KLM has recently raised its fuel surcharges. The airline says that half of these increases will be withdrawn as soon as oil prices stabilize below US$100 a barrel and the other half when oil prices stabilize below US$95.

UBS has given Air France-KLM a “neutral” rating with a 12-month target share price of 19 euros. The shares closed at 20.24 euros a share on May 16, down from a high of 40 euros in June 2007. As of Dec. 31, 2007, the French government owned 16.7% of the 300.2 million common shares outstanding. The company is in the process of delisting its American depositary receipts.

A report from New York-based J.P. Morgan Securities Inc., which also rates the stock “neutral,” notes that Air France-KLM has 4.4 billion euros in cash and an excellent fuel-hedging program, with 75% of its costs hedged for the fiscal year ending March 31, 2009, and 55% of its costs hedged for fiscal 2010. “This should provide a buffer against high oil prices,” the report says.

Charles Burbeck, head of global equities at HSBC Halbis Partners in London, is not enthusiastic about Air France-KLM but says investors may be able to make money trading the stock, adding that the stock can be viewed as a defensive holding.

@page_break@Air France-KLM reported net income of 767 million euros in fiscal 2008, vs 887 million euros in fiscal 2007. Revenue was 24.1 billion euros vs 23.1 billion euros. Net debt was 6.9 billion euros as of Mar. 31.

> British Airways PLC. A UBS report has a “buy” on this stock, with a 12-month share price target of £3.90, up from the £2.23 a share at which the widely held shares closed on May 16. The stock had reached a high of £5.80 in February 2007. There are 1.2 billion shares outstanding; British Airways ADRs are being discontinued.

At current prices, the stock is trading at book value and has never been cheaper, says the UBS report. But the report notes that there’s a risk that British Airways could be in a loss position in the fiscal year ending March 31, 2009, if oil prices remain at recent levels. As a result, book value is the preferred valuation measure.

British Airways has hedges for 72% of fuel purchases from April through September, 60% for October through March 2009, and 30% in fiscal 2010. British Airways also has fuel surcharges in place.

In a surprise move, British Airways’ board of directors has proposed a £0.05 dividend for fiscal 2008; if approved at the July annual general meeting, this will be the first dividend issued by the company since July 2001. The airline also announced that staff will get a £35-million bonus. However, the company plans to reduce its capital investment over the next three years, as well as cut costs other than labour.

The UBS report notes the huge challenge for British Airways from Open Skies, the new aviation agreement between the U.S. and Europe. Since the end of March, Open Skies has allowed airlines to make flights that neither originate nor end in their home countries. For example, British Airways can now fly from Paris to New York without routing through Britain. The caveat is that the airline must buy landing rights, which are expensive and for which there may be more demand than supply.

But the UBS report assumes that the negative impact of Open Skies, in terms of competition at Heathrow, will be more than offset by the positive impact of improved quality of service at the airport’s Terminal 5, which opened at the end of March. British Airways is the sole occupant of Terminal 5 and is consolidating all its operations there.

There were a lot of problems when Terminal 5 opened, resulting in cancelled flights, baggage delays and a temporary suspension of check-ins. “It was a real mess, and one for which management must take accountability,” says Burbeck. He expects the bad publicity and the compensation that will have to be paid as a result of these problems to delay the cost efficiencies expected from the move to the new terminal by a period of six to nine months.

However, Burbeck believes, the problems will be sorted out; he notes that the new Hong Kong airport had similar issues when it opened in 1998, but that those were soon resolved.

Burbeck is not enthusiastic about British Airways’ stock, but considers it a reasonable defensive investment in the current economic environment.

A couple of other pluses for British Airways mentioned in the UBS report are the lack of runway capacity at Heathrow, which will limit the amount of new competition coming in, and the strong demand for long-haul premium travel, an area in which British Airways is increasing its capacity. The UBS report notes that when redevelopment of the rest of Heathrow starts, Terminal 5 should be the terminal of choice because it should escape disruptions.

A J.P. Morgan report is less enthusiastic, rating British Airways’ stock “neutral”; J.P. Morgan analysts have cut their earnings estimates for the airline for fiscal 2009 and 2010 three times and are “mistrustful” of even those numbers. Until earnings stabilize, the report “prefers to remain cautious.”

The J.P. Morgan report assumes US$110-a-barrel oil and warns that British Airways could lose money in one or both of the next two years if the price goes much higher. But, the report adds, “Of course, the rest of the industry would then be in far deeper trouble.”

British Airways reported net income of £694 million in fiscal 2008, vs £304 million in fiscal 2007. Revenue was £8.8 billion vs £8.5 billion. Net debt was £2.8 billion as of Mar. 31.

> Singapore Airlines Ltd. Burbeck favours this company and a report issued by UBS Securities Asia Ltd. in Hong Kong rates the stock a “buy” with a 12-month share price target of S$21. The common shares, of which there are 1.2 billion, closed at S$16.30 on May 16.

Burbeck, who expects at least 10% annual earnings growth in the next three years, considers Singapore Airlines a good defensive play in the current environment, noting that it has the best balance sheet in the industry globally, is the most conservatively financed and has the least amount of debt.

The UBS Asia report concurs: “Industry-leading margins, an extremely strong balance sheet and low asset-based valuations provide fundamental inves-tors with protection on the downside.”

The report notes a doubling of the dividend with the release of the results for the 2008 fiscal year ended March 31, and says the strength of the balance sheet “provides the board with ability to continue meaningful dividends despite the coming downturn.”

The report puts Singapore Airlines in UBS Asia’s “new Nifty 50, a list of companies that can take advantage of tough times to position for eventual rebound.” Specifically, this means the airline is likely to add to its market share “as weaker airlines are forced to curb growth plans and/or downsize in the more difficult market environment.”

The UBS Asia report notes that cargo results were particularly impressive in the fourth quarter, with the segment returning to profitability. In its view: “Regional cargo capacity rationalization looks to be improving pricing dynamics.”

Looking at the longer term, Burbeck believes Singapore Airlines has “enormous growth potential in the next 10 to 15 years. The company is ideally situated in the centre of Asia, making it a natural stopover location for both travel within Asia and journeys to Europe, the U.S. and Australia.”

Singapore Airlines has 49% stakes in both low-cost Tiger Airways, based in Singapore, and Britain-based Virgin Atlantic Airways Ltd. Singapore Airlines is also working at getting more exposure to China by investing in China-based airlines, although it didn’t succeed in its bid to buy a 24% stake in China Eastern Airlines in January. Singapore Airlines can fly to China, but not within China.

Singapore Airlines offers excellent service, for which it can charge more. Burbeck notes that the airline and Hong Kong-based Cathay Pacific Airways Ltd. “always do well in service surveys.”

Singapore Airlines is 54.5% owned by Temasek Holdings (Pte.) Ltd., which manages the Singapore government’s direct investments.

Normally, government ownership is a drawback, but in this case, says Burbeck, it has resulted in “very favourable tax treatment that allows the company to depreciate very aggressively purchases of aircraft and, thus, have one of the youngest aircraft fleets, with an average age of five years.”

Young fleets mean greater fuel efficiency. Burbeck notes that fuel efficiency will increase with the Airbus 308s — the new double-decker aircraft that can seat 700 passengers — that Singapore Airlines started using last October. The company is the first airline to use the A380s, providing novelty value; most airlines won’t have A380s for three to four years.

Singapore Airlines uses two brands, Singapore Airlines for long hauls and Silk Air for shorter flights. Although not a discount airline, Silk Air is low-cost.

Singapore Airlines reported net income of S$2.1 billion (C$1.5 billion) in fiscal 2008, down slightly from S$2.2 billion a year earlier. Revenue was S$16 billion vs S$14.5 billion. Long-term liabilities were S$1.6 billion as of Mar. 31. IE