Investment: Should you invest in... air travel?

THE CHOICE for the UK investor looking for involvement in the air travel sector is limited. "From the UK major capitalisation point of view, there are only really two stocks, British Airports (BAA) and British Airways (BA)," says Jon Thornton of Aberdeen Asset Management.

"There are some plays on the regional airports, where bus companies have taken an interest, but you are mainly dealing with small cap stocks."

The airline side of the business is being affected by of factors which reduce the airlines' income at the same time their costs are rising. Hak Salih of Hill Samuel Asset Management says: "The industry is being squeezed."

The problem is overcapacity, particularly on transatlantic routes, a significant part of BA's business. Geoff Miller, head of research at Brewin Dolphin Securities, says: "You have to be very careful of airline companies. They are very cyclical and they have to get their strategy right. Internationally, airlines have a history of not getting their strategy right and those that don't are not there any more.

"They are traditionally an area where investors have had their fingers burnt and, at the moment, they will look at the way airfares are going and avoid the sector completely, because they assume you can't make any money flying people to Ireland at pounds 40 a time."

Investors have a choice between companies which actually fly people from place to place and those which provide services to them before take- off and and after landing. Jon Thornton says: "We favour BAA over British Airways. The issues for us as investors, as far as airlines are concerned, are the continuing overcapacity on major routes, increasing competition and the cutback on business fares as the world economy has slowed, and more of a concentration on cheaper fares. All these things have put pressure on British Airways."

Hak Salih says: "British Airways is a very hard stock to play. It did have a rally in the early part of the year when the market was playing the cyclicals but more recently the market has had a `reality check'. BA's figures were disappointing and the share price came off 10 per cent afterwards."

Jon Thornton adds: "BA is also affected by the valuation of airlines overseas. The US airline sector is out of favour and that will affect sentiment. At some point, British Airways will probably look attractive but not yet : the safer play for investors is definitely BAA."

But Hak Salih believes British Airways is healthier shape than most of its competitors internationally. "BA had the foresight to announce it will be maintaining its capacity at current levels this year and cutting it next year and this is the only major airline to have done this. Competitors, including KLM and Lufthansa, are still saying they are going to be increasing capacity. The company has also been continuing its cost-cutting programme, which will have taken pounds 1bn out of its cost base by financial year 200. But this will not necessarily show through in its figures because its income stream will be depressed".

Geoff Miller says: "BA has had its problems, but it's getting to grips with them by focusing on the business travel market. It doesn't matter which niche you choose, as long as you are focused on what customers actually want and can deliver it to them. With business customers, you have to have a very efficient service, with things like frequent-flyer programmes, to make sure they fly with you next time. This is the route that BA has chosen. Within the economy sector, Virgin is still doing pretty well by focusing on economy travel to Europe and the Far East, making money by giving its customers a decent service. If you are not so focused, as KLM has found, you will struggle".

Jon Thornton says: "We think it is a little early to get enthusiastic over British Airways. Its earnings are pedestrian and we prefer the safer earnings stream of BAA, where the share price has also suffered, we think somewhat unjustly. BAA will reap the benefits of increasing competition between the airlines and of increasing passenger volumes. It picks up revenues in a number of ways. There are landing charges, of course but there is also the retail angle and it is, in a small way, a property play because it has a lot of land available."

Geoff Miller says: "Airport companies are far more interesting for investors and they will benefit from growing passenger numbers as a result of the airlines' activities and their own efforts. For example, BAA already has some very good figures and a well-respected management and can clearly expect greater future growth from Stansted. But it is also trying to attract more passengers to Heathrow by, for example, introducing check-in facilities at Paddington rail station, which is a very exciting development."

The retail element is the key. As international shopping malls Heathrow and Gatwick are the jewels in BAA's crown. Jon Thornton says: "Any increase in passenger volumes will obviously benefit the retail side. BAA will benefit from any pick up in general travel and is a relatively defensive way for investors to play the airline sector. Nor is it an expensive one, following a year's underperformance".

One cloud on the horizon of the retail-orientated airport business is the ending of duty-free concessions, but Jon Thornton feels this has already been accounted for. "Most of the investment community accept duty-free will go and we think the abolition and the potential effects of regulation are reflected in BAA's price".

And what about the other regional airports? Hak Salih suggests there is potential, but via a more earthbound form of transport. "Regional airports are getting much greater growth in passenger numbers than Heathrow or Gatwick, but the way to play them is via the bus groups. For example, FirstGroup owns 51 per cent of Bristol, Stagecoach owns Prestwick outright and National Express has East Midlands and Bournemouth airports. There is also another quoted airport operator, TBI, which has announced take- over of an international operator which will give it interests in airports around the world."

Geoff Miller says: "There are two other companies worth looking at. One is TBI, which sold its property development side and did a deal in the US which will turn it into a pure airport operator. It is a small company that could do very well, and an interesting play for investors who want to take a bit of a risk."

Mr Miller's second suggestion focuses on the likely future of services that integrate several forms of transport. "FirstGroup, has airport interests I believe the management is keen to increase. There are interesting opportunities in providing integrated transport services to airports and FirstGroup has already been named as preferred provider for the Edinburgh Airport link. It has Bristol International Airport and I am sure it is looking to develop its airport interests further, because a lot of local airports are going to be privatised over the next few years."