Trouble on the horizon for U.S. airlines

By Chris Reiter and Kyle Peterson

NEW YORK/CHICAGO (Reuters) - A slowing U.S. economy and soaring oil prices could cripple the U.S. airline industry's fledgling recovery and push carriers into seeking merger partners.

For the last year and a half, major carriers like AMR Corp's (AMR.N: Quote, Profile, Research, Stock Buzz) American Airlines and Continental Airlines Inc (CAL.N: Quote, Profile, Research, Stock Buzz) have been clawing back some of the $35 billion in losses racked up during the industry's long slump following the September 11, 2001, attacks.

Despite the recent turnaround, the industry remains fragile, and losses could return if the airlines are unable to pass on higher oil prices to their customers.

"If you can't make lots of money when your planes are loaded, then you're in deep dog poo when things turn against you," said Richard Gritta, a finance professor at the University of Portland, Oregon, who studies the airline industry.

Even with packed planes, the U.S. airline industry eked out a profit margin of about 1.9 percent in 2006, according to data from the Air Transport Association.

Mergers are seen by many industry experts as the answer to the boom-and-bust cycle that has plagued U.S. carriers for decades.

While deals -- which face formidable obstacles such as potential antitrust issues and labor opposition -- have been rare, that could change.

Airline managers are under mounting pressures from disgruntled shareholders to boost value by selling off assets or merging.

Another downturn could force executives to act and lead to the first deal in the industry since US Airways and America West merged to create US Airways Group Inc (LCC.N: Quote, Profile, Research, Stock Buzz) in 2005.

"A couple of bad quarters would test the patience of stockholders," said Joe Schwieterman, transportation expert at DePaul University in Chicago. "It could force an airline to make a move."

WALL STREET WORRIES

Since hitting a three-year high in January, the Amex airline index .XAL has fallen about 40 percent, hovering at its lowest levels since April 2003. And some believe further weakness is in store.

"Despite the recent weakness in airline equities, we think the risk/reward is still not compelling," said Goldman Sachs analyst Robert Barry in a note.

"Our primary concern remains the degree to which carriers will be able to pass on rising fuel prices in the face of a slowing US macro environment," he said.

On November 27, Goldman Sachs cut its view on the sector to "cautious" from "neutral."  Continued...