“It’s really about the premium business traffic. It’s linked to the strength of the corporate sector, and the pick-up in world trade growth, which is continuing,” said Richard Batty, strategist at Standard Life Investments in Edinburgh

Investors have started to buy back into European airlines in anticipation of a period of top-line growth, as business travel picks up and with more of the gains seen going to the bottom line. More profitable business travel is rising again, as economies emerge from recession, after a period when companies were cutting back on spending.

— Rise in business traffic improves sector sentiment
— Outperformance of sector’s shares expected to continue
— Winter freeze disruption not regarded as significant

Air France-KLM, for example, is set to see revenue rise to 27.2 billion euros for the year to March 2012, up 11 percent on the year to March 2010, according to Credit Suisse estimates, largely driven by a rise in premium traffic. Analysts say airlines’ costs will not rise as much as turnover because revenue per unit of traffic tends to be higher for business travel, even with budget airlines. Overall passenger traffic for most airlines in recent months is up on a year ago, reversing a trend earlier in the year, according to the airlines’ own figures, and on average more seats are being filled, thereby boosting operating margins, analysts say.

The International Air Transport Association (IATA) said earlier this month that the number of passengers travelling in premium seats – first and business class – was 10.9 percent higher in October than a year earlier. It also said the world’s airlines will return to profit this year and next at higher levels than previously expected, due to an upturn in the market and better capacity usage. “The airlines did a good job on restructuring (through the downturn)”, said Stephen Furlong, analyst at Davy Research, who has an “outperform” rating on the sector.

STOCK PICKS Amongst individual stock picks British Airways is still seen as having potential for further price gains next year despite the shares having gained 25 percent in the past six months, according to some analysts. “We favour British Airways,” said Richard Batty at Standard Life.

Perceptions of the company have changed dramatically since it posted a record loss of 541 million pounds for the year to March 2010, hurt by the recession and industrial disputes. The impact of cabin crew strikes has not been as severe as some had feared, say analysts, who also see benefits coming from the forthcoming merger with Iberia, which will create International Airlines Group, and a newly-approved transatlantic alliance with AMR Corp’s American Airlines.

The Iberia merger alone is expected to yield about 400 million euros of synergies and analysts predict combined revenue will grow to around $22 billion in 2012 from about $18 billion in 2010. The pick-up in the market, especially for premium traffic, means that analysts are now forecasting BA will return to making a profit, in the current year to March 2011, and with the combined IAG making a profit of about 1.2 billion euros in the following year, according to Credit Suisse, when its forecast price-earnings ratio falls to about 8. This compares with a forecast earnings multiple of 10.7 in 2012 for the STOXX 600 European Travel & Leisure index, according to Thomson Reuters Datastream.

Analysts also see Air France-KLM and Deutsche Lufthansa continuing to outperform the broader European share market. Air France is likely to follow a similar pattern to BA, albeit with a slightly delayed recovery. It may struggle to break even in 2011, but is expected to bounce back in 2012, putting its price/earnings ratio back into single digits.

Credit Suisse recently upgraded both Air France and Lufthansa to “outperform”, with BA/Iberia its top pick in the sector, already on that rating. “Earnings recovery should remain a key theme for all flag carriers in 2011,” Credit Suisse said in a note, forecasting further growth in premium demand.

Even budget airline easyJet is expected to benefit from a pick-up in business travel with revenue set to rise 20 pct over the next two years and earnings per share to double. EasyJet’s forecast price/earnings multiple falls from 9.6 for 2011 to 8.2 for 2012, according to Datastream.

Rival budget airline Ryanair is also another stock liked by Standard Life’s Batty. A recent decision to return 500 million euros in cash to shareholders instead of buying more planes was applauded by some analysts, despite the implications for growth prospects in the longer term, and the carrier is seen continuing in its relentless drive to further cut costs.

Airlines still face challenges, not least with fuel prices which account for between 25 and 40 percent of a carrier’s total costs and with oil prices hitting $90 a barrel in recent days the ratio has been at the upper end of the range.

But while recent forecasts suggest oil prices may go higher analysts say if this is linked to economic growth, rises in fares and traffic will more than compensate and any surprise moves in the oil price are being managed by airlines hedging their requirements.

“If the oil price is higher that will be reflected in the fares as well,” said Gert Zonneveld, analyst at Panmure Gordon. The impact of the cold weather in recent days is also seen as a short-term, “one-off event” and should not affect investment ratings, said Tony Shepard, analyst at Charles Stanley. Analyst have compared the disruption to that caused by the volcanic ash cloud earlier this year, which hit market sentiment in the short term, but had no lasting impact.

Which leaves the outlook for economic recovery as the most important factor in determining whether airline stocks will continue to outperform the overall market. “Airlines have had better than expected growth levels and this is clearly a positive,” said Philippe Gijsels, head of research at BNP Paribas Fortis Global Markets.