A report from The New York Times on Wednesday that United Airlines and U.S. Airways were in merger talks set off a flurry of trading of both stocksMerger rumors fueled a rally in airline stocks on Thursday as the market seems to be sending a message that fewer airlines would be better for the industry's long-term future.

A report from The New York Times on Wednesday that United Airlines (UAUA) and US Airways (LCC) were in merger talks set off a flurry of trading of both stocks, lifting United 6.75% to $20.23 and U.S. Air 10.70% to $7.55 at the close on Thursday.

Although neither airline confirmed the rumors, shares of other major carriers also surged: American Airlines' parent company, AMR (AMR), jumped 2.11% to $8.73; Delta (DAL) was up 4.52% to $14.81; Continental Airlines (CAL) rose 3.56% to $21.23; JetBlue Airways (JBLU) gained 2.09% to $5.85; Southwest Airlines (LUV) was up 0.75% to 13.40; and AirTran (AAI) shares lifted 3.85% to $5.39.

Consolidation Is the Next Logical Step


Just the hint of more consolidation in the overcrowded airline industry, with its high operations costs and notoriously low profit margins, was enough for traders to pounce at the opportunity to get ahead of a move they hope will lead to higher airfares and lower overall operating costs industrywide.

Experts believe consolidation is good for an industry whose growth has suffered double-digit percentage losses the last two years. The last merger of major airlines was Delta and Northwest in April 2008, which created the nation's largest carrier.

"Any merger, combined with the Delta-Northwest DAL consolidation and the judicious capacity decisions made during the last recession, suggests that the airline industry could be en route to earning its cost of capital, as the removal of redundant overhead costs and overlapping routes should translate into better financial performance," Morningstar analyst Basili Alukos says in a note to investors.

After all of the flight-cutbacks, internal restructuring and cost-cutting airlines have engaged in just to survive the recession, consolidation is viewed as a next logical step. Analysts project that a merger of United and US Air would create a carrier on par with Delta in size, but with potentially a larger share of the U.S. market and a smaller international footprint than its rival.

Saving on Fuel and Labor Costs

In a research note, JP Morgan approved of the merger as a way to continue reducing the number of flights in several markets.

"We continue to believe that duplicative networks -- rather than end-to-end combinations -- offer the greatest potential for reduced capacity," the note reads.

Toon van Beeck, senior analyst at IBISWorld, also approves of the United-US Air pairing, noting that the merger would allow the companies to save on fuel and labor costs, the two largest expenditures that eat away at airline earnings. While he acknowledges there may be high merger costs and job losses, van Beeck says the two airlines may be able to integrate their operations better than they could with Continental, because they use a similar cost structure to pay their pilots.

Morningstar's Alukos and other analysts have suggested that Continental might make a better merger partner in recent weeks. But just the fact that merger talks are alive in the industry is a sign that airline stock prices may be headed higher.

Stronger Growth Ahead?


"It's a good thing that these airlines are looking at every opportunity for profitability because 2010 may prove to be one of the most crucial years in the history of the airline industry," warns van Beeck. After horrible years in 2008 and 2009, and with 2010 likely to be a down year as well, van Beeck says airlines must begin positioning themselves for the turnaround that has begun in travel as tourism is predicted to take an upswing in 2011 and beyond.

He predicts the international and domestic airline industry will grow by 7% in 2011 and enjoy strong growth in 2012 and 2013 as well. If companies use the right hedging strategies against the price of oil, the revenue growth should lift their stock prices long term. Judging from the trading activity, others on Wall Street agree.

"It's just a matter of whether these companies can manage their expenses," says van Beeck. "The bottom line is, can these airline companies manage a profit? If they can, then it's justifiable that their stock prices grow. If they cannot, then there's obvious reason for them filing for Chapter 11."

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