Where do we fly from here? We do not expect a broad-based cyclical recovery in 2009 but expect to see a muted recovery from a lower base in 2010. A more protracted downturn is likely as the market continues to adjust to excess capacity, falling premium traffic, threats posed by low-cost carriers (LCC) and the risk of lower traffic resulting from the Influenza A epidemic.

We do not expect operating margins to recover to pre-crisis levels of 10-13% any time soon and that 5-6% margins will be the norm for the next 2-3 years for full service carriers (FSC) such as Singapore Airlines (SIA) and Cathay Pacific Airways (CX). We remain UNDERWEIGHT on the sector and are sellers of all airline stocks featured in the report, except for Air China.

Air China is a BUY and the top pick in the sector. Among FSCs featured in this report, it will be the only one to show top-line growth, given its strong domestic passenger traffic growth (+18.6% ytd). It also has the largest potential for cost savings as domestic fuel prices have declined 50-60% from 2008 levels. The impact on its bottom line will thus be amplified by two factors: higher traffic growth and a simultaneous estimated 10% fall in unit cost for 2009. We also like Air China for its exposure to Beijing Capital International Airport, which is ranked second in the world in terms of passenger traffic throughput.

We are sellers of SIA and CX and now AirAsia. SIA's continued weak traffic numbers in the face of a slight uplift for international peers is our primary reason for maintaining our SELL call. For CX, we are sellers due to its lack of a consistent pattern in traffic growth, high EV/EBITDA valuation and high gearing. Air Asia is a SELL due to its relatively high valuation premium vis-a-vis LCC peers and weak 1Q09 load factors. PE valuations appear low, but this is due to deferred tax write-backs.

Yields could surprise on the downside. In April, American carriers reported a 21.9% decline in yields for the Atlantic region and an 18.0% decline in the Pacific region even as traffic declined just 1.4%. The real story for 2009 is the extent to which yields fall and we sense that deflationary pressure from weak ticket prices remains high in Asia. AirAsia, for example, has stated that ticket prices are likely to fall in 2H09. We believe the market is thus far focusing primarily on actual traffic numbers partly because Asian carriers do not report monthly yields.The impact will be greatest on FSCs that operate out of financial hubs, ie SIA and CX.

Fuel not a major concern at the moment. Both CX and Air China had hedged 40-60% of FY09 fuel requirements as at end-Dec 08, while SIA had hedged 25% as at end-Mar 09. Additional hedges since then would have lowered their effective averages for 2009 and 2010. Ongoing fuel surcharge revisions will defray costs so long as fuel prices do not rise sharply. AirAsia, however, remains exposed to spot prices.

Capacity to expand in 2H09. According to aviation data provider Ascend, fleet strength is expected to remain constant in 2009. What this means is that the previous capacity cuts and retirement ytd will be negated by forward deliveries. Thus, unless traffic growth picks up sharply, further capacity cuts will be required.

We are UNDERWEIGHT on MROs. A leading indicator of a turnaround in the MRO business is when airlines utilise grounded aircraft or increase flight frequencies. That has not happened in either the Asia Pacific or North America. The rate of aircraft parked in the desert has simply slowed down. Even if traffic patterns improve, newer-generation aircraft require less frequent checks and these can be performed progressively, thus cutting manhour billing for airlines and conversely lowering revenue for MRO players. Overhaul and Maintenance magazine has projected industry-wide growth of just 1.4% in 2009.