United Continental Holdings, Inc. (NYSE:UAL)

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Player Avatar PAQuaker (< 20) Submitted: 6/10/2010 12:53:32 PM : Outperform Start Price: $21.86 UAL Score: +40.94

Today’s Airline Economics: It’s the Intersection that MattersRecommendations:Strong Buy: USAirways, United Airlines (UAL)Buy: Continental Airlines (CAL), Delta Airlines (DAL)Hold: American Airlines (AA)America’s bankruptcy courts are littered with the corpses of business men and women who thought they could make money in the airline industry. Ah…high fixed costs, low marginal costs, capital intensive, perishable inventory, commodity product, government regulation, unionized environment, and terrorists love the attention the airline industry brings. And I didn’t even mention oil price volatility. I mean, from an investor’s point of view, what’s not to love? Even Warren Buffet has sworn off airlines.While I wouldn’t be foolish enough to encourage long-term investing in the airline industry, at least on the equity side, now may be a good time to look at airline stocks if you are seeking some sizeable returns, albeit for a relatively short time period of 6-12 months.Airlines in 2010 and 2011You can’t forecast 2010 without looking at both 2008 and 2009. Because oil went crazy in 2008 and yield plummeted in 2009, it’s best to actually look at revenue from 2008 and expenses from 2009, without including fuel hedge gains or losses. When you combine the two years, you can see that 2010 should be a fairly healthy year for the airlines. While fuel expense will be higher in 2010 vs. 2009, Passenger Revenue per Available Seat Mile (PRASM – or airline revenue divided by seat supply) will be higher in 2010 vs. 2008. In the first quarter, PRASM was up between 10-20%, depending on which airline you examine. April PRASM improvement, year-over-year, was even better, as much as 13% higher at USAirways and 23% higher at United. While this improvement may seem unrealistically high, the bottom of the PRASM trough in 2009 was in May/June, so I expect 2nd Q PRASM improvement to exceed April, by an average of 3-7%. While forecasting a 28% (the highest among the airlines) PRASM improvement for UAL may seem a bit aggressive, the PRASM drop off in the 2nd quarter of 2009 was just as aggressive. PRASM in 2010 is simply 4-7% higher than 2008, to help keep perspective. If we assume capacity discipline will continue (a pipe dream for some), I expect PRASM to improve a further 2-5% in 2011 vs. 2010 given modest GDP growth.* This PRASM growth will be determined by capacity growth vs. GDP growth. I expect PRASM growth to meet or exceed expected increases in non-fuel expenses, driven mainly from wage increases at UAL, CAL, USAirways, and possibly AA. This should improve operating margins. *6/5/10 Update: US job report released June 4th was weak, which is actually a good sign for 2011. If the major airlines have been able to generate significant increases in PRASM with a weak jobs report, I suspect 2011 will be an even better year, improving PRASM an additional 2-4% from previous forecast to 4-9%.If any single airline talks about growing capacity in excess of 3-4%, watch out! That creaking you hear is the breakdown of profitable yield curves. When you put it all together you get some very interesting numbers: *EstimateWhile airline stocks performed extremely well over the past year, some airline stocks still have room to grow. USAirways, UAL, and, to some extent, CAL are trading at bargain prices. Risk of a liquidity squeeze has dissipated as airlines are carrying healthy cash balances and have learned a few lessons in fuel hedging. Recent legislation should also help damper the oil price elevator of 2008. Net Operating Losses should carry forward for the next 2-3 years as well. With low single digit P/E ratios for forecast 2010 earnings (and this does not even factor in an assumed improved 2011), airlines (UAL and USAirways) may be a steal, at least looking at the next 6-12 months. While DAL may have more downside risk since it is already priced near 8x 2010 projected earnings, cost synergies and improved yields should boost the stock modestly. USAirways may provide the highest upside potential with its low P/E ratio and the possibility it still may merge, although at this point, a merger with troubled American Airlines may create more short-term problems than solutions. Of all the major airlines, American is the only one that should not be profitable in 2010. This leads me to believe American may be staring at a significant restructuring in the next few years. A successful restructuring is not only important for AA but for the entire industry. A weakened major carrier, in a liquidity squeeze and facing bankruptcy (at least with our current laws), will inject downward pricing pressure, hurting everyone’s interest. (The public’s interest is not served with airlines passing through the bankruptcy revolving door every decade.) With most airlines carrying healthy cash balances and expecting improved cash flows, 2010 and 2011 should bring retirement of debt (improved credit ratings, lower borrowing costs, and improved bottom lines) along with a return of cash to shareholders. It’s important to understand the importance of oil prices since airlines cannot make significant capacity changes quickly. Oil at $150/barrel and everyone is looking at a liquidity squeeze. Oil at $40/barrel and everyone’s a winner! (For further discussion on oil prices and profitability, read below.)USAirways (Strong Buy) – This airline has the greatest potential upside (significant PRASM improvement) matched with some real fuel price risk. Expected yields and cash on hand should prevent any liquidity squeeze. It still has open labor contracts which actually help keep wages low, but the day of reckoning will eventually arrive – a merger with AA may drastically increase wages. If a merger with AA does not happen, it may have to develop a creative merger strategy. The likelihood of USAirways remaining “single” over the next decade is not high. I forecast a stock price in the $15-$20 range by January 2011. No hedge position – get ready to ride the roller coaster, although right now its fuel position is riding high with oil near $70/barrel.UAL (Strong Buy) – Business traffic coming back should boost PRASM, while cost synergies with CAL should eventually cut operating costs by approximately $1B annually…at least that’s the plan. Much of the ground work for the merger has already been accomplished with steps taken for CAL’s inclusion into the STAR Alliance (i.e. IT platform and gate relocation), so I expect lower merger costs than what Delta faced, assuming management deftly combines the two distinct cultures. (A big IF!) Merger cost savings should help negate expected wage increases. While the merger with CAL will create the best domestic route structure and global alliance, be careful about believing all the talk about revenue synergies. If all the airlines merge into three carriers, they can’t all generate revenue gains in a zero-sum-gain situation. If the stock trades at 8x expected 2010 net income (i.e. Delta), it should trade above $36 (Fully diluted). Successful merger cost savings should drive the stock eventually over $50 by fall 2011. Fuel hedge position is better than average, although slightly above current market prices. An eventual approval nod from the Justice Department will provide a nice short-term bump for the stock.CAL (Buy, risk of merger cancellation hurts rating) – The stock is trading below where it should and it should rise and fall with UAL. Delta is looking to take over New York, and with AA not lying down, CAL can expect a real fight with Delta and AA, although the battle will probably focus more on service (Whew!), rather than pure pricing, for those returning business travelers. Fuel hedge position is slightly below average. Merger with UAL will help Newark hub.DAL (Buy) – With the full integration almost complete, Delta has generated impressive cost savings. Individual wages are slightly higher than the other majors (merger synergies have hidden this), but expect these labor costs to improve vs. industry as other open contracts are finalized. PRASM is recovering nicely. The only issue is that the stock is already trading near 8x expected 2010 earnings, so I wouldn’t expect a huge run. DAL is highly leveraged with significant near-term maturities [$11.6B through the end of 2014, compared to $4.4B(UAL), $7.4B(AA), $3.2B(USAirways)]. Delta should generate significant cash flow in 2010 and 2011 to pay down this debt level, improving its credit rating and lowering interest payments. DAL’s Enterprise Value is already 40% greater than a combined UAL/CAL. The already high market cap and relative enterprise value could pressure this stock from generating any significant returns. Fuel hedge position is better than average. Future wages advantage vs. new industry labor contracts along with good merger management may bump up stock 20% by the end of the year. I expect unit labor expenses to be lower than at the new UAL.AA (Hold) – AA has some real issues – it should be the only major airline not to earn a profit in 2010. It avoided bankruptcy (to its credit) but in avoiding bankruptcy it was unable to dump some legacy costs other airlines were able to cut. Wages are significantly higher at AA on a unit cost basis and there will be some tough negotiating. There is a chance AA will have labor problems this summer which may temporarily spill revenue to other airlines. (Flight Attendants are poised to strike, but until they walk, it’s all talk. Pilots are not happy either.) I wouldn’t be surprised to see the underfunded defined benefit pensions frozen and exchanged for improved defined contribution pensions. Anyone in the industry relying on a defined benefit

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