United Continental: Set to fly?

by George Putnam, editor The Turnaround Letter

United Continental Holdings (UAL) is one of the largest passenger airlines in the world. It was formed by the merger of UAL (parent of United Airlines) and Continental Airlines in October 2010.

Like many airlines, both of the merger partners had previously been through bankruptcy. Continental had filed for Chapter 11 twice, in 1983 and again in 1990, and United filed in 2002.

The integration of the two airlines has proven more challenging than management expected. As a result, the stock is down more than 30% from the time of the merger, and it has lagged a number of the other airline stocks recently.

The major airline stocks remain out of favor with most investors despite solid results for several quarters. Perhaps it relates to bad memories of past bankruptcies and stock volatility. We like the airlines in general because most of them have used bankruptcy effectively to reduce their cost structures and improve their balance sheets.

Moreover, unlike past business cycles when the airlines expanded quickly and then were over-extended when the economy turned down, most airlines have been very disciplined in managing capacity in the last few years.

In addition, industry consolidation has improved profitability. Among the airlines, we particularly like United Continental right now because of its strong international route structure and the poor recent performance of its stock, which we view as temporary.

We don’t know exactly when the merger-related glitches will stop, but we suspect it will be pretty soon. Once this finally happens, passengers will come back to the airline, and the integration costs will go away. The impact of Hurricane Sandy is already in the rear view mirror.

Longer-term, we believe United Continental is well positioned. The United side has long dominated the lucrative Asian routes, and Continental provides good coverage in areas of the U.S. where United was weaker.

Once the integration problems are solved, the combined airline should be able to generate significant efficiencies and cost-savings.

Because of investor wariness about the industry in general and short-term concerns about United Continental in particular, the stock is trading at quite a low valuation – about ten times this year’s expected earnings and perhaps as low as five times next year’s.

As the airlines in general begin to show more consistent results, investors will give the group higher multiples, and as UAL’s integration issues recede, its stock should rise even further. We recommend buying United Continental stock up to 27.

Learn more about this financial newsletter at George Putnam's The Turnaround Letter.

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