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The Tailwind Behind Continental

By Jim Corridore While airlines and their stocks have been poor performers over the past few years, we at Standard & Poor's Equity Research Services think signs of an improving financial picture are starting to emerge for at least one carrier: Continental Airlines (CAL

; recent price, $13). We believe that recently ratified cuts in labor costs by most of Continental's unions, along with signs of industry unit-revenue improvement, should allow the airline to reduce its operating loss this year. Plus, we think it will return to profitability in 2006.

We don't think the stock's valuation fairly reflects the potential yield improvement and return to profitability that we foresee. Based on this view, as well as our relative-valuation analysis showing Continental trading at a discount to historical levels in times of airline profitability, we have a 5 STARS (strong buy) recommendation on the shares. If oil prices decline significantly, we think Continental -- and airline stocks in general -- will likely see significant appreciation.

On Mar. 31, Continental announced that unions for pilots, mechanics, and dispatchers had ratified new contracts, while its flight attendants' union had voted down a proposed new contract. Along with labor cost-cutting among executives and nonunion personnel, Continental projects savings of $418 million annually, vs. the $500 million it was reportedly seeking. It expects to re-engage its flight attendants' union, and we see a likelihood that it will be successful in getting the union to agree to cost-cutting.

WEIGHTY DEBT. The U.S. airline industry has been in a severe downturn for more than four years, and the major carriers have racked up billions of dollars in losses over that time. At first, much of this downturn, was related to poor demand for air travel after the 9/11 terrorist attacks. Since that time, however, industry overcapacity, the growth of aggressive low-cost carriers, and sharp fuel-price increases have all helped cause ongoing losses.

Furthermore, many carriers are carrying increased debt burdens, necessitated by cash losses, that have raised interest expense and constrained their abilities to fund future growth. At the same time, large underfunded pension plans have compelled carriers to divert important cash resources to keep retirement funding above legal limits.

We expect industry conditions to improve slightly in 2005. Historically, the best time to invest in airline stocks has been when the industry is coming off a cyclical low point. (We note, however, that past performance is not necessarily a guide to future results.) High oil prices have continued to hurt airlines, including Continental. But we see some signs that the industry may have bottomed and that the revenue and earnings outlook for Continental is improving.

MORE LIFT FROM FARES? Continental is the sixth-largest airline in the U.S. as measured by revenue passenger miles (RPMs, a measure of passenger traffic). Together with its regional-airline partners, it serves 130 U.S. cities and 113 international destinations. Major hubs are in Houston, Newark, and Cleveland. It also has an alliance with Northwest Airlines (NWAC

; S&P rank, 3 STARS, hold; $7) and Delta Air Lines (DAL

; 2 STARS, sell; $4), and is a member of the SkyTeam global airline alliance.

In 2004, Continental's consolidated revenues increased 10%, to $9.7 billion, and were only 1.5% below 2000 levels, the last year of relative health in the airline industry. RPMs rose 11% (surpassing 2000 levels) on an 8% capacity gain, leading to a passenger-load factor (a measure of how full aircraft are, on average) of 77.6%. This is an improvement of 2.1% over 2003. On the negative side: Yield (average airfares) declined 2.5% and was 15% below 2000 levels, and unit costs were up 3%, mainly due to higher fuel costs.

We think the growth in passenger levels and fuller flights are encouraging signs. It shows that passenger demand is strengthening. And fuller flights -- as shown by rising passenger-load numbers -- likely will allow the carriers to continue making modest hikes in airfares, similar to those over the past month. This would allow average yields to rise, a necessary condition for Continental to return to profitability.

REBOUNDING FUNDAMENTALS. A recent decision by Delta to cap all fares at a maximum of $499 each way is having an effect on average airfares in the airline industry. Continental in most markets has matched this change. It recently estimated that this move would cost it $200 million a year in lost revenue. However, since that time, lower-end airfares have risen, which appears to be mitigating the impact.

Besides the labor savings, another change has helped the carrier's financial outlook: Continental, along with other major airlines, has raised fares four times in the past month. All the increases seem to have stuck -- a marked change from past attempts to raise fares. The latest increase of $10 per trip means that, on some routes, passengers are now paying up to $60 more than they were a month ago. While we believe these increases still leave average airfares too low, they signal that unit revenues finally may be moving in the right direction.

Partly related to the fare increase, along with strong travel demand and Easter occurring in March this year, Continental reported that March unit revenues were up 15% and that it was likely to have a 4% to 5% increase in yields. We see both of these as strongly positive. In addition, it reported a passenger-load factor of 80.5% for the month, a 5.6% improvement over the prior year and an operational record for the month of March. All of these indicate that industry fundamentals are starting to improve.

INVESTORS ABOARD AGAIN? However, one major uncertainty hangs over airline stocks in general -- the direction of oil prices. Crude oil closed at a record high of $58.28 on Apr. 3. Though it has receding somewhat since then, oil investors appear to be clearly worried about sufficient supplies heading into the peak summer driving season.

Moreover, we believe that high oil prices are here to stay. However, if oil prices back off slightly from current levels, this could spur a sharp increase in investor interest in the airline sector, in keeping with historical industry trends. Oil prices tend to have an impact on airline stocks that's greater than the actual impact of fuel costs on the bottom line. Therefore, even though prices are still too high for the industry as a whole to make money, a modest drop could drive up airline stocks significantly, in our opinion.

As of Dec. 31, 2004, Continental had $1.7 billion in cash and short-term investments. We believe the carrier has enough liquidity to fund operations and pay financial obligations over the next 12 months, given our projection of revenue and expense levels and scheduled debt maturities.

BIZ-TRAVEL PREFERENCE. For 2005, we expect Continental's revenues to rise approximately 9%, as a projected 5% climb in capacity growth along with expected improvement in passenger levels offsets our forecast for a 2% to 3% decline in average airfares. This estimate doesn't factor in any improvement in average fares from price increases, which is possible for the reasons cited above.

We think the company has a higher share of business travelers than many of its peers, partly due to its hub at Newark Liberty Airport and partly because of what we sense is business travelers' perceptions that Continental provides them with a better level of service. For this reason, we expect the company to be able to get a better mix of business travel vs. leisure passengers on its flights, which could drive a RASM (revenues per available seat mile) premium compared to peers.

We expect labor-cost savings to help Continental cut these expenses as a percentage of revenues to 26.8% in 2005, from 28.9% in 2004, and we see a further decline of such costs to 25.9% of revenues in 2006. Offsetting this, however, we're modeling a fuel-price increase of about 31% for the carrier in 2005. We expect a loss of $3 per share in 2005, vs. a loss of $5.49 in 2004.

GOING MORE GLOBAL. For 2006, we expect 8% revenue growth on increased passenger levels and higher fares, while projected decreases in labor costs (including eventual labor-cost reductions by flight attendants) and some expected moderation in fuel prices should allow Continental to post EPS of $1.25.

The airline's recent efforts to boost revenues from international travel and cargo should also help create a better financial performance in 2006. Continental is attempting to redeploy growth to areas that are profitable. On Apr. 6, it announced that it would start flying from Newark to New Delhi, India, in October, 2005, subject to governmental approval.

It's also seeking to fly to Shanghai, China, pending approval, and has already been approved to fly from Newark to Beijing, starting in June, 2005. Average airfares and yields are likely to be stronger for international travel than for domestic travel in coming years, and we think a revenue boost from overseas routes would help the company improve average yields.

PRICIER PENSION PLAN. Also, as Continental increases its international travel, particularly to Asia, it creates opportunities to raise revenues from cargo operations. Cargo contributed 10% of total revenues in 2004, and we see that percentage likely rising in the future.

Our 2005 Standard & Poor's Core Earnings estimate is for a loss of $2.61 a share, vs. our operating EPS estimate of a $3 loss, with the difference reflecting our estimates of likely pension income and option expense. For 2006, our S&P Core Earnings estimate is for a profit of 88 cents, with no added option expense (due to likely requirements on options being fully expensed). But there likely will be additional pension costs, largely reflecting the difference between the carrier's assumptions on its expected long-term rate of return on plan assets vs. S&P's expectation on assumed total return of such assets.

Continental's significantly underfunded pension plan is likely to lead to additional pension expenses in the future, in our opinion. As of Dec. 31, 2004, its projected pension benefit obligation was $2.9 billion, vs. a $1.3 billion fair value of plan assets.

LEASING COSTS. Continental's stock was recently trading at 10 times our 2006 EPS estimate of $1.25, in the middle of its historical price-earnings range (from 1995-2000) when the company was profitable. If it can successfully return to sustainable profitability, we think it can generate a p-e multiple at the higher end of this range. Valuing the stock at 13 times our 2006 EPS estimate gives us our 12-month target price of $16.

Our target implies about 25% price appreciation potential over recent trading levels. As a result, we expect the shares to outperform the S&P SmallCap 600 index.

In general, we're positive on Continental's corporate-governance practices. Among the positives we see: The board of directors is controlled by a supermajority of independent directors, the use of independent directors on the audit and compensation committees, and the ownership of some stock by all directors. Of concern, in our opinion, is the lack of separation of the offices of the chairman and CEO, both of which are held by Lawrence Kellner.

POTENTIAL FOR TURBULENCE. Risks to our recommendation and target price, include the possibility that oil prices do not recede and actually go sharply higher, as they have in each of the past two years. Continental currently has no fuel hedges in place to offset higher oil prices, which means that any increase will filter almost directly to the bottom line. Visibility into both fuel prices and industry pricing power remain extremely limited.

Plus, while airlines have been successful in recent weeks in raising fares, the industry's competitive environment is brutal, and continued pricing pressure is possible as discounters like JetBlue (JBLU

; 3 STARS; $20) and others continue to grow.

A significantly underfunded pension plan could lead to higher pension expenses in the future. If competitors are successful in eliminating their pension obligations through the bankruptcy process, this could put Continental at a competitive disadvantage if it continues to stay out of bankruptcy and maintains its pension obligations.

Airline investing is fraught with risk and uncertainty. Industry stocks in general are highly volatile and likely to remain so. Small swings in oil prices or other news can often lead to large swings in share prices. Analyst Corridore follows shares of airline companies for Standard & Poor's Equity Research Services

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