Tuesday, November 29, 2005

Continental Airlines

My faith in the airline bounce continues. It is built on powerful premise but is also helped by the potential for fuel price reductions.

The powerful premise is that airlines have traditionally done well during the expansion phase of the economic cycle; the phase we have been moving into for the past few months. Airlines make their money when business travel is strong. Consumer traffic does not hurt but supply demand does not boost yields until business travel kicks-in. The recent conversion after conversion of planes to increase business and first class seating along with historically high load factors makes it clear that business travel is taking up all the slack.

After a 62% run in the price of Continental, the market has traded around the $57 crude oil fulcrum. Oil at $57 translates into airline fuel of about $1.70. Most analyst have made their projections of airline profits on average fuel costs of better than $2.15. Should the price level off at $57, CAL should make (according to JP Morgan) $2.94 per share in 2006! Obviously many analyst assume that fuel prices are near a winter bottom and will go back up in the spring, otherwise they would not be estimating losses for CAL in 2006.

I happen to believe that before 2006 is gone, fuel prices will be below $50 per barrel and below $1.50 per gallon for jet fuel. Should fuel prices average $1.60 for 2006, JP Morgan estimates that CAL will earn $4.32 per share!

CAL still has plenty of problems but the sale of more shares has boosted cash reserves. An IPO of a foreign carrier will produce additional liquidity. The company may need the cash to help ward of a potential strike. The dead line for a deal with the sterwards is December 7. I believe the company is ready to operate without the current union labor force for as long as it takes.

The ties between CAL, NWAC and DAL continue to grow. The companies just made a deal to open their airport club lounges to each others passengers. This makes 90 airport clubs available. These lounges are important features to attract and hold the high dollar long-distance traveler.

The code sharing and lounge sharing cause one to wonder if a merger will take place. LCC is the merger of American West and US Air. This combined firm is now the cheapest of major carriers on an enterprise basis as the debt of US Air was largely shed during bankruptcy court. CAL, NWAC and DAL code share as a marketing agreement that allows each to avoid duplication of services while selling both legs of many trips. The leap from code sharing to a merger is a big leap but the bankrupted carriers best chance of long-term survival is through merger.

Recent regulation changes allows a higher level of foreign ownership of US carriers. It appears that British Airways and others may have interest in combining operations with American carriers.

By the way, don't be surprised at 4th quarter losses. The airlines make their money during the spring, summer and fall. They are always very busy during the year end holidays but traffic is otherwise relatively low during the cold weather months. The following are a few estimates from JP Morgan:

Fuel Cost CAL 2006 EARNINGS

$1.75 $2.25
$1.70 $2.94
$1.65 $3.63
$1.60 $4.32

A nickle a gallon can increase earnings $.69 per year. A decline in crude of $1 per barrel, at current levels, converts into a decline in jet fuel of about $.03. It is not a smooth relationship as the crack spread is a higher percentage as the price goes down. However, $1.75 per gallon is the equivalent of $58.50 per barrell with a crack spread of $12 which makes current cost about $1.70 at current crude prices of about $57. Put another way, it will take prices of about $53 per barrell to produce earnings greater than $4 per share. $53 oil could push the share price of CAL to $40 or higher!


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