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Continental's IPO: Don't Rush In


Investing in airlines, as a hedge-fund investor once warned me, demands elaborate precautions: nothing short of garlic necklaces and voodoo incantations. So susceptible are airlines to every gust--rising fuel prices, slowing economic growth, stormy labor relations, and rotten weather--that the stocks seem to suit only the brave or the foolish.

Now, Continental Airlines (CAL) is getting ready to offer investors a new way to prove themselves heroes or fools. In September, Continental aims to sell stock to the public in a unit called ExpressJet Holdings. ExpressJet runs Continental's fast-growing feeder airline, Continental Express, the nation's No. 2 regional--with routes to 113 cities, from Quebec to Ixtapa, Mexico. If all goes according to plan, six months or so after the deal, Continental will hand out the rest of its ExpressJet stock to its own stockholders, and ExpressJet will be on its own.

As Continental and underwriter Salomon Smith Barney have structured the spin-off, ExpressJet will be insulated from some of the vagaries of the airline biz. By mid-August, Continental (whose execs aren't commenting) had not estimated its price for the shares or specified how much of ExpressJet it hopes to sell. Yet from a look at Continental's preliminary securities filing, I think anyone interested in ExpressJet stock had better keep the garlic handy.

UP HIGH. Not that I foresee a crash. Revenue last year rose 30%, to $844 million. In this year's first quarter, it grew 33%. If Continental had set up and done the accounting for ExpressJet last year the way it does now, the regional would have posted an $84 million operating profit. With scores of new jets ordered for the next three years (chart) and with Continental having contracted to buy all of that capacity, ExpressJet has a good line on near-term growth. The contract also calls for Continental, not ExpressJet, to bear such risks as light loads, low fares, and high fuel prices.

So what's wrong? First, the fleet-use contract targets an operating profit margin for ExpressJet that financial statements indicate is 10%. Whether that's high, low, or just right, I don't know. The point is, at least through 2004, it won't vary much. If ExpressJet realizes a slimmer margin, Continental will "true up," or supplement, its payments to ExpressJet. If ExpressJet's margin exceeds the target, it will have to refund some fees. So, just as ExpressJet's risks are limited, so is its potential. Whether ExpressJet will price its stock high, compared with expected earnings, remains to be seen. But don't count on getting it at a discount.

The bigger worry facing investors is ExpressJet's continuing dependence on Continental. Yes, Continental aims to spin off its entire stake in ExpressJet. But as its largest customer, Continental will still wield huge influence through a seat on the board and a raft of contractual conditions, including a "most favored nation" clause. That gives Continental the right to enjoy any concessions ExpressJet might offer to attract business from another major airline. Yet at the same time, Continental is free to license the Continental Express name to other regionals. ExpressJet also can probably forget about being taken over at a nice premium. As long as Continental is ExpressJet's largest customer, a change in control would let it slash payments on its flights until ExpressJet's profit margin vanishes.

Just how much ExpressJet hopes to raise in the deal is unknown, but by now you can guess who gets the proceeds: Continental. ExpressJet is saddled with a debt to Continental of $552 million. Whatever ExpressJet raises in the initial public offering will go to pay that off. In addition, Continental is using the deal to lighten its own hefty debt load. It plans to give ExpressJet stock to its banker, Salomon, in exchange for taking $150 million in debt off its hands. Salomon then would resell those shares in the IPO.

It's hard to look at this deal without concluding that the chief beneficiary will be Continental. Investing in Continental may suit the brave. Chances are, ExpressJet's IPO is just for fools. By Robert Barker


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