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Continental's Surprising Ascent


With the price of oil hitting an all-time high, double where it was just two years ago, investors are dumping shares of any company that stands to be hurt by higher energy costs. Retailing stocks are selling off on fears that high gas prices will squeeze consumers. Ditto, restaurants. Even Yum! Brands (YUM), purveyor of the 59 cents taco, has been marked down.

You'd think big legacy airlines, the stock market's perennial D-students, would be suffering disproportionately, given how much fuel they guzzle. Quite the opposite: Continental Airlines (CAL), which has twice been in bankruptcy, has seen its stock price triple in 10 months. Shares of AMR (AMR), parent of American Airlines, and US Airways Group (LLC), each have doubled.

It's not that the big guys have hedged themselves particularly well against rising oil prices. Discount king Southwest Airlines Co. (LUV) is the best hedged, having locked in most of its fuel through 2009 at under $40 per barrel, according to Cathay Financial in New York. Yet its shares are up only 20% since last September.

Out of nowhere, legacy airlines have figured out how to make a buck despite surging fuel costs. "Industry fundamentals have not been this good in years," says Merrill Lynch & Co. (MER) airline analyst Michael Linenberg. Their secret: packing carefully chosen fleets and routes with passengers who will accept fuel surcharges and higher fares.

For once, major carriers are using their natural advantages to beat the discounters. Southwest, JetBlue Airways Corp. (JBLU), and others rely too heavily on aggressive expansion and race-to-the-bottom pricing, says Raymond E. Neidl, an airline analyst with Calyon Securities in New York. Neither is a particularly attractive option right now. In fact, Southwest recently did the unthinkable, pushing through a $10 increase to its highest one-way fare. The major carriers, by contrast, are optimizing their big route networks and seat inventories to squeeze the most profits out of them. Continental, whose shares recently changed hands at 30, up from 9 last fall and 4 in 2002, has been especially impressive. It's running planes at 85% capacity, vs. 78% three years ago, and even hit 94% on the last day of June. By keeping its seat count steady as travel demand climbs, it can command higher ticket prices, particularly with the discounters easing up on their expansion plans.

PLENTY OF CASH

Continental's improvements aren't all on the revenue side, though. Legacy carriers are famously bloated, but Continental was able to wrest $500 million in wage and benefit cuts from its workers last year. It's a classic strategy: Cut costs now so that any revenue gain will send profits jumping. Smart balance-sheet management has allowed Continental to stockpile more than $2.6 billion in cash; it recently retired $100 million in debt due next year, avoiding a high interest expense.

According to investment bank UBS (UBS), Continental is the only carrier that sports the four-way combination of capacity improvement, a diversified network of routes, popularity with higher-paying business travelers, and strong gross profit margins. It banks 25% of each additional dollar in sales as profit. And none of its domestic routes represents more than 1% of revenue.

All told, analysts were expecting Continental to report second-quarter earnings of $1.90 a share on July 20, more than double the take the year before. It's on track to swing from a $2.92 loss in 2005 to a $3.13 profit this year. And those estimates could prove conservative if oil prices start to decline and Continental takes advantage of packed planes to ratchet prices even higher. "Hopefully," says Neidl, "they're smart enough to do that."

By Roben Farzad


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