Tuesday, July 05, 2011

Does United Continental Merger Make a Profitable Stock Investment?

United Continental Holdings (NYSE: UAL) expect to add $1.2 billion to their combined revenues and cost savings through their merger. Does this signal a buying opportunity for the stock?

In October 2010, United and Continental merged. And BusinessWeek reports that United Continental "told Wall Street that it can find $1.2 billion in new revenue and cost savings from the marriage within three years."

In charge of that rationalization process is a former Continental attorney Lori Gobillot’s, Vice-President of Integration Management, who is trying to wring that money out of a network that flies in and out of 373 airports in 63 countries, with hubs in New York, Chicago, Houston, San Francisco, Washington, Los Angeles, and Tokyo.

Doing so means "combining 1,400 separate systems, programs, and protocols." And their respective workforces are represented by different labor unions with different work rules flying different aircraft -- while United’s fleet has first-class; Continental’s planes have just business and coach, reports Business Week.

Should the possibility of achieving these results spur you to invest? I think there are three reasons to wait:
  • Downgraded 2011 airline industry profits. In June, the International Air Transport Association, cut its 2011 profit forecast 54% to $4 billion from its March 2011 forecast and 78% below the industry's 2010 net profit of $18 billion net profit. The $4 billion 2011 profit would represent a mere 0.7% margin of expected revenues of $598 billion.
  • Disappointing first quarter results. United Continental lost $213 million during the first quarter -- its jet fuel costs were up 26.5% to $560 million despite only a slight increase in traffic. Higher airfares covered much of the higher fuel prices -- with revenues up 10.8% to $8.2 billion. The good news was that its adjusted EPS was negative 41 cents -- seven cents less than analysts surveyed by FactSet had expected.
  • Progress in trying to earn more than its capital cost. United Continental does not earn enough in after-tax operating profit to offset its cost of capital. But it is getting closer. After all, it’s producing positive EVA Momentum, which measures the change in “economic value added” (essentially, profit after deducting capital costs) divided by sales. In 2010, United Continental ’s EVA momentum was up 1%, based on 2009 revenue of $16.3 billion, and EVA that improved from negative $1 billion in 2009 to negative $991 million in 2010, using a 7% weighted average cost of capital.
The only good news for this stock is that it's cheap. United Continental trades at a price-to-earnings-to-growth (PEG) ratio of 0.69 (where 1.0 is considered fairly valued). United Continental’s P/E is 25 on earnings expected to climb 36% to $5.55 a share in 2012. With 2011 earnings expected to shrink 5%, this forecast hinges on a much better 2012.
Weighing the pros and cons of United Continental, my verdict is to avoid this stock.


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