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After being frozen in a trading range between $19 and $21 for several months, mega-airline United Continental (NYSE:UAL) has recently rallied above $23/share, with most of those gains occurring in the past week (UAL closed below $20 as recently as December 5). There are several potential explanations for this jump. Gulf Coast jet fuel prices have remained at relatively moderate levels for the past few weeks, around $3/gallon. Earlier this month, United reported that the company had its best operational performance of the year in November, suggesting that the worst integration pains may be over. Lastly, speculation about a potential merger between US Airways (LCC) and American Airlines (AAMRQ.PK) has heated up, particularly since pilots at the latter ratified a new contract.

While United finally may be bottoming out, I think it is too early to buy into a potential turnaround. I expect United to become a successful business again in the long term, but there are other airlines out there (such as Delta (NYSE:DAL) and Hawaiian (NASDAQ:HA)) that are already successful, but are cheaper than United when valued on either a TTM earnings multiple or a forward earnings multiple. As a result, there is no compelling reason to own shares of United unless/until the company demonstrates that it can win back travelers who have switched to other carriers over the past year.

Merger Benefits?

United could benefit somewhat from a merger between US Airways and American Airlines, if the merged competitor were to cut capacity in markets where the two compete. However, investors are probably reading too much into US Airways CEO Doug Parker's criticism of American's "cornerstone strategy". Parker has stated that American is too focused on serving major markets rather than building dominant hubs that can create a strong network for domestic travel. A merged carrier under Parker's leadership might cut back somewhat in highly competitive markets like New York, Chicago, and Los Angeles (where United also has hubs). But these cuts are not likely to be deep; these hubs serve all of American's traffic to Asia, which is a key region where the combined carrier would want to grow, not shrink. Moreover, the Chicago hub would be the combined carrier's only hub in the Midwest, making it an unlikely target for serious downsizing. Meanwhile, US Airways' management has specifically reassured Los Angeles that it would not cut service there.

There are thus good reasons to believe that American will continue to compete in the markets where it overlaps with United. There may be token schedule cuts, but on the flip side, the addition of US Airways' strong East Coast network could help American win some business away from United (and Delta) going forward. This could be aggravated by the fact that US Airways would leave United's Star Alliance in the event of a merger. United will only gain substantial benefits in the event of a US Airways-American Airlines merger if there were serious merger integration problems for the latter pair. This is certainly a possibility, but is not an investable hypothesis, in my opinion.

Will the Revenue Premium Reappear?

On the Q3 earnings conference call, CEO Jeff Smisek explained United's performance trajectory as follows:

We made substantial progress with our integration during the third quarter and continue on the right path today. However, we recognize that some of our customers chose to fly other airlines during the summer when our operational performance degraded. Just like when your preferred road to work undergoes construction, you might choose to take a detour until the road gets repaired. Well, the road is repaired. And with our operations back on track, our unmatched global network and our industry-leading product offering, we expect to earn back those customers who took a detour and we expect to attract new customers as well.

If United can consistently produce a good product over a period of years (not months), then Smisek may be vindicated eventually. However, assuming that a US Airways-American merger does occur, United will be facing two equally large network carriers in the future. So gains are likely to be slow and contingent on providing good service at the right price. United does not have a strong track record on that score. In 2011, the United and Continental units placed #12 and #11 in the annual Airline Quality Rating study. This put them just behind American and US Airways, and well behind Delta. For 2012, United's performance deteriorated sharply, which will leave an even wider gap with Delta in particular. It is true that the Continental brand used to have a very good reputation, but that goodwill is all but gone now. There is no guarantee that the "new United" will ever achieve that level of quality recognition. In a best case scenario, it will probably take five years for United to fully rebuild the Continental "work hard/fly right" reputation.

Thus, I think Smisek's interpretation is a little too rosy. Some customers may return when they are satisfied that United's operations have improved, but others may find that they are very satisfied with Delta, or even American. United will be facing fairly easy comparable figures in 2013, which should give it the opportunity to return to PRASM growth in the low-mid single digits. (Excluding the effects of Hurricane Sandy, PRASM has been roughly flat for the past two months, after showing a decline in September.) However, revenue improvements on that scale will be offset to a large extent by cost increases triggered by new labor contracts. United will therefore need to see decreasing fuel prices just to meet the average analyst estimate for EPS of $3.87 next year. These may materialize, but other airlines would benefit just as much or more in such a scenario.

Conclusion: Avoid United Continental

The worst may be behind United Continental, but that does not imply that a rapid recovery to peak earnings and beyond will occur. United's current multiple of more than 12X expected FY12 earnings and 6X expected FY13 earnings already assumes smooth sailing going forward. Yet Delta trades for much lower earnings multiples despite delivering vastly more consistent performance. I think that Delta is the best bet amongst network carriers by a long shot, while niche carrier Hawaiian Holdings is probably the best overall airline investment for 2013.

I would therefore consider setting up a pair trade between either one of those carriers and United, by buying Delta or Hawaiian while shorting United. This strategy would allow you to hedge against industry events such as significant changes in overall demand or fuel prices, while still benefiting from strong profitability at Delta and Hawaiian and the continuation of mediocre results at United.

Source: United Continental Has Flown Too High, Too Fast

Additional disclosure: I may initiate a short position in UAL over the next 72 hours.