Continental and UAL: An Airline Pair Trade

Long ago, I was taught that everything has value at a certain price. If you perform enough due diligence and think creatively, you can construct a trade where the upside is reasonable and the risk contained.

Following such advice, I have invested in some odd companies over the years. When others were buying hot technology stocks, I was looking at tobacco and chicken producers. Such an approach has yielded some interesting discussions with clients, but positive gains have justified the approach.

Despite the view that everything has value, I avoid some sectors because I think their business models are doomed. One such sector is the airlines. Over the years, time and again, hot airlines have attracted attention, profits, and investors' dollars only to eventually succumb to competitive forces and deliver large losses. As this pattern is constantly repeated, it has become clear that an outright investment in airlines is foolish. However, a pair trade is another story.

The purest version of a pair trade involves two securities that are affected by similar economic factors and are trading at prices that differ from their historical ranges. When we find this situation, we can buy one item, short the other, and wait for the typical relationship to reemerge.

With respect to the airline industry I have focused on two large carriers offering contrasting results-Continental (CAL) and UAL (UAUA). CAL has twice the market capitalization as UAUA and a better, but not good, balance sheet. UAUA carries larger sales volume. While I would never trade either outright, the relative relationship is promising.

For the past year, CAL has traded at 183% of UAUA. Extend that time period to two years and the average price relationship is 135%. Currently CAL is priced at 216% of UAUA.

Knowing relative value ranges can change, we cannot simply plug in numbers and create trades. Instead, we need a sense of why the relationship will revert. In this situation, I am encouraged by the price movements that have occurred in recent weeks. When airlines were hitting recent lows, the spread between CAL and UAUA reached a high of 300%. From that point, we see a steady decline in the ratio where drops are followed by consolidation and then further drops. The ratio has been hovering in the 213% range for five trading days, has started trending lower, and is prepared to approach the 180% historical range.

Buying a stock in an industry you dislike is always difficult. However, we will remain hedged and look for relative, as opposed to absolute, value. To implement the pair trade, I recommend purchasing a position in UAUA and shorting an equal position in CAL as this week's fundamental trade.

Comments

[notsosmart:]

continental will surely go bankrupt.can they meet their obligations next year?

Sep 04 10:34 AM

[AirBoss:]

You do know that these two carriers are linked via code-share, global alliance and M&A discussions, right?

Sep 04 12:10 PM

[Lentako:]

Continental will not go bankrupt anytime soon, and especially not prior to UAUA or LCC. CAL has the one of the best balance sheet of the majors.
Also, Larry Kelner, CAL's CEO, is out at the end of this year. There is a VERY good chance that merger talks will resume between CAL and UAUA as soon as he leaves.
Another factor is the swine flu. If there is an actual outbreak or just a media scare, airline stocks will tank.
I would never short a stock that could be on the front page. And CAL could easily be on the front page soon for an acquisition of UAUA.

Sep 04 12:34 PM

[zedman:]

Used this article as a basis to build a story for my stock lending blog ... thanks

www.stocklendingtoday....

Sep 06 08:19 AM

[Why did I c...:]

Sir,
While I respect your blog and respect your DD I will add one caveat as I'm an airline employee and knowing UAL has 6 contracts all due 12/31/09 you seem to overlook the unions and the finacial impact of a strike,work stoppages,$465 due 09',$1.2 billion due10',no new AC on order,dis-gruntled workforce,aging fleet,mis-management throught the entire company and a negative book value of -$18.73 per share plus assetswhich are depreciating on a daily basis and no business travel demand. On the other hand you have the poster child of how-to-run-a-legacy carrier CAL with positive cash flow and equity despite all the negatives surrounding the airline and economy. CAL went thru bankruptcy 3 x's and finally got it right. UAL on the other hand underestimated it's business model pre-exit and now has to de-leveradge losing market share to it's rivals. Sure UAL has an excellent route network , but UAL lacks the higher paying passenger which is the saving grace of legacy carriers like AMR and DAL.
If the H1 N1 virus crops up and passengers shy away and the economy double dips you got to ask yourselves " who will survive UAL or CAL...? I'll take the odds that CAL will be the one left standing.

Sep 06 09:47 PM

[wunderbra:]

UAL is in serious trouble again and very near to bancruptcy. CAL is in relatively much better shape, although no one in the industry is in "good" shape.

Kellner's departure from CAL will have no effect on any merger possibilities. Even the board at CAL knows that a merger with UAL would be suicide. They will wait to pick up the pieces, when UAL begins the downsizing or liquidation. Have you noticed they are paying 17% on their latest debt offering?

Trading UAL is very risky, but possibly profitable.

Sep 12 07:22 AM