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In an earlier article, I argued that Southwest Airlines (NYSE:LUV) will "fuel" considerable value creation through its merger with AirTran. This transaction created considerable market power by adding more convenient connections. Since the piece was published, the stock has gone up by 14.8%. At the same time, competitor JetBlue Airways (NASDAQ:JBLU) appreciated by 44.7%. Analysts currently rate shares of the former a "hold" while those of the latter are closer to a "buy". As many have largely forgotten about Southwest's high-growth past, investors should possibly consider going long Southwest while shorting JetBlue in order to benefit from the market correction.

From a multiples perspective, JetBlue remains the cheaper of the two - making the above strategy risky. It trades at a respective 19.4x and 10.3x past and forward earnings. Southwest, meanwhile, trades at a respective 40.2x and 11x past and forward earnings. In addition, JetBlue's loyal demand allows the carrier to charge higher prices; Southwest specializes more in offering low costs. Accordingly, the firm has gross margins that are roughly 220 basis points higher than Southwest's 21.1%. At the same time, JetBlue faces greater competitive pressure and I anticipate that this GM differential will be closed in Southwest's favor.

At the third quarter earnings call, Southwest's CEO, Gary Kelly, noted disappointing performance:

We had $122 million third quarter profit, excluding special items. That's $0.15 a share, $0.01 better than the Wall Street estimates. And of course, that's very satisfactory. However, the results are 37% below last year's third quarter, and that's not satisfactory. But I am very proud of our people. The challenges to earnings are cost related, and especially fuel cost, they were up 33.8% on a per gallon basis compared to last year. And were it not for that, our earnings would've been outstanding, excluding items.

Our people deserve a lot of praise because we had a stellar revenue performance. We had record load factors, record yields, record revenues. We had a All-New Rapid Rewards program that was a very significant contributor, and we also had much improved operations performance.

It gives me pause that the company is now scaling back on operations. It is downsizing AirTran and expected to make cuts near the end of the first half of 2012, particularly in Philadelphia, Boston, and Orlando.

Southwest has been considerably ravaged by fuel volatility and delays in resolving global debt crises. Although I think EU and American politicians will reach agreements faster than expected, this is not something that I see as a major catalyst for shareholder value. Meanwhile, Southwest is hedging against uncertain energy prices by improving its network and the acquisition of AirTran was the step in the right direction. Moreover, the carrier sets itself apart from the competition withs its investment grade rating, in addition to having a strong brand.

Consensus estimates for Southwest's EPS are that it will decline by 44.6% to $0.41 in 2011 and then grow by 92.7% and 32.9% in the following two years. Assuming a multiple of 15x and a conservative 2012 EPS estimate of $0.41, the rough intrinsic value of the stock is $10.65. This implies 26.2% upside. If the multiple is 14x and 2012 EPS turns out to be 36.7% below the consensus at $0.50, there is only 17.1% downside. Overall, I do not believe that Southwest provides the most attractive value play at this moment and thus agree with the Street consensus that it is between a "hold" and a "buy".

As for JetBlue: the firm will benefit from initiatives in the Caribbean and Boston. The carrier has solid productivity and customer demands that considerably reduces uncertainty in operations. Thus, a short investment may have considerable upside; but, it comes with plenty of risk. Consensus estimates for the firm's EPS are that it will decline by 25.8% to $0.23 in 2011 and then grow by 113% and 32.7% in the following two years. Assuming a multiple of 13x and a 2012 EPS estimate that is 30.6% below the consensus at $0.34 implies 12.5% downside.

Source: Southwest Possibly Worth $11; JetBlue A 'Hold'