Bankruptcy pays for United

By Robert Walberg

Bankruptcy has helped turn the skies a bit friendlier for United Airlines.

The carrier's parent company, UAL (UAU, news, msgs), got legal protection from its creditors and drastically cut costs, saving as much as $7 billion per year, according to some accounts. Strong passenger demand, less capacity and lower fuel prices helped the airline gain ground on low-cost rivals such as Southwest Airlines (LUV, news, msgs).

UAL's operating margins improved to 5.9% -- better than most of its peers and a big change from recent quarters. (Cost per available seat mile, excluding fuel and special items, fell by 0.4%, while revenue per available seat mile jumped by 10.2%.) By comparison, operating margins over the trailing 12 months are 1.75% at JetBlue Airways (JBLU, news, msgs) and 2.4% at AirTran (AAI, news, msgs).

Though a few analysts would have liked to see UAL cut deeper, management says ongoing efforts will enable it to continue the momentum. If the company can keep it up, it may turn the tables on the low-cost carriers that were eating its lunch just a couple years ago.

Fuel hits the bottom line

One factor out of the company’s control, of course, is the price of fuel. Crude oil prices spiked to near $80 per barrel before recently tumbling below $60 -- good news since fuel costs remain airlines' second-biggest cost.

Hedging contracts mean that market prices don't directly impact the bottom line. UAL has hedged about 34% of its exposure over the next couple of quarters, a step that limits the gains if oil prices drop and provides relief if prices soar. Given the volatility in the energy market, the company can’t be faulted for being cautious.

Meanwhile, Southwest, which benefited significantly by locking in oil below $30 a barrel over the past couple of years, will see much of its advantage disappear over the next year as the percentage it has hedged decreases. The airline is still better positioned than its peers, but its own quarterly comparisons will begin to suffer as the legacy carriers are positioned for improvement.

That’s one reason money has begun to flow out of the stocks of Southwest and many of the other low cost, short-haul carriers back into the legacy companies. Since early August, Southwest's stock is down 16% and AirTran is off 26%, while UAL has soared 61% and AMR is up 49%.

Legacy carriers in favor

I recommend investors continue playing the momentum. UAL, AMR and US Airways Group (LCC, news, msgs) have drastically reduced their costs and still have room to bolster their margins. While low-cost carriers are busy adding routes and capacity to compete with each other, legacy carriers benefit from profitable long-haul, overseas routes that are increasingly popular and profitable.

Even stock valuations don’t favor the low-cost carriers. Despite its sharp drop in price, Southwest, AirTran and JetBlue trade at an average of 0.95 times trailing 12-month sales and 20.9 times next year’s estimated earnings. UAL, AMR and US Airways Group trade at an average of 0.3 times trailing sales and seven times future earnings.

Legacy carriers still need to improve their balance sheets but, overall, the group is the best way to play the airline sector over the next 12 months. I’ll add AMR to my Street Patrol portfolio.

Robert Walberg is a financial writer based in Chicago and a regular guest on CNN's "Moneyline." He was formerly chief equity analyst at Briefing.com and ran for Congress in Illinois in 1994.

At the time of publication, Walberg did not own or control shares of any companies mentioned in this article.