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By Jeremy Glaser | 05-11-2010 05:20 PM

Two High Flying Bond Picks

Morningstar's Basili Alukos and Rick Tauber survey the post-United/Continental merger airline landscape and examine two high-yield bond picks.

Jeremy Glaser: I'm Jeremy Glaser with Morningstar.com.

Airlines have been in the news a lot recently, with the recently announced merger of Continental and United Airlines. I'm here with equity analyst Basili Alukos and credit analyst Rick Tauber to talk about the impact on the entire industry, and what it could mean for investors. Gentlemen, thanks for joining me today.

Rick Tauber: Thank you.

Basili Alukos: Thank you.

Glaser: Basili, first off, what does this mean for the industry? Is this really the consolidation that you've been looking for a couple years now?

Alukos: Well, there's been a lot of talk, for a couple years as you said. This the second time that United and Continental have been in merger talks. They actually almost merged in 2008, and so it's not a surprise to us that the two decided to tie the knot.

But overall, I think it speaks volumes to the changing landscape of the airline industry. Obviously, everyone dealing with the recession, people were cutting back capacity. Even the likes of low cost carrier Southwest actually reduced capacity this year.

And I think for once in a recent while, the airline industry is actually using and implementing the capacity discipline that has escaped the industry.

Glaser: United and Continental don't have a ton of route overlap. So do you think this particular deal is going to help reduce a lot of capacity, or is it more the pricing power that they could get from being larger?

Alukos: That's correct. I think I've read somewhere, less than 10 routes actually overlap. So I think you're right. It's mostly to reduce expenses, at least in my view. Merger in the airline industry is about cutting costs, removing redundant expenses, because at the end of the day the airline industry has too many costs facing too few of revenue.

Glaser: Given these synergies, does it now make sense for people to jump into airline stocks?

Alukos: Well, there is the potential. I mean, given the merger they expect to generate between $1 and $1.2 billion of synergies by the third year of the merger. We think there's a potential that the combined United/Continental entity may be worth between $1.5 to $3 billion greater than what their standalone values are worth.

But at the end of the day, we caution investors that airlines are extremely uncertain, and it's very difficult to forecast with any bit of certainty what the fair values of these companies might look like.

Glaser: So another big spike in oil could definitely put a big dent into profitability.

Alukos: Absolutely.

Glaser: So Rick, looking at credit side, if maybe these entities aren't great for an equity investor, is there another place in the capital structure where there could be some opportunity?

Tauber: Sure. The interesting thing about the airline capital structure is typically there's a pretty substantial amount of secured debt in the capital structure. If we look at United/Continental on a pro forma basis, this would mean merged, almost 60 percent of their capital structure is secured debt. Probably around 10 percent is unsecured debt, and the rest would be the equity.

There's always opportunities to find investments on the bond side because of the good collateral coverage that you might have on a lot of the securities.

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