Fitch affirms Continental Airlines at 'B-' after merger announcement; Outlook stable

The Rating Outlook for CAL is Stable.

The affirmation reflects Fitch's view that a merger between CAL and UAL, if ultimately closed under terms similar to those outlined today, will eventually support sustainable improvements in margins, positive free cash flow (FCF) generation and stronger liquidity in a post-merger scenario. Significant execution risk exists, however, and the terms of new labor contracts could have a substantial impact on the economics of the merger. Fitch will remain focused in particular on regulatory risks related to the antitrust review by the U.S. Department of Justice (DOJ) and the inevitable complexity of labor integration for unionized work groups at CAL and UAL.

Absent major asset disposal requirements in a future antitrust decision, the combined UAL-CAL route network would offer clear opportunities for the post-merger carrier to deliver a sustainable revenue per available seat mile (RASM) premium to the industry. The two stand-alone networks are very complementary, with United's notable strength in trans-Pacific routes meshing well with CAL's strong market position in New York and into Latin America via the Houston hub. The depth and breadth of the post-merger route network, together with the premium product focus of both carriers, should put the post-merger carrier in a strong position to deepen penetration in key high-fare business markets.

Revenue-related synergies will ultimately be more decisive in determining the long-term financial success of the merger. Recognizing immediate cost saving opportunities associated with the elimination of duplicative operations (in particular, headquarters and certain overlapping airport operations), unit costs for the post-merger carrier could eventually move higher if pay rates and benefits for United employees are moved up to match CAL contracts. Cash integration costs, moreover, are likely to be significant, and will put some pressure on FCF for both UAL and CAL this year and into 2011.

Although the proposed stock swap agreement limits the need for additional debt to support post-merger liquidity, the new airline's lease-adjusted leverage will remain very high in Fitch's base case forecast scenario. Post-merger balance sheet debt for the new airline will likely exceed $14 billion, in addition to approximately $10 billion in capitalized aircraft leases. Combined unrestricted liquidity will likely approach $7 billion (over 20% of pro forma post-merger annual revenue). The new airline will face heavy and steady scheduled debt maturities. Combined maturities total $2.1 billion in 2011 and $1.3 billion in 2012. CAL also faces rising cash pension funding obligations for its frozen but substantially under-funded pension plans.

Assuming modest global economic growth and solid RASM growth moving into 2011 and average jet fuel prices at $2.40 per gallon, Fitch expects the combined carrier to generate positive FCF in 2011 with pro forma lease-adjusted leverage exceeding 6 times (x) at the end of next year. Fitch's forecast assumes that the transaction would be closed by early 2011.

CAL's stand-alone credit profile has improved over the last few months as consistent signs of strengthening high-fare business travel demand have driven a turnaround in RASM performance. While CAL reported a net loss of $136 million in 1Q'10, better corporate demand and stronger yields resulted in a consolidated RASM increase of 7% on flat capacity. While this performance lagged that of United, CAL has historically reported a RASM premium to the industry, and stronger business demand is likely to support solid passenger unit revenue growth for the remainder of 2010.

Liquidity trends are also positive, with unrestricted cash and investments increasing to $3.1 billion at March 31, 2010. CAL faces higher near-term cash obligations than United, with current debt maturities of $919 million. Fleet-related capital commitments, driven by the delivery of new Boeing aircraft, will keep CAL's stand-alone FCF negative again in 2010, assuming approximately $1.3 billion in gross capital expenditures this year. Heavier capital spending commitments at CAL may push post-merger combined capex above $1.5 billion in 2011. Factoring in increased cash flow impacts linked to merger integration costs and potentially higher post-merger unit labor rates, UAL and CAL together can generate positive FCF in excess of $500 million during 2011 if industry demand and yield trends continue to strengthen.

Fuel price risk remains a major concern for CAL and the entire industry as a result of the steady run-up in energy prices seen since early 2009. CAL's current fuel hedging position is light relative to United's, with approximately 24% of fuel consumption over the next year hedged via crude oil swaps and call options. Swap protection starts at jet fuel prices above $1.83 per gallon, and options provide protection above $2.25 per gallon. Like United, CAL has minimal hedge coverage beyond 2010 and remains vulnerable to a sharp spike in jet fuel prices linked to stronger than expected growth in global energy demand later this year.

A revision of the Outlook to Negative is possible if forecasted RASM growth and/or a significant fuel price spike drives negative FCF and growing pressure on unrestricted liquidity later in 2010. In addition, larger than expected cash merger transition costs potentially tied to labor integration difficulties could lead to a negative rating action. No positive actions are anticipated prior to the closing of the proposed merger. If merger integration issues are successfully addressed and the operating outlook remains encouraging at or before the time of closing, Fitch would likely upgrade UAL and United's ratings to the 'B-' level, in line with CAL's current IDR.