It's no secret that Sept. 11 changed the way airlines do business. The ensuing rise in oil prices, the growing penetration of low-cost carriers such as JetBlue (NASDAQ:JBLU) and perennial favorite Southwest (NYSE:LUV), and the massive losses for the airline industry forced the legacy carriers to make fundamental changes to their businesses. It's about time! Airlines have never been the best capital allocators, and many horrific decisions from the 1990s have caught up with them. All of this has combined to create a perfect storm for the legacy carriers. I believe the end is now in sight, and the sun is ready to peek through the clouds.

Delta's (NYSE:DAL) recent fare-slashing of up to 50% was a signal to investors that it needed to bring back lucrative business travelers who had departed from the carrier in the 1990s. Continental (NYSE:CAL) has indicated that it is matching Delta's fares, a move that bodes well for boosting traffic. Delta is reporting significant increases in traffic in Cincinnati -- a 30% uptick in traffic in the five months since the promotion began. Previous significant industry events included achieving hundreds of millions in labor cost savings, and introducing new sub-carriers such as Delta's Song and United's Ted. The ultimate consensus among legacy carriers' upper management was "I don't think we're in Kansas anymore, Toto." Management had ignored the creeping threat of the low-cost carriers in the booming 1990s and paid a heavy price.

Continental breakfast?
Continental has been working its crystal ball overtime. The shift to international expansion is wise, as JetBlue and Southwest have been very quiet on that front. Granted, there is considerable competition from various regional carriers, but Continental's connections have opened up new markets in China, and growth away from the zero-sum game that seems to be the U.S. airline market.

The carrier's $1.3 billion bet on 10 Boeing "Dreamliner" airplanes speaks volumes about the importance of the company's international growth strategy. The Dreamliners are smaller and more fuel-efficient, a combination that offers an advantage over other carriers that are using older and higher-maintenance aircraft. The recent, much-needed $500 million in labor concessions from employees resolved the company's short-term liquidity issues, and Continental is now expected to break even in 2005.

Continental's balance sheet with net tangible assets of -$693 million would make many an investor reach for the sick bag. Its debt/equity ratio of 22 is not good. Given the company's $1.38 billion in cash in at the end of the most recent quarter, servicing the debt and its losses should not be a problem for the foreseeable future. That said, "debt serviceability" (paying debt as it comes due) depends on the company's ability to continue to generate cash going forward. Revenues have been flat since 2000, and the company has reported losses in three out of the past four years, with 2004 coming in at -$363 million. Continental's long-term debt over the same time period has increased almost $2 billion from $3.6 billion in 2000 to $5.5 billion at the end of 2004, contributing to a four-year decline in shareholder equity from $1.1 billion to $266 million. Industry-specific negatives paint a worse picture: continuous overcapacity, high oil prices, years of losses, and bankrupt competitors being allowed to continue to operate, affecting the rest of the industry's profitability. This is a wreck, and any smart investor would be long gone, right? Wrong.

My investment thesis for this company is:

1. An industry turnaround is finally here. While there is still overcapacity in the industry, pricing has finally reformed, with Delta's price cuts providing the final impetus for business travelers to return to the revamped legacy carriers. Given this situation, Continental should be able to attract its fair share of travelers. Labor costs have come down and, though still high, are definitely more workable than they were a few years ago. More importantly, airline management and unions have struck a more conciliatory tone, thus allowing better employee/management relations to develop. Management has achieved $900 million of its planned $1.1 billion in cuts, not including the additional $418 million in labor concessions that was recently agreed upon.

2. Further expansion into new (and old) markets (international expansion, ExpressJet carrier) will provide profits away from the more competitive traditional routes. Revenue growth from the regional, Latin America, and Pacific areas are 25%-30% a year (in 2004) vs. a flat to slightly negative growth in domestic travel. Recent wins for new routes in China and code-sharing with Air France strengthen the company's position internationally.

3. While the cost of crude oil will continue to be extremely high, the achieved cost savings and an improving economic picture for the company will help decrease the impact of oil prices. Continental does need to better manage its fuel costs by using futures to hedge oil price movements. However, in my view, the focus on oil costs is overblown by Wall Street right now, and the improving economic picture for the airline industry is being ignored. If nothing else, it is a least an industry-wide problem, and not specific to Continental.

At the recent price of $11 and change, Continental's stock offers an interesting opportunity for the value investor. There are several catalysts for an increase in the stock price. The stock represents a hedge on oil, as any decrease in oil prices will show up on the bottom line for the airline industry. With the recent labor concessions, a major overhang for the stock has been removed, given that Wall Street does not like uncertainty. A third catalyst would be a return to profitability. If oil prices decrease or profitability returns, the stock price should zoom accordingly. The upside potential is considerable if the stock price returns to a more reasonable valuation. Northwest (NASDAQ:NWAC), AmericanAirlines (NYSE:AMR), and Continental all trade at about two times operating cash flow, while Southwest trades at about 10 times operating cash flow. Sure, the stock is cheap with good reason, but a double in the stock price only moves the company to four or five times cash flow -- still value-priced when compared to Southwest. Because of perception issues on Wall Street, I think this stock offers above-average returns in exchange for a manageable amount of risk.

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Fool contributor Stephen Ellis is a freelance writer living in Southern California. He admits to saying "Dude!" a few too many times, but he hasn't bleached his hair yet. He owns stock in Continental. The Motley Fool is investors writing for investors.