Don't Read Into United Continental's Ratings Upgrade

Although we don't believe in timing the market or panicking over market movements, we do like to keep an eye on big changes -- just in case they're material to our investing thesis.

What: United ContinentalHoldings' winning streak continued this morning, with shares gaining more than 4% after Goldman Sachs upgraded the stock to buy from neutral.

So what:Analyst Tom Kim finds United Continental stock to be relatively undervalued vis-à-vis peers, and expects it to hit $44 over the next six months. That's a 15% upside at current stock price of around $38. More importantly, Kim expects United Continental's earnings per share to nearly double to $4.87 in 2014. Goldman sees the carrier's shares strengthening as investors gain confidence over the company's earnings power.

Now what: Earlier in the week, United Continental outlined plans to cut costs by nearly $2 billion and improve its pre-tax earnings manifold by 2017. That's probably one factor that has got analysts at Goldman excited. But it may be too early to rejoice. While United Continental plans to reduce costs by using more fuel-efficient planes and increasing productivity, it isn't the only in the industry that's doing so. More importantly, as fellow Fool Adam Levine-Weinberg rightly points out, United Continental's initiatives may just help it offset inflationary pressures, but not reduce costs in the true sense. In fact, the carrier expects its non-fuel unit costs to increase 6%-6.5% this year. If the trend continues, cutting back on fuel consumption will be of no use.

At the same time, United Continental's increasing ancillary revenue (revenue earned outside the ticket price from extra services such as baggage fees, on-board food, and so on) isn't boosting profits much. Worse yet, United Continental's challenges will only get bigger once AMR merges with US Airways. The biggest threat from the merger is losing traffic in key growing areas such as Asia. With peer Delta Air Lines also eyeing a share of the pie, United Continental may find it tough to maintain and gain market share in that region.

United Continental's long-term strategy sounds exciting, but near-term headwinds appear too strong to enable the company to hit those targets easily. Goldman may have found United Continental undervalued, but with the shares already trading at 52-week high, and given the challenges ahead, investors may want to think twice before boarding the airline.

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Fool contributor Neha Chamaria has no position in any stocks mentioned. The Motley Fool recommends Goldman Sachs. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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