Northwest Airlines (OTC:NWACQ) moved up over 30% today after Owl Creek Asset Management - a 5% holder in the company - said that the company could be worth as much as $19.75-$33.50 per share in the event of a merger with Continental Airline (NYSE:CAL). How do they come up with this valuation?

Let's take a look at their 13D/A filing with the SEC that details their analysis:

"Though it is early to value Northwest for recovery purposes, Owl Creek submits that, based on Wall Street analyst reports, the trading markets value Northwest's legacy carrier peers (American, Continental, United, and US Airways) at 5-1/2 to 6 times "EBITDAR."(3) Carriers like Northwest with a higher likelihood of being a merger candidate trade for more than 6x EBITDAR and carriers with a lower likelihood of being a merger candidate trade closer to 5.5x EBITDAR. Based on similar 2007 fuel price assumptions to those underlying the comparable company valuations, Owl Creek forecasts Northwest's 2007 EBITDAR to be $2,700,000,000. Given a valuation of 6.0x 2007 EBITDAR, Northwest should have a total enterprise value of over $16,200,000,000 at the time of its expected emergence from bankruptcy protection in September of 2007. With a cash build up of over $1,000,000,000 during the remaining pendency of the bankruptcy cases, this would result in an equity value of $19.75 per share AFTER covering all claims with interest and the preferred stock.

Furthermore, US Airways' hostile offer for Delta Airlines last week -- aside from signaling directly the consolidation trend in the legacy carrier market from which Northwest's value undoubtedly will increase -- demonstrates the inherent value, recoverable by Northwest's equity holders, that a merger of Northwest with a strategic partner will create. US Airways announced that it expects the combination to generate $1,650,000,000 of annual synergies, which is 6.2% of the combined Delta/US Airways passenger sales. Assuming comparable proportional synergies to a Northwest merger with Continental (Continental Airlines is the most logical partner, but this analysis would be equally applicable to another carrier), then the synergies generated by a combination of Continental Airlines with Northwest would be approximately $1,250,000,000 annually. Valuing the company at a post-merger multiple of 5.25x EBITDAR including one half of the synergies accruing to Northwest (the other half to the merger partner) results in an implied stock price of $33.50 per share.

This is not a "what if" analysis. Experts have been calling for consolidation for some time, and US Airway's offer for Delta Airlines suggests the starting point. SEE, E.G., Benjamin Silverman and Susan M. Donofrio, TWO EVENTS MAY TRIGGER AIRLINE CONSOLIDATION THIS FALL, Cathy Financial Industry Report, September 22, 2006; Jeff Bailey, A REVITALIZED US AIRWAYS IS CREATING A MERGER BUZZ, N.Y. Times, July 31, 2006, at C2 ("The surprising early success of US Airways Group, the result of a merger last year, has led to some behind-the-scenes talks among investors and airline executives that could lead to more industry consolidation in the months ahead"); Susan Carey and Melanie Trottman, MERGER TALKS BRING OUT FEAR OF FLYING, Wall Street Journal, April 21, 2006, at C1 ("Most airline investors agree that consolidation would be great for an industry with too many airlines chasing too few dollars"). The value of the mergers becomes immediately apparent in the change in trading prices of Delta Airlines unsecured bonds following the November 15, 2006 announcement of US Airways' offer. The trading price of Delta Airlines bonds increased by fifty percent in the week after the announcement, and Delta's board has neither accepted nor closed that transaction yet." (Read More)

NWACQ is currently trading at just $3.49 per share, making the above valuations seem somewhat outrageous. In reality, the assumptions above are correct; however, everything depends on the airline's ability to pull itself out of bankruptcy and successfully orchestrate a merger. It is this risk premium that is keeping the stock at its low levels. This is definitely a stock to watch; however, prudent investors may want to wait until the bankruptcy picture clears up before investing a significant amount of capital.

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Continental Airlines (CAL)