Continental Airlines

(CAL) - Get Report

stock rose 3.5% after J.P. Morgan upgraded the carrier to overweight from neutral, telling investors the carrier's strong international presence helps it beat low-cost competitors.

With many investors preferring to buy into the turnaround story at

AMR

(AMR)

, the parent of American Airlines, J.P. Morgan analyst Jamie Baker told investors that Continental's shares were undervalued. In Baker's view, the stock has been unfairly punished given Continental's cost position relative to peers and its expected return to profitability in 2004.

"The stock was trading more like a carrier in labor crisis than one expected to produce a full-year profit, in our opinion," said Baker, in his research note. "

CEO Gordon Bethune's retirement, weak domestic revenue trends and American's cost achievements don't sully a still-respectable cost structure and well-diversified network. Market confidence in Continental may be waning, but ours is not."

Recently, shares of the carrier gained 49 cents, or 3.5%, to $14.35. The move erases some of the 20% Continental shares have lost in the last four weeks, part of an industrywide selloff on fears that high oil prices, deep discounting and overcapacity have left earnings estimates overly optimistic.

Not that Continental's share-price decline was totally undeserved. In the month of January, Continental showed a year-over-year decline in revenue per available seat mile, or RASM, a key industry metric. Baker estimates that Continental was the only carrier among peers which reported a drop in RASM to the Air Transport Association, the industry's trade group. And with American and

Delta Air Lines

(DAL) - Get Report

offering two-for-one deals on

JetBlue's

(JBLU) - Get Report

routes and overall competition heating up, the revenue outlook remains weak in the near term.

But while the competition is fierce for Continental, Baker said the airline has been able to beat low-cost competition with discounts of its own, forcing

ATA Airlines

(ATAH)

to stop serving the once-lucrative Newark to San Francisco route.

Not everyone agrees. While many on Wall Street prefer the network names -- UBS Warburg and Goldman Sachs have both expressed a preference for the earnings leverage the recovering legacy carriers have -- a small consensus is building for the long-term growth at low-cost carriers.

On Feb. 12, Raymond James' analyst Jim Parker upgraded the low-cost sector, telling investors that sales were a short-term phenomenon and the long-term cost advantages carriers like Southwest have make them attractive at current levels.

"The legacy carriers' recent initiatives to bring back capacity in competition with the low-cost carriers, we think, are exacerbating their own poor financial performance," argued Parker, in his upgrade.

But Continental and the other network carriers are seeing increased strength from an area that low-cost competitors can't match: international travel.

In the month of January, RASM increased 2.7% year over year along domestic routes, a signal airlines were adding back flights to meet demand, keeping prices relatively high overall while discounting in select markets. While this RASM gain was good, the year-over-year RASM increase on international routes was even better, with RASM jumping 13.5% on Atlantic routes and 16.4% on Asia-Pacific ones.

Part of the improvement stems from easy comparisons. A year ago, demand for international travel dried up before the war in Iraq, forcing airlines to cancel flights and lower prices to meet the reduced demand. But part of this, in the view of many Wall Street analysts, represents a big advantage the legacy carriers have going forward.

As a result, Baker narrowed his loss estimates on the legacy carriers, telling investors he expected the group to lose just $300 million in 2004, vs. a loss of $2.9 billion in 2003.

"Apparently, it does pay to have a network and multiple fleet types after all. At the same time, we are reducing our 2004 profit expectations for low-cost carriers, since, well, they don't have international franchises from which to subsidize the increasingly hostile domestic environment," said Baker.