United Continental May Have a Free Cash Flow Problem

While earnings per share, or EPS, can be a handy statistic for investors to use to evaluate the performance of stocks that they own, it does not always tell the whole story. Ultimately, free cash flow is the holy grail for investors. Free cash flow is calculated by taking the amount of cash generated from operations and subtracting capital expenditures. In short, it represents the amount of profit left over after a company has made necessary investments in the business. Free cash flow is a particularly important metric for shareholders because it represents money that potentially could be returned to them through dividends or share repurchases.

On a straight P/E basis, United Continental (NYSE: UAL  ) looks fairly cheap even though it hit a new 52-week high last Friday. The Friday closing price of $27.38 is just 7.4 times the average analyst estimate for 2013 EPS, and 5.6 times the average estimate for 2014 EPS. However, free cash flow tells another story. United Continental is facing a period of heavy investment that will probably sap free cash flow through the end of this decade. This poor free cash flow outlook makes United a questionable investment candidate compared to peers, particularly Delta Air Lines (NYSE: DAL  ) .

Operating cash flow: a baseline
Over the past three years, United Continental's operating cash flow has been very inconsistent. This has been the result of two factors: profit instability caused by integration problems and rising oil prices, and one-time merger integration costs. In the past three years, operating cash flow has ranged from a low of $935 million last year to a high of $2.4 billion in 2011. If we add back United's approximately $600 million of special charges in 2011, United would have generated as much as $3 billion in operating cash flow.

If we assume a return to that level of operating cash flow in 2013 and modest growth through the end of the decade (a bullish assumption, given United's poor performance recently and the turbulent history of the airline industry), United may produce $25 billion in operating cash flow through 2019: an average of $3.57 billion a year. However, shareholders will see very little of that money.

Heavy capital commitments
The reason why shareholders may fare poorly even in the relatively bullish scenario outlined above is that United has very heavy capital commitments over the next seven years, as can be seen in the following table:

Year

Capital Commitments

2013

$1.8 billion

2014

$1.5 billion

2015

$2.0 billion

2016

$3.0 billion

2017

$2.5 billion

2018

~$2.5 billion*

2019

~$2.5 billion*

Total

~$15.8 billion

Data from United Continental's 2012 10-K (p. 139); * denotes author's estimate.

United Continental has thus committed to spending nearly $16 billion in capital expenditures over the next seven years. Nearly all of those commitments relate to aircraft acquisitions. The company currently has 247 aircraft on order, most of which will be delivered by 2019 (the exception is United's order for 100 Boeing 737 MAX 9 aircraft, for which deliveries run through 2022).

However, capital expenditures will be higher than the level of commitments suggests. The commitments refer primarily to aircraft purchases, but United will need to upgrade old aircraft from time to time (such as United's current project to add Wi-Fi service on all its aircraft). The company will most likely have to invest in IT systems and ground facilities as well. Capital expenditures could fly even higher if United chose to exercise any of its aircraft purchase options.

For 2013, United has projected that capital expenditures will total $2.5 billion, $700 million ahead of the committed expenditures. Assuming that capital expenditures will exceed commitments by just $500 million annually thereafter, we would reach the following capex estimates:

Year

Capex (estimate)

2013

$2.5 billion

2014

$2.0 billion

2015

$2.5 billion

2016

$3.5 billion

2017

$3.0 billion

2018

~$3.0 billion*

2019

~$3.0 billion*

Total

~$19.5 billion

Data from United Continental's 2012 10-K (p. 139); * denotes author estimates.

Based on the relatively optimistic operating cash flow forecast of $25 billion through the end of the decade and this estimate of United's future capex, the company would generate free cash flow of just $5.5 billion over that time period. United's current market cap of $9 billion is therefore 11.5 times its average (estimated) annual free cash flow for the next seven years. This makes United look a lot more expensive than its P/E ratio would suggest.

Analysis
United Continental's heavy investment cycle is due in part to underinvestment during United's bankruptcy and the 2008-2009 industry downturn, but can also be attributed to management's strong preference for new aircraft. While new aircraft offer fuel efficiency and maintenance cost benefits, the high upfront investment makes this strategy risky. Commercial aircraft have useful lives of 25-30 years, and changes in the competitive environment, fuel costs, and other considerations over that period of time could invalidate the original cost benefit analysis justifying a major aircraft order.

Unlike United, Delta has repeatedly shown an ability to do more with less capital. While United has committed aircraft expenditures of $10.8 billion over the next five years, Delta's aircraft commitments are just $4.9 billion over that time period. This is part of an explicit strategy to maintain capex at moderate levels of $1.5 billion-$1.7 billion annually. (Moreover, Delta has consistently produced operating cash flow of $2.5 billion-$3 billion over the past three years, unlike United.)

Disciplined free cash flow management has allowed Delta to announce an intention to begin returning cash to shareholders next year. By contrast, United's heavy capex plan means that it probably cannot follow suit. United has $6 billion of debt maturing in the next three years alone, which will probably soak up whatever minimal free cash flow the company manages to produce.

Conclusion
Delta's strong cash flow profile sets it apart from many other airlines, particularly United. In a perfect scenario, wherein the airline industry flourishes for the next decade or more, patient United shareholders could see good returns, particularly if capex ramps down in 2020 and beyond. Knowing the turbulent history of the airline industry, this is probably wishful thinking. Poor execution or an industry downturn could easily wipe out all of United's projected free cash flow for this decade. Delta's consistent free cash flow production makes it a much more desirable investment opportunity.

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