United Airlines: The Outlook Brightens (a Bit)

Last Thursday, United Continental (NYSE: UAL  ) filed an investor update, providing some more insight into the company's likely Q2 results. The update was generally positive from a revenue perspective, suggesting that United is seeing relatively good demand for the summer travel season. However, the analyst community still has unrealistically high expectations for United, in light of the company's unfavorable cost structure.

Revenue rises, but so do costs
The first piece of welcome news for investors was that passenger revenue per available seat mile (or PRASM, probably the most important measure of revenue in the airline industry) will increase between 0.3% and 1.3% for the quarter. That's certainly not strong growth, but it implies that PRASM showed a solid 3%-4% increase in June after declines in April and May.

United also seems to be boosting non-ticket revenue. This consists of bag fees, change fees, and other optional passenger charges; "third-party business" revenue, such as maintenance work done for other airlines; and cargo revenue. These revenues totaled $1.17 billion in Q2 of 2012, but are forecast to rise to $1.30-$1.35 billion last quarter. This suggests that United is continuing to have success in diversifying its revenue sources.

On the other hand, unit costs (excluding profit sharing and third-party business expenses) are expected to rise 1.4%-2%, despite a $0.25 decline in jet fuel prices from $3.29 in Q2 of 2012 to $3.04 last quarter. In other words, non-fuel unit costs are increasing so quickly that it is overwhelming the effect of lower fuel prices. Furthermore, third-party business expenses rose from $60 million last year to an estimated $170 million in the same quarter this year (explaining much of the increase in non-ticket revenue).

The net effect is that United's Q2 adjusted EPS will probably be pretty similar to last year's $1.41 result; analysts currently expect EPS of $1.38. By contrast, Delta Air Lines (NYSE: DAL  ) -- which has led the major carriers in terms of profitability for the past year or two -- is expected to post strong 35% growth in adjusted EPS. Delta is starting to realize the first cost savings from its $1 billion cost reduction program, and is making market share gains in New York, where it has invested a lot of money to grow its presence at LaGuardia and JFK Airports.

Great expectations
United posted a slightly larger loss year over year in Q1. With the company on track to produce a Q2 profit similar to last year's $1.41 per share, overall first-half earnings will be slightly lower in 2013 than in 2012. Nevertheless, analysts still expect United's adjusted profit for 2013 to more than double compared to 2012! This implies that the company's profit margin would increase by 450-500 basis points in the second half of the year compared to the same period in 2012.

While the company faces easier comparisons in the second half of the year, investors seem to be asking too much of United. First, the company cut capacity significantly in the first half of 2012, which tends to boost unit revenue by restricting supply. By contrast, United has projected slight increases in capacity in the second half of the year, including significant capacity growth on its routes from Newark to San Francisco and Los Angeles.

Furthermore, based on the current price of jet fuel, United will realize a smaller benefit from fuel prices in Q3. The company currently projects an average fuel price of $3.02 after hedging costs, compared to $3.18 in Q3 2012. The year-over-year decrease is thus projected at $0.16 for Q3, compared to a $0.25 decline last quarter.

Be careful
Like most airline investors, I expect United to return to solid profit growth in the third quarter, as it bounces back from a weak 2012. However, this alone does not seem like a good reason to buy the stock. United already has perhaps the highest cost structure in the airline industry, and the company is likely to experience above average cost increases for the next year or two as it signs new labor agreements with flight attendants, mechanics, and other workers.

United's high cost structure might be manageable if it could sustain a revenue premium against competitors like Delta and AMR (UNKNOWN: AAMRQ.DL  ) . However, United was the worst airline in the U.S. according to most customer service metrics in 2012, destroying customer goodwill. Unless the company can make a miraculous turnaround and justify higher fares than competitors, United's high cost structure will doom it to mediocrity in the long run.

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