Why United Continental's Shares Popped... and a Secret Catch-22

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What: It was a terrific Tuesday for investors of United Continental Holdings  (NYSE: UAL  ) as the stock shot through the roof to hit an all-time high of $38.91, fueled by the optimistic initiatives announced by the world's largest carrier at its annual Investor Day conference.

So what: Here's a snapshot of what United Continental plans to do, together with where it stands now vis-à-vis some of those goals:

  • Cut back on fuel consumption and sourcing costs while improving productivity to reduce annual costs by $2 billion
  • Double to quadruple its pre-tax earnings over the next four years (for perspective, United Continental lost $764 million pre-tax last year)
  • Increase ancillary revenue (revenue earned outside the ticket price from services such as baggage fees, on-board food, and so on) by nearly $700 million, in line with the company's goal to generate over $3.5 billion in ancillary revenue by 2017
  • Achieve 10% return on invested capital (United Continental had a negative 10.8% return on invested capital last year)
  • Increase cash flow by 2015 to begin rewarding shareholders

Sounds great, but how does United Continental plan to meet those revenue and profit targets? To begin with, the company will introduce the Boeing 787 Dreamliner on new routes. Since the 787 uses 20% less fuel compared to similar-sized planes, that should help United reduce its overall fuel costs. At the same time, United Continental will strike off unprofitable routes, like Seattle to Tokyo, from its list while increasing flight frequency on more lucrative routes, such as Houston to Tokyo. United Continental will also build up on transatlantic and new seasonal routes to increase passenger traffic and sales. The carrier also launched a mobile app last week and is overhauling its main booking website to improve customer experience.

Now what: While lower costs, higher pre-tax earnings, and greater returns on capital are inspiring, I'm not sure about United Continental's stress on increasing ancillary revenue. Of course, extra revenue can never be bad, but United Continental already rakes in the largest revenue from add-on services in the industry, but is still losing money. So charging higher fees for optional services could actually be backfiring and eating into United Continental's ticket sales. While ancillary revenue has assumed significant importance in the airline industry in recent times, United Continental either needs to find innovative ways to make the customer willing to pay for the extra services, or simply shift focus to core business by expanding into high-growth and profitable routes.

In the initiatives laid down today, United Continental didn't really specify how it will grow its revenue; until it increases sales, those earnings targets will be nearly impossible to achieve. And until the company turns its losses and negative free cash flow around, investors cannot expect dividends or returns in any other form. It's a clear wait-and-watch situation, and I don't think investors should get too excited about United Continental's plans yet.

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