1 Thing You Need to Know About United Continental's Plans

United Continental (NYSE: UAL  )  on Tuesday outlined a program at its investor day conference that is intended to cut costs by $2 billion each year. According to the airline,"The plan includes reducing fuel consumption, increasing productivity, reducing sourcing costs, improving maintenance processes and inventory procedures, and optimizing distribution methods."

United Continental revealed a $2 billion cost-cutting plan on Tuesday. (Photo: United Continental)

For now, this plan has struck a chord with analysts and the financial press. However, there's one tiny detail that they're missing: The supposed $2 billion of cost cuts are not actually leading to a reduction of United Continental's costs!

In 2017, when all the cuts will have been implemented, United Continental's unit costs will be higher than they are today. By cutting $2 billion in annual expenses over the next four years, United Continental is merely offsetting the rampant cost inflation it has faced recently. As a result, the company is still on track to face a long-term-cost disadvantage relative to its top competitors, Delta Air Lines (NYSE: DAL  ) and AMR (UNKNOWN: AAMRQ.DL  ) .

The plan in a nutshell
United Continental's "cost-cutting" plan comes in two parts. First, the airline plans to reduce fuel consumption by replacing older planes with new fuel-efficient aircraft, retrofitting existing aircraft with fuel-saving winglets, adding extra rows to certain planes through the use of slim-line seats, and optimizing route planning. In total, these initiatives are expected to improve fuel efficiency by 7% by 2017, saving the company $1 billion annually.

The second part of the plan involves managing those non-fuel costs better. The most important initiative here is improving worker productivity, with additional savings to come from several other areas.

Nominally, this second part of the plan will "save" $1 billion annually, but only in relation to the recent pace of unsustainable cost growth. In fact, despite all of the promised reductions in non-fuel costs, United Continental expects non-fuel unit costs to grow over the next four years, albeit at less than the rate of inflation.

Non-fuel unit costs will rise 1%-2% next year. If we assume a similar rate going forward, the company's non-fuel unit costs (roughly two-thirds of its total costs) will be up by about 6% by 2017. At the same time, United Continental's fuel efficiency improvements would reduce fuel costs (roughly one-third of the total) by 7% in that time frame, holding jet fuel prices constant. The net result is that at the conclusion of its $2 billion "cost-cutting" plan, unit costs will be 1%-2% higher than they are today.

Keeping pace (barely)
Keeping cost growth below the rate of inflation is certainly a good achievement, but it's not quite the same thing as actually reducing costs by $2 billion. To be fair, Delta used similar language when it announced its structural cost reduction initiative last year, even though that too was designed to keep unit cost growth below inflation.

A better way to think about United Continental's cost initiatives is by comparing the results to what we can expect from competitors. As it turns out, all three major carriers are likely to experience unit cost growth below the rate of inflation over the next five years. Thus, the plan United Continental unveiled this week will only allow it to keep pace with its competitors.

Delta's plan to halt non-fuel unit cost growth is already starting to pay off. Delta's non-fuel unit cost increased just 1% last quarter and is expected to rise approximately 2% in the current quarter. While it has not laid out a total fuel cost reduction goal, Delta is also rapidly renewing its fleet, and should achieve at least as much fuel cost savings as United.

Delta is also investing in fleet renewal. (Photo: Delta Air Lines)

Delta's activity in the used aircraft market has been well documented, but the company is also buying plenty of new planes. In September, Delta took delivery of the first of 100 new Boeing 737-900ERs. Delta is outfitting these planes with 180 seats, whereas the typical configuration at United allows only 167 seats (giving Delta lower unit costs). Delta also recently ordered 40 new Airbus aircraft, which will arrive between 2015 and 2017.

If anything, American Airlines will see even better cost performance following the AMR-US Airways (UNKNOWN: LCC.DL  ) merger. American is quickly reducing its non-fuel unit costs in the bankruptcy process; last quarter, non-fuel unit costs were down 5% year over year (excluding reorganization costs). American expects further cost savings to hit the bottom line once the company exits bankruptcy.

The merger with US Airways should provide additional cost savings, although the net effect will be relatively small after accounting for increases in employee pay rates. Furthermore, American has the most aggressive fleet renewal plan of the legacy carriers. In 2011, American placed a massive double order for 460 narrow-body aircraft from Boeing and Airbus, with deliveries between 2013 and 2022.

Much ado about nothing
Today, United Continental has the highest cost structure in the U.S. airline industry. When all is said and done, the company's $2 billion cost-cutting plan will not actually reduce these costs; it will just offset the cost inflation that would have occurred otherwise.

This is probably not good enough, as Delta and American have their own plans for keeping unit cost growth to a minimum going forward. At the conclusion of the four-year plan, United Continental will still have the highest cost structure in the industry. This will put it at a competitive disadvantage versus peers for the long haul.

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