Why United Airlines' Revenue Premium Is in Peril

Earlier this week, United Continental (NYSE: UAL  ) outlined plans to rebuild its ability to charge more for its flights -- its revenue premium -- compared to the rest of the U.S. airline industry. As recently as 2011, United's unit revenue beat the industry average by 16.8%, but that number shrank to 14.9% in 2013 .

However, while United is taking important actions to improve its own performance, that extra revenue premium may be gone for good. Big legacy carriers like United Continental primarily create a premium by offering a comprehensive global route network -- and United already has the best one .

United Airlines has a stellar global network, which makes it hard to improve (Photo: United Continental)

As a result, it is hard for United to make anything other than incremental improvements to its network. By contrast, top competitors AMR (NASDAQOTH: AAMRQ  ) and Delta Air Lines (NYSE: DAL  ) have much more room for improvement -- and they are both seizing that opportunity. If anything, AMR and Delta are likely to be in better position vis-a-vis United Continental in a few years than they are today.

The direct merger impact
The first big challenge for United is the upcoming merger of AMR and US Airways (NYSE: LCC  ) . Currently, US Airways is a member of the Star Alliance, along with United. United and US Airways have maintained a code-sharing arrangement in the past. This was particularly important, because whereas United has the best route network to Asia of any U.S. carrier, US Airways does not fly to Asia at all.

The American-US Airways merger will give American a competitive boost (Photo: AMR)

Corporate clients in the US Airways hub markets -- Philadelphia, Charlotte, and Phoenix -- were therefore likely to use code-share flights with United for most travel to Asia in the past. After the merger, these cities will be American Airlines hub markets. Corporate customers will therefore tend to fly on American or one of its Oneworld alliance partners (such as Japan Airlines or Cathay Pacific) for travel to Asia .

United's loss will thus be American's gain. The same effect may also occur in other regions, both domestically and internationally. While US Airways was strong in a few areas, it relied on partners like United to fill in some major gaps in its route network. The new American closes those gaps.

New competition to Asia
A second long-term challenge for United is that while it was a first mover in Asia, its advantage is shrinking. Delta and American are both focused on broadening their Asian route networks, and they've made plenty of recent progress.

Delta is quickly growing its Seattle international gateway (Photo: Delta Air Lines)

Delta is building up an international gateway in Seattle, which will increasingly compete for Asia-bound traffic with United's San Francisco hub. Delta now flies from Seattle to both Tokyo airports (Narita and Haneda), Beijing, and Shanghai. The carrier plans to introduce service to Seoul and Hong Kong next June. Furthermore, Delta has made it clear that it intends to expand even more in Seattle in the coming years .

American Airlines has an even smaller Asian presence than Delta today, but it's also looking to catch up. Earlier this year, it began nonstop flights between Dallas-Fort Worth and Seoul . Just last month, the carrier announced plans to begin flying to Hong Kong and Shanghai from Dallas-Fort Worth .

American and United dominate the Texas air travel market; both airlines maintain their largest hubs in the state. The addition of direct service to key Asian travel destinations from Texas could give American a leg up compared to United in competing for corporate contracts in the region.

China's rapid growth is also spurring significant industry capacity increases, which will hurt United more than Delta or American because of its higher exposure to the country. For example, Cathay Pacific is boosting capacity on its Chicago-Hong Kong route next year, and it is also starting nonstop service from Newark to Hong Kong next year (competing directly with United in both cases ).

Foolish conclusion
While United Continental is taking steps to rationalize its international route network, it's not operating in a vacuum. United already earns a revenue premium thanks to its superior network, especially in the Far East. United is expanding that network by adding service to "secondary" markets like Taipei and Chengdu, but competitors like Delta and American are catching up just by increasing their service to primary markets like Shanghai, Seoul, and Hong Kong.

The American-US Airways merger will only accelerate this natural narrowing of the gap between United and its competitors. As US Airways and its customers move from Star Alliance to Oneworld, United will lose codeshare business for its flights to Asia and other areas where US Airways is weak.

United may be able to maintain some degree of a revenue premium against Delta and American for the foreseeable future. However, United's service improvements will not be enough to widen the gap, in light of the significant network improvements coming at both of its top competitors. As a result, its cost disadvantage will continue to keep United's margins well below the industry average.

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