Can United Continental Keep Investors' Portfolios Flying High?

Investors have bid shares of United Continental higher over the past year, believing that the major airline left its red ink in the past. Is it time for investors to look for the exit?

Jan 6, 2014 at 2:31PM

United Continental Holdings (NYSE:UAL) had a solid year in 2013, with its stock price up almost 60%, as it benefited from lower fuel prices and a better overall load factor on its flights. The company has made its mark as the top-ranked domestic airline for international departures, offering daily flights to a diverse network of airports on six continents. Like its remaining competitors, the company should also benefit from the elimination of major competitor American Airlines, recently acquired by US Air.  With nimble low-cost competitors on its heels in the domestic market, though, now is a good time for investors to take a closer look. 

What's the value?
United has a solid position as one of the top four domestic airline networks, shuttling approximately 140 million passengers to their destinations each year on its United and United Express-branded planes. The company gained immeasurably from its 2010 merger with major competitor Continental Airlines, a combination that added significantly to its capacity and generated roughly $1.2 billion in operating synergies. The net result has been an enterprise better able to weather the effects of rising energy prices, and a unionized workforce that accounts for 80% of its employee base.

In FY 2013, United has posted a marginally higher top line, up 1.8%, as higher average ticket prices were only partially offset by a conscious decision to reduce capacity. Despite the more favorable pricing environment, though, United's adjusted operating profitability slipped slightly, due to rising employee compensation and higher costs to repair and maintain its aging fleet.  On the upside, United's operating cash flow has enjoyed a solid gain in the current period, allowing the company to fund the development of new routes to popular destinations like Paris and Tokyo.

Of course, much of the airline industry's recent profitability improvement has come from a better matching of industry capacity to consumer demand, thereby avoiding the tendency to engage in profit-busting price wars. Unfortunately, it is likely only a matter of time before the age-old profit motive causes more efficient competitors to pursue capacity expansion in a bid to gain further market share. Indeed, one needs only to look at the recent moves of industry leader Delta Air Lines (NYSE:DAL) for a potential precursor of things to come.

Delta has not increased its overall capacity in FY 2013, but it continues to significantly increase its operations at key hub locations, including a 40% capacity increase at New York's LaGuardia Airport and an upgrade of its terminals across town at Kennedy Airport. 

In addition, it bought a 49% stake in competitor Virgin Atlantic in June 2013, an aggressive move designed to increase gate access at London's Heathrow Airport, one of Europe's busiest locations. Delta's moves, along with its 2012 purchase of an oil refinery, position it to expand its flight capacity and profitably capture incremental passenger activity, even at lower average ticket prices.

A better way to go
Given the industry's history of engaging in competitive pricing, and the costs of maintaining global hub networks, investors will likely find better returns with low-cost niche players, which also have the benefit of being potential acquisition targets down the line.  One of the best positioned companies in the domestic travel market is Spirit Airlines (NASDAQ:SAVE), an ultra-low-cost airline that has leveraged its home base in tourism-heavy Florida into a network serving 54 airports throughout the Americas and the Caribbean.

Spirit has continued its strong growth trajectory in FY 2013, with a top-line gain of 24.7%, aided by the addition of aircraft to its fleet and a strong load factor for its flight network. The company uses a low-cost operating structure, including leasing all of its planes, to entice customers with low, no-frills fares, hoping to up-sell them with ancillary services at various prices.  Spirit's success with its up-sell strategy is evident from its operating margin, which increased to 17.4% during the current period, far above operating margins at either United or Delta.

The bottom line
The strong year-over-year gain for United's share price indicates that investors believe that the company will be able to maintain its profitability going forward.  However, the company's high exposure to energy prices, accounting for one-third of its costs, as well as the ever-present danger of work stoppages, means that investors would be better off looking for providers that can earn a profit throughout the business cycle. As such, investors looking to take flight in the sector should stick with low-cost niche players, like Spirit Airlines. 

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