Has the United Continental Turnaround Finally Arrived?

For much of the last two years, United Continental (NYSE: UAL  ) has been the "Brooklyn Dodgers of the airline industry." It would enter each year with lofty expectations, but eventually stumble and dash investors' hopes, only to promise better times ahead. While most airlines have seen significant margin expansion since 2011, United's profit margin has contracted to the low single digits since then.

After two years of underperformance, is United finally bouncing back? Photo: United Continental.

However, United may finally be ready to break out from its long streak of underperformance. Uncharacteristically, after providing a glum Q4 outlook back in October, United managed to smash its revenue guidance for the quarter. While I am still skeptical of United's competitive position due to its high cost structure, the company is finally making a case that it can catch up to competitors over time.


The guidance
In October, United shocked the market when it told investors that unit revenue was likely to decline 0%-2% in the fourth quarter. The company blamed this expected decline on several factors, including dampened demand caused by the government shutdown, a poorly calibrated revenue management system, and increased competition on routes to China.

However, this forecast quickly began to look overly pessimistic. In early November, United disclosed that October unit revenue was flat -- significantly better than the original forecast -- due to "larger than normal positive adjustments identified during the month-end close process."

Like most other U.S. airlines, United experienced a modest decline in unit revenue for November due to the calendar shift of Thanksgiving toward the end of the month. That pushed most of the lucrative Thanksgiving return traffic into December. Sure enough, United announced this week that unit revenue soared by about 12% last month. Once again, the company highlighted higher than normal positive adjustments from the "month-end close" as a factor boosting unit revenue.

The net result of United's better than expected performance is that unit revenue is now projected to rise 2.8%-3.8% for Q4 2013. At the midpoint, that would represent an improvement of better than four percentage points over the original guidance. It would be hard to overstate the significance of this guidance beat; nearly all of that incremental revenue will drop to the bottom line. This should allow United to crush analysts' Q4 earnings estimates, which have been hovering around breakeven recently.

What's the long-term story?
United's Q4 performance looks very solid, to be sure. However, we at the Fool recommend that investors take the long-term view; it's the best way to build wealth. So what does United's Q4 revenue performance mean for its long-term prospects?

This is where the story becomes more muddled. In two separate months during Q4, United pointed out big positive adjustments related to interline tickets that boosted unit revenue. It's not clear whether investors can rely on these positive adjustments going forward or if they were "one-time" in nature.

On the flip side, competition for flying to Asia is just going to get more and more brutal for the foreseeable future, as the top carriers jockey for position. For example, Delta Air Lines (NYSE: DAL  ) is building a trans-pacific gateway in Seattle that is starting to compete with United's San Francisco hub. Delta began flights to Shanghai last summer, and in June it will begin service to Seoul and Hong Kong.

Delta is stepping up the competition on routes to Asia with its new Seattle international gateway.

Meanwhile, Cathay Pacific is starting service between Newark and Hong Kong in March, giving United its first direct competition on that route. Cathay Pacific also plans to boost service on its Chicago-Hong Kong route this summer, again in direct competition with United.

More broadly, United has the highest cost structure in the airline industry today. Despite efforts to offset cost growth, it will be hard for United to do more than keep pace with top competitors Delta and American Airlines (NASDAQ: AAL  ) , which are also actively pursuing cost-cutting opportunities. This means that, unless United can sustain an even bigger revenue premium than it does today, it will have to accept permanently lower margins.

Foolish takeaway
United Continental appears well positioned for solid margin expansion in 2014, barring a spike in oil prices. However, for me to become comfortable with United as an investment, I would need to see to see the company consistently reduce the margin gap vis-a-vis Delta and American over the course of several quarters (at a minimum).

Based on United's new guidance, it looks like the carrier gained some ground on the airline industry in Q4 in terms of profit margins. Now, United just needs to repeat that performance a few more times, and it will finally be in decent shape.

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  • Report this Comment On January 10, 2014, at 1:24 PM, ffbj wrote:

    Haha, the Brooklyn Dodgers. You would have to be pretty old, or from the New York area to get that comment, The Dodgers were perennial doormats or also rans. Eventually they went to L.A. in the 50's I think.

    Nice analysis UAL the market seems to agree.

  • Report this Comment On January 10, 2014, at 1:30 PM, ffbj wrote:

    Oh, and it reminds of the perennial oft asked question in the 40's. "How are the dodgers doing?"

    Immortalized in the movie 'Dark Star' when asked by the captain who has been frozen.

  • Report this Comment On January 10, 2014, at 1:44 PM, TomJelen wrote:

    underperformance ? the CEO and the BOD have under performed considerably and when the BOD smartens up, gets rid of the money monger greed driven CEO Smisek and Tilton CO will have better performance when the employees see the light of day rather than the dracoinion method of managment that suppresses the employees.

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