As the airline industry has recovered in the past few years, JetBlue Airways (NASDAQ: JBLU ) and United Continental (NYSE: UAL ) have been left behind. It's not that either company is in grave danger -- both are solidly profitable. However, they have fallen behind best-in-class competitors such as Delta Air Lines (NYSE: DAL ) and Southwest Airlines (NYSE: LUV ) .
Earlier this month, airline analyst John Godyn surveyed institutional investors about JetBlue and United's relative prospects. Two-thirds of investors thought United Continental was more likely to engineer a successful turnaround than JetBlue. (Godyn also liked United's turnaround chances better.)
However, the smart money may be wrong on this question. While United is implementing a $2 billion cost-cutting program called "Project Quality" to boost earnings, JetBlue has a clearer path to matching the financial performance of Delta and Southwest.
U.S. airline industry profits have soared in the past two to three years. However, the gains have largely come from a few companies that moved quickly following the Great Recession to manage costs, reduce fuel consumption, and boost revenue.
Among the big global network carriers, Delta Air Lines has been the clear leader. Among low-cost or hybrid carriers, Southwest has reasserted its dominance. While margins have remained roughly flat at JetBlue and United, Delta and Southwest have pulled way ahead.
The performance gap has continued to widen this year. For example, in Q2, Southwest posted a 16.3% adjusted operating margin, and Delta wasn't far behind with a 15.1% adjusted operating margin. United and JetBlue were laggards, with adjusted operating margins of 10.4% and 9.4%, respectively.
This divergence in profitability has caused a corresponding divergence in stock performance. All four stocks -- along with virtually all other airline stocks -- have performed extremely well in the past two years, but the gains have been much greater for Delta and Southwest.
Closing the gap: fuel efficiency
United Continental's better-than-expected Q2 performance has reinforced the notion that United has more upside than JetBlue. However, JetBlue has several overlooked advantages.
For example, United's "Project Quality" aims to derive half of its cost savings (or $1 billion) by 2017 from fuel-efficiency improvements. These include adding rows to certain aircraft, replacing older planes with newer, more efficient models, and retrofitting certain aircraft with more advanced winglets that reduce fuel burn.
However, United is held back by its massive size. United has nearly 700 mainline planes in its fleet, plus more than 550 regional aircraft. By contrast, JetBlue has fewer than 200 planes today, and 85% of its capacity comes from its fleet of 137 Airbus planes. With a much smaller fleet, JetBlue can quickly make fuel efficiency improvements.
Next year, JetBlue will begin retrofitting 110 of its Airbus planes (which account for the vast majority of its capacity) with "Sharklet" winglets. These can reduce fuel burn by as much as 4%.
JetBlue also has 39 Airbus A321 aircraft on order between 2015 and 2017. Most of these will be configured with 190 seats (compared with 100 to 150 seats for most JetBlue planes today) and should consume at least 15% less fuel per seat than JetBlue's fleet average. (Southwest has used a similar "upgauging" strategy to grow its margins recently.)
Starting in 2018, JetBlue will receive a large number of A321neos with upgraded engines that will offer even bigger fuel savings. JetBlue's small size will thus allow it to easily match or beat United's fuel-efficiency improvements over time.
United also plans to find $1 billion of non-fuel cost savings by 2017. Half of this will come from productivity initiatives such as deploying self-service technology. However, JetBlue may have an advantage over United in this field, too.
For example, JetBlue recently began an "automatic check-in" program that will completely eliminate the check-in process for certain customers. This program will be rolled out more broadly next year. The addition of 190 seat A321s will also vastly improve JetBlue's productivity. Pilots will receive the same pay as for an A320, but the planes will have 27% higher seating capacity.
Revenue risks and opportunities
Lastly, JetBlue has some advantages on the revenue side. Going forward, United is likely to face unit revenue pressure in the off-peak seasons on routes to China, because of rapid growth in competitors' capacity. It will also face pressure in Latin America starting late next year, when Southwest Airlines begins international flights from Houston, United's main Latin American gateway.
United's main tools for combating these pressures are relatively small tweaks to the status quo. It's working to improve its revenue management system to boost fares. United is also looking to squeeze more ancillary revenue from its first-class and Economy Plus seats.
JetBlue has bigger opportunities. In June, it introduced a premium cabin with lie-flat seats on flights from New York to Los Angeles, and the service will be extended to New York-to-San Francisco flights in October. These "Mint" seats will command much higher fares than coach tickets -- and may draw some customers away from United's competing "P.S." premium service.
JetBlue also has plans to boost ancillary revenue, and it's starting from a lower base than United Continental, giving it a bigger opportunity. The biggest change that's coming is the introduction of "fare families," which will allow JetBlue to tailor its ancillary offerings by route and by customer to bring in more revenue.
United Continental and JetBlue both have a long way to go to catch up to industry leaders such as Delta and Southwest. However, looking out over the next five years, JetBlue has a better chance to catch up to best-in-class competitors than United does.
United's problems stem in part from its size, which makes it harder to quickly revamp its fleet. It is also likely to face atypical increases in competition on routes to China and Latin America, as well as on the lucrative transcontinental routes. JetBlue's opportunities to cut costs by upgauging and boost revenue with its Mint service and fare families give it an edge over United in the race to catch up.
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