In the past five years, United Continental (NASDAQ:UAL) has fallen badly behind its rivals in the U.S. airline industry in terms of profitability.
Its underperformance compared to Delta Air Lines (NYSE:DAL) has been particularly stark. In 2011, United's adjusted pre-tax margin was 3.6%, compared to 3.4% for Delta. By contrast, in 2015, United's pre-tax margin was 11.9%, whereas Delta's pre-tax margin was 14.4%. Delta is poised to gain even more ground during 2016, widening its margin advantage to at least 5 percentage points.
On Tuesday, United Continental held an investor conference call to explain how it plans to narrow its margin deficit relative to competitors like Delta. In total, United announced initiatives that could add $3.1 billion to its bottom line by 2018 relative to 2015. Here are some of the key aspects of this plan.
Getting back to basics
Of the $3.1 billion profit improvement opportunity identified by United, roughly 40% ($1.3 billion) relates to better execution. For example, improved revenue management techniques and revenue growth from United's MileagePlus loyalty program could together contribute $500 million in incremental profit by 2018.
Additionally, better operational performance will help United Continental regain premium customers while reducing costs related to rebooking passengers from canceled flights. United has made some progress on this front, but it still lags Delta in reliability by a wide margin. Higher operational reliability could generate $300 million in incremental profit by 2018.
Finally, United Continental is extending the successful "Project Quality" cost reduction initiative it launched in 2013. By simplifying its maintenance program, introducing new technology to improve productivity, and negotiating better deals with suppliers, United expects to cut another $500 million in annual structural costs by 2018.
Putting more seats on the plane
The second major profit improvement opportunity for United is increasing the number of seats per departure. Management estimates that going from 105 seats per departure in 2015 to 121 seats per departure in 2018 could add $800 million to the bottom line.
There are two ways to move toward this goal. First, United is installing slimline seats on some of its fleet, allowing it to increase seating capacity without cutting legroom too much. Second, United is upgauging its fleet, replacing planes that are ready to be retired with larger ones.
A key part of this upgauging strategy is United's move to reduce its fleet of cramped, inefficient 50-seat jets from more than 250 planes today to fewer than 100 by the end of 2019. The lost capacity will be replaced with small mainline jets in the 120-130 seat range.
This is another area where Delta Air Lines has been far ahead. By the end of 2016, Delta expects to have about 125 50-seat jets in its regional fleet, half as many as United.
Increasing customer segmentation
The third and final bucket for United's profit improvement plan is improving customer segmentation. This means getting more revenue from less price-sensitive customers while also appealing to more cost-conscious travelers.
Within this category, United expects to get $750 million by increasing sales of first class and extra-legroom seats. By 2018, United will grow its inventory of Economy Plus extra-legroom seats by 20% and its inventory of premium cabin seats by 30%. Much of this increase is driven by replacing the 50-seat jets (which have an all-coach configuration) with larger planes. United is also improving distribution, selling these upgraded seats through travel agents and other third-party channels.
Another $250 million annualized benefit stems from the upcoming introduction of entry-level fares and fare bundles. Together, these products will enable United to target the lower end of the market while also encouraging customers to upgrade to higher-value services.
United faces an uphill battle
While United Continental presented $3.1 billion in profit improvement opportunities, investors should not actually expect the company's pre-tax profit to rise by $3.1 billion by 2018.
In the next few years, United is likely to face significant cost headwinds related to new labor contracts and rising fuel prices. At the same time, United's upgauging initiatives will lead to more seats or fewer departures on many routes. That will naturally put pressure on unit revenue. Rising competition from budget carriers could drive further unit revenue weakness.
That said, United shares currently trade for less than six times projected 2016 earnings, and the company's market cap is just half that of Delta. This shows that investors are deeply skeptical of United's ability to maintain even its current level of profitability.
If United Continental can use the initiatives discussed on Tuesday to hold profits at 2016's level for the next few years despite the expected revenue and cost pressures, shareholders should do very well. This seems like a much more achievable goal for the company.
Adam Levine-Weinberg owns shares of United Continental Holdings and is long January 2017 $40 calls on Delta Air Lines. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.