United Continental (NASDAQ:UAL) reported another quarter of earnings growth on Tuesday afternoon. United produced a pre-tax margin of 14.5% in Q2, at the high end of the 14%-14.5% estimate range that the company provided last week. As a result, adjusted earnings per share exceeded the average analyst estimate by $0.05 at $2.61.
Thus, United Continental's performance was fairly solid last quarter. Nevertheless, United continues to lag Delta Air Lines (NYSE:DAL) by a wide margin in terms of profitability and shows no clear signs of improvement there.
The unit revenue environment remains challenging
Last week, United pleasantly surprised investors by raising its Q2 unit revenue forecast for the second time in the span of a month. Ultimately, passenger revenue per available seat mile (PRASM) declined 6.6% for the quarter. That was as good as investors could hope for in light of United's original forecast that PRASM would decline 6.5%-8.5% in Q2.
Nevertheless, this was a meaningful decline. And while Delta Air Lines missed its own unit revenue guidance last quarter, it still outperformed United, with PRASM down just 4.9% year over year.
Looking ahead to the third quarter, United expects PRASM to decline 5.5%-7.5%. Meanwhile, Delta has projected that PRASM will fall 4%-6% this quarter. Thus, United isn't losing as much ground to Delta as it was in late 2015, but it is losing ground nonetheless.
New labor contracts are driving cost pressure
On the cost side of the ledger, United Airlines has been hurt by a sharp increase in labor costs this year. This is the result of it having made progress in reaching long-term labor contracts covering most of its workers. (Of course, United would be even worse off if it hadn't reached these new labor contracts and worker morale remained low.)
As a result, United's adjusted non-fuel unit costs increased 2.5% year over year in Q2 and are expected to rise 2.5%-3.5% in Q3. Unit cost performance has been much better at Delta recently. Adjusted non-fuel unit costs declined 0.1% in Q2 and are expected to be roughly flat in Q3 at Delta.
No clear path to close the revenue gap
United Airlines does have some clear opportunities to reduce its cost gap relative to peers like Delta in the next couple of years. United recently outlined a number of cost reduction initiatives that will remove $1.3 billion in annualized costs by 2018. Much of the savings comes from "upgauging": increasing the average number of seats per departure.
Delta Air Lines has its own upgauging plans for the next few years, but it has already capitalized on much of this opportunity. Furthermore, Delta's pilots are due for a raise whenever they agree on a new contract, which will help United Airlines catch up on the cost side.
By contrast, United will probably struggle to close the revenue gap with Delta. While Delta has reported disappointing revenue results for two consecutive quarters, it expects trends to improve dramatically by September, setting the stage for a stronger Q4 performance. It has announced additional capacity cuts for Q4 in order to maximize its chances of stabilizing PRASM by then.
United has a bigger hill to climb to stabilize PRASM. Furthermore, management has pointed to declining market share in its hubs as a key cause of United's revenue erosion over the past few years. So cutting capacity isn't a straightforward fix.
In fact, while United said this week that it will trim some domestic flying on Saturdays and cut some capacity in the U.K. due to Brexit, it's not planning any broad-based capacity reductions. United's domestic capacity growth will accelerate in the second half of 2016 relative to last quarter.
This suggests that United will have a hard time matching Delta's unit revenue performance until travelers fully recognize its recent customer service improvements. This could take years to play out. If United wants to speed up the process, it may need to resort to more radical actions, such as closing one of its underperforming hubs in order to focus on stronger markets.