United Continental (UAL 4.98%) has come a long way in terms of regaining investor support in the past few years. United Continental's board finally replaced longtime CEO Jeff Smisek two years ago, hiring railroad executive (and United board member) Oscar Munoz. In the past year, Munoz has hired several top deputies with lots of airline industry experience. This new team quickly created a plan to improve the company's operational and financial performance.
The new leadership team has announced some sensible strategy changes. Furthermore, United's operational performance has improved dramatically, driving better cost performance. However, during 2017, United's management has seemed to exaggerate how well the company is doing -- and that's troubling for investors.
Fun with numbers
During United's earnings call last week, CEO Oscar Munoz said that the company had a terrific quarter. President Scott Kirby followed by stating that the carrier had reduced its margin gap relative to Delta Air Lines (DAL 3.05%) for five straight quarters.
Management was happy with United Continental's Q2 performance. Image source: United Airlines.
This was an interesting statement insofar as United reported that its pre-tax margin declined by 1.3 percentage points in the second quarter, whereas Delta reported earlier this month that its pre-tax margin increased by 1.1 percentage points year over year. To get the result it wanted, United Continental appears to have excluded Delta's one-time fuel hedging losses from Q2 2016, but not a variety of other adjustments for "one-time" effects.
Meanwhile, for the third quarter, United Continental projected that its pre-tax margin will be 12.5%-14.5%, down from 15.7% a year earlier. By contrast, Delta Air Lines expects its operating margin to be roughly in line with its 19% reported operating margin from Q3 2016 and ahead of its 17.6% "normalized" operating margin from that period.
Thus, United's momentum toward closing the margin gap has either already stalled out or will do so this quarter. While the management team would like to report steady progress, it would be better to admit that United may take a step backward from time to time.
Unit revenue growth is stalling out
Last quarter, United Airlines' unit revenue returned to growth for the first time in years, rising 2.1%. However, this positive trend may not last. For the third quarter, United expects passenger revenue per available seat mile (PRASM) to be roughly flat year over year (plus or minus 1%).
Management had several explanations for this weak guidance, such as unfavorable timing of various holidays and short-term pressure related to adding new cities to United's route network. That said, Delta expects much stronger PRASM growth of 2.5%-4.5% -- and this discrepancy can't be fully explained by one-time factors.
Delta expects to post strong PRASM growth this quarter. Image source: Delta Air Lines.
Furthermore, unit revenue growth will be even harder to come by in the fourth quarter, when year-over-year comparisons will get a lot tougher. To make matters worse, Alaska Air is beginning a big growth push in San Francisco (a key United hub) in August. Meanwhile, ultra-low cost carrier Frontier Airlines will begin a major expansion in Denver (United's most profitable hub) this fall. This will put further pressure on United's unit revenue.
Does management have the situation under control?
With unit revenue stalling out and competitive capacity growth potentially about to accelerate this fall, United Continental is not in a good position to narrow the margin gap with Delta anytime soon. United's faster capacity growth and strong operational performance are helping to limit unit cost inflation, but that can't make up for a lack of unit revenue growth.
Perhaps this is all temporary. If United's new markets in the U.S. mature as expected, supply demand trends improve in China, competitive capacity growth tapers off -- and United Airlines can avoid any further embarrassing customer service gaffes -- the company may be able to start gaining ground on Delta again next year.
Yet it's also possible that United's turnaround has come as far as it can based on management's current strategy. While United Continental claims to have lots of "earnings improvement" opportunities ahead of it, so do its rivals. On the other hand, they all face various cost and revenue pressures that could offset most or all of their apparent earnings improvement potential.
In short, United Continental executives may be overconfident with respect to the company's turnaround progress. Given that United's profit margin is set to decline dramatically in 2017 and the company is no longer gaining ground on Delta, a more circumspect attitude is warranted.
