2017 is shaping up to be a down year for many airlines. Jet fuel prices are still quite low by historical standards, but the price of fuel has increased relative to 2016. Labor costs are also rising, as new union contracts kick in for many airline workers. Unit revenue isn't rising fast enough to offset these cost increases.
United Continental (NASDAQ:UAL) has been one of the hardest-hit airlines this year. The outlook just got worse, after Hurricane Harvey -- and some unrelated strategic missteps -- wrecked its third quarter profitability.
Profit declines as United gets aggressive
In the first six months of 2017, most U.S. airlines (including United) faced significant year-over-year increases in fuel prices for the first time in several years. While United Continental's revenue per available seat mile rose by 1.2% in the first half of the year, that wasn't nearly enough to offset its fuel and non-fuel cost increases.
As a result, United reported an 8.2% adjusted pre-tax margin for the first half of 2017: down dramatically from the 11.6% adjusted pre-tax margin it posted in the year-earlier period.
As of mid-July, United Continental projected further margin deterioration for the third quarter. While the rate of cost inflation was expected to slow, unit revenue growth has stalled out. United's original Q3 guidance called for an adjusted pre-tax margin of 12.5%-14.5%, compared to 15.7% a year earlier.
Look out below
Since mid-July -- when United Continental issued its third quarter guidance -- oil prices have been moving steadily higher. This will put pressure on its third quarter earnings. (Higher fuel prices were a big reason why Delta Air Lines slashed its Q3 guidance earlier this week.)
Moreover, Hurricane Harvey has dealt United a double whammy that will torpedo its profitability this quarter. First, by knocking out a number of refineries along the Gulf Coast, Harvey has caused jet fuel prices to spike even higher since last week.
Second, Harvey forced United Airlines to cancel a massive number of flights at its Houston hub. Indeed, United and its regional affiliates account for the majority of the more than 13,000 U.S. flights that have been canceled since August 25. For several days during the peak of the storm and its immediate aftermath, United was forced to cancel its entire schedule in Houston. The carrier doesn't expect to return to a full schedule in Houston until Friday.
These flight cancellations have hurt unit revenue, due to many customers abandoning travel plans for late August and the Labor Day weekend. Disruption caused by the storm will also drive up unit costs. Industry analyst Helane Becker estimated last week that the storm would negatively impact United's third quarter earnings by at least $265 million.
Sure enough, at an investor conference on Wednesday, United Continental cut its Q3 margin guidance by 4.5 percentage points. It now expects to report a pre-tax margin of 8%-10% for the quarter. Harvey-related impacts account for a significant chunk of that revision.
For comparison, the only other carrier that will feel a significant direct impact from the storm is Southwest Airlines (NYSE:LUV), which is a distant No. 2 in the Houston market. Southwest has been forced to cancel more than 2,000 flights due to Harvey. However, Becker projects that the storm will reduce its Q3 earnings by just $77 million. Furthermore, Southwest Airlines is starting as a much more profitable company than United Continental.
United's price war isn't helping
In the past few months, United Airlines has become extremely aggressive about matching budget carriers' fares. It is also adding capacity in markets where rivals are threatening its market share.
Other major airlines (including Southwest) have felt compelled to respond with matching fare cuts. As a result, the U.S. airline industry is on the verge of an all-out fare war. The vicious pricing environment also contributed significantly to United's reduced Q3 margin guidance. This is in many respects a self-inflicted wound.
After reporting full-year pre-tax margins around 12% in each of the past two years, United Continental is now on pace to see its earnings fall by 30% or more in 2017. Until management presents a credible turnaround plan, investors should steer clear of this airline giant.