Five years ago, Delta Air Lines (NYSE:DAL) introduced the concept of no-frills "basic economy" fares in the U.S. market. These fares carry a lower price tag but come with additional restrictions. Most notably, it's not possible to change your flight, and advance seat selection isn't permitted.
Last year, United Continental (NYSE:UAL) announced that it would roll out its own version of basic economy in 2017. United's basic economy fares are even more restricted than what Delta offers: Customers who buy a United Airlines basic economy ticket may not bring a carry-on bag.
United's management -- and investors -- expected basic economy to have huge financial benefits for the company. However, a few months of real-world experience have shown that adding this new fare class may not be nearly as effective as investors had hoped.
The theory behind basic economy
The rollout of basic economy is part of a broader push by legacy carriers such as Delta Air Lines and United Continental to offer price-sensitive travelers cheap fares, while pushing other customers to buy pricier tickets. In particular, they want to match budget carriers' base fares, to avoid losing market share, while minimizing the potential impact on their unit revenue.
In theory, basic economy fares are a great tool for pursuing this goal. Indeed, the early evidence suggests that at least half of consumers will pay an extra $20-$30 one-way to upgrade from a cheap basic economy ticket to a regular coach fare.
United's basic economy offering has also reduced the number of carry-on bags on each flight. This development is helping the company speed up the boarding process and stay on schedule more often.
Back in November, United Continental estimated that its segmentation initiatives -- of which basic economy is the most important -- would boost pre-tax earnings by $1 billion by 2020. This figure accounts for a substantial chunk of the $4.8 billion in profit improvement opportunities that United's management identified last fall.
United's basic economy runs into problems
While Delta Air Lines has been very happy with the performance of its basic economy offering, United Continental has run into some unexpected problems. Since basic economy became available across United's full domestic network, it has had a net negative impact on profitability.
As expected, United has generated plenty of incremental revenue from customers upgrading to regular economy fares to avoid the restrictions of basic economy. However, this new revenue stream was more than offset by market-share losses to other legacy carriers that have more customer-friendly policies. As noted, customers buying Delta's basic economy tickets can still bring a carry-on bag. Furthermore, while American Airlines' basic economy fares also don't include a carry-on allowance, American hasn't rolled out basic economy as broadly.
United Continental has reacted by scaling back the availability of basic economy fares: From now on, basic economy won't be offered in every domestic market. In addition, once prices for a given flight rise past a certain level, United will stop selling basic economy fares for that flight.
These tweaks should lead to better results starting later this year. Nevertheless, United's target of a $1 billion earnings boost from segmentation is starting to seem overly optimistic.
United is still floundering
In each of the past two years, United Continental has produced a $4.5 billion adjusted pre-tax profit. By contrast, Delta Air Lines' adjusted pre-tax earnings totaled about $6 billion in each year.
The margin gap between United and Delta is set to widen further this year. United Continental issued a dreadful guidance update last week, driven in part by Hurricane Harvey but also in part by its own strategic missteps. It is now on pace to report an earnings decline of 30% or more in 2017.
According to the long-range plan that management presented at United's 2016 investor day, the company should have already realized $1.8 billion of its $4.8 billion profit improvement goal. Instead, its profitability has declined substantially.
Perhaps United's strategic initiatives will reach a tipping point in the next year or two, allowing it to finally start closing its margin gap relative to Delta. But thus far, the company's new management team doesn't appear to be any more effective than the previous one. There are plenty of better opportunities for investors in the airline sector.