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United Continental's Management Has No Answers for Wall Street

By Adam Levine-Weinberg - Oct 23, 2017 at 7:05AM

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Profit is crashing at United Continental this year, leading analysts and investors to lose faith in the company's turnaround plan.

On Wednesday afternoon, United Continental (UAL -0.84%) reported subpar third-quarter earnings results (as expected) and provided a dismal outlook for Q4. The following day, a collection of Wall Street analysts raked United's management over the coals on the company's quarterly earnings call.

Indeed, while Wall Street tends to be overly focused on short-term performance, the analysts were entirely justified in questioning United's strategic direction. Management has laid out lofty turnaround goals, but United Continental isn't making tangible progress toward improving its earnings performance.

Profitability is evaporating

During 2015 and 2016, United Continental posted adjusted pretax margins of around 12%. While these were record results for the company, United's profit margin remained well below the industry average. At its investor day last fall, management presented a number of initiatives designed to produce $4.8 billion of earnings improvement by 2020.

United Continental executives insist that most of the profit improvement initiatives are on track. Nevertheless, the company's adjusted pretax margin has plunged by more than 4 percentage points year to date, and it's on track to fall even more in the fourth quarter.

A United Airlines plane on a runway.

United's profit margin has contracted sharply in 2017. Image source: United Airlines.

To be fair, management has always stated that the $4.8 billion target was in an "all else equal" scenario. In the absence of United's earnings initiatives, profit might have fallen even further in 2017.

Analysts don't believe the story anymore

Unfortunately, it's hard for outside observers (like Wall Street analysts) to get a handle on how much of United Continental's $4.8 billion in supposed earnings improvements will flow through to the bottom line by 2020. United executives didn't offer much guidance in this regard, despite repeated prodding by analysts. Indeed, they seemed to back away from a variety of previous projections during the course of the earnings call.

For example, management wouldn't commit to margin improvement in 2018 -- the year with the biggest projected gains from United's earnings initiatives. Furthermore, CFO Andrew Levy highlighted a variety of cost pressures coming next year and would not promise nonfuel unit cost growth below 1% for 2018 (a target that United had publicly reiterated as recently as Oct. 3).

In short, United's management has created another big credibility gap. Analysts are no longer willing to trust management's short- or long-term forecasts. Not surprisingly, 2018 earnings estimates for United Continental are falling rapidly.

No recovery in sight

United Continental CEO Oscar Munoz and his leadership team want investors to be patient, arguing that it will take time for the company's earnings improvement initiatives to pay off.

This may be wishful thinking on management's part. For example, its introduction of a no-frills "Basic Economy" fare has hurt unit revenue this year rather than help it. United executives have attributed the problem to being ahead of American Airlines in terms of rolling out basic economy. This gave fliers an incentive to fly American, which was selling regular economy fares for the same prices as United's basic economy offering.

However, low-fare carriers like Alaska Air (ALK -1.13%) and Southwest Airlines (LUV -0.55%) have no plans to join the basic economy bandwagon. United faces stiff competition from Southwest in many of its hub markets, especially Chicago, Denver, and Houston. Meanwhile, Alaska Air is growing rapidly in San Francisco, United's main West Coast hub.

Thus, United Continental's basic economy product will go up against regular economy fares from the likes of Alaska Air and Southwest Airlines in numerous markets for the foreseeable future. If fliers overwhelmingly choose Alaska or Southwest in that scenario, the $1 billion expected benefit from segmentation may never materialize for United.

This is just one aspect of United's profit improvement plan that may never come to fruition. Meanwhile, the carrier will continue to face rising competition from lower-cost airlines, putting pressure on unit revenue. As a result, United Continental will be hard-pressed to repeat the margin performance it achieved in 2015 and 2016, let alone grow its earnings from that level.

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United Airlines Holdings, Inc. Stock Quote
United Airlines Holdings, Inc.
UAL
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Alaska Air Group, Inc. Stock Quote
Alaska Air Group, Inc.
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