The long-sought turnaround at United Continental (NYSE:UAL) continues to grow more distant.
On Tuesday afternoon, the No. 3 U.S. airline posted decent earnings results for the fourth quarter, easily exceeding its original forecast. On the other hand, United Continental's first-quarter guidance wasn't very inspiring. Furthermore, the company is doubling down on a dubious strategy of aggressive growth, which could lead to further margin erosion during 2018.
Minimal unit revenue growth
Three months ago, United Continental projected that passenger revenue per available seat mile (PRASM) would decline 1%-3% during the fourth quarter. This subpar forecast -- along with a lack of transparency about the status of United's profit improvement initiatives -- caused the stock to tumble.
However, United's unit revenue guidance was overly conservative. The company subsequently boosted its PRASM forecast twice. On Tuesday, it reported that PRASM rose 0.2% last quarter. Nonfuel unit cost growth also came in lower than expected, offsetting an uptick in fuel prices.
The net result was that United Continental's adjusted pre-tax margin came in at 6.7%, well ahead of the initial forecast of 3%-5%. Adjusted earnings per share of $1.40 beat the average analyst estimate of $1.34 by a comfortable margin.
That said, United had posted adjusted EPS of $1.78 a year earlier, with a 9.5% adjusted pre-tax margin. Furthermore, Delta Air Lines (NYSE:DAL) achieved an adjusted pre-tax margin of 10% last quarter, despite facing some unusual cost headwinds. Delta delivered strong PRASM growth of 4.2% to maintain its margin advantage during the period.
Nonfuel costs will decline, but is it enough?
Fuel prices have increased significantly in the past few months. The price of Gulf Coast jet fuel has been hovering around $1.90-$1.95 per gallon in January, up from $1.50 per gallon as recently as mid-August. Based on the current price of jet fuel, rising fuel costs could be a roughly 4-percentage-point pre-tax margin headwind for airlines like United Continental in 2018.
Prior to United Continental's earnings report, investors were optimistic that airlines would be able to offset this big cost increase with strong unit revenue growth. Earlier this month, Delta Air Lines forecast that unit revenue would rise 2.5%-4.5% in Q1, supporting this view.
However, United provided a dismal first-quarter outlook. Management projects that PRASM will increase just 0%-2%. On the bright side, adjusted nonfuel unit costs are set to rise no more than 1%. That's a small consolation, though, given that United expects to pay $2.11 per gallon for jet fuel, up from $1.71 per gallon in the year-earlier period. United Continental is calling for its pre-tax margin to be around 0% this quarter, compared to 6%-8% for Delta Air Lines.
The future could look very similar
The first quarter is always seasonally weak for United Continental. Nevertheless, its projected breakeven performance would represent yet another year-over-year margin decline: United eked out a 2.3% pre-tax margin in Q1 2017.
Additionally, United's management is preparing for further margin erosion in the next few quarters. Following Delta's lead, United provided full-year EPS guidance for the first time on Tuesday afternoon. It expects EPS of $6.50-$8.50, compared to $6.76 in 2017, which implies a pre-tax margin of roughly 5.7%-7.6%. That would be down from 8.4% in 2017 and 12.2% in 2016.
Perhaps management is just starting with another conservative forecast. However, the carrier's efforts to drive stronger unit revenue growth will probably be undermined by its plan to increase capacity 4%-6% this year. Capacity growth is usually negatively correlated with unit revenue growth, at least in the short run. United will continue to benefit from strong nonfuel cost performance -- largely because of its growth -- but this trade-off still leads to lower profitability.
2018 may not be an isolated year of pain, either. United's management plans to continue increasing capacity at a mid-single-digit annual rate through 2020. This could lead to even more loss of margin at United Continental and possibly at rivals like Delta Air Lines as well.