United Airlines (NASDAQ:UAL) shareholders have become accustomed to earnings beats over the past couple of years. The airline stayed true to form in the second quarter, reporting solid unit revenue growth and a pre-tax margin near the upper end of its guidance range.

The Q3 outlook looks solid as well, with management calling for a fourth consecutive quarter of year-over-year margin expansion (excluding special items). United also raised its full-year earnings guidance range. However, falling free cash flow is a significant concern for investors.

Another excellent quarter

In the second quarter, United Airlines increased its capacity 3.6% year over year. That was slower than its typical growth rate in recent quarters, largely due to the grounding of the Boeing 737 MAX. It also came in at the bottom of the company's guidance range for 3.5% to 4.5% capacity growth.

The slightly slower growth may have helped to boost unit revenue, though. Passenger revenue per available seat mile (PRASM) rose 2.5%, reaching the high end of the 0.5% to 2.5% guidance range provided in April. Total revenue per available seat mile (RASM) increased 2.2%, as the weak cargo market partially offset strong demand for air travel. Revenue hit $11.4 billion, up 5.8% year over year and just ahead of analysts' estimates.

Turning to costs, United Airlines performed well, limiting its adjusted nonfuel unit cost increase to just 0.6% despite lower capacity growth. Furthermore, United's average fuel price fell to $2.16 per gallon from $2.26 per gallon in the prior-year period.

A United Airlines plane on a runway.

United achieved solid unit revenue growth and strong cost control last quarter. Image source: United Airlines.

As a result, United's adjusted pre-tax margin improved to 12.4% from 10.4% a year earlier. That helped propel a 27% increase in adjusted pre-tax income, to $1.4 billion. Adjusted earnings per share surged 31% to $4.21, comfortably beating the average analyst estimate of $4.08.

Solid guidance -- and it may be conservative

For the third quarter, United is projecting that PRASM will rise 0.5% to 2.5%. Cargo and other revenue will dip slightly -- compared to 2% growth last quarter -- based on the midpoint of the company's guidance range. Meanwhile, adjusted nonfuel unit costs are set to rise 1% to 2%, as year-over-year capacity growth slows further to a range of just 2% to 3%. This cost inflation will be more than offset by lower fuel prices again. United expects to pay between $2.12 per gallon and $2.22 per gallon for jet fuel this quarter, down from $2.29 per gallon a year ago.

Incorporating all of the elements of this forecast, United Airlines expects to report an adjusted pre-tax margin between 10% and 12% for the third quarter, compared to 9.7% in Q3 2018. Based on the midpoint of the guidance, revenue would reach $11.4 billion again, while adjusted EPS would rise to approximately $3.79 -- solidly ahead of the average analyst estimate of $3.64.

Of course, United Airlines' PRASM growth reached the high end of management's guidance range last quarter. There's a good chance that the company issued another conservative forecast for the third quarter. At the high end of United's Q3 guidance, adjusted EPS would come in roughly in line with last quarter's result of $4.21.

For the full year, United Airlines raised its adjusted EPS guidance from a range of $10 to $12 to a new range of $10.50 to $12. The low end of this range still seems extremely conservative. The average analyst estimate currently stands at $11.33.

Cash flow is the one weak spot

United Airlines stock closed just below the $94 mark on Tuesday. That puts its valuation at just 8.3 times the company's projected 2019 earnings, which seems quite low in light of United's recent earnings growth trajectory.

That said, there has been a sharp divergence between United Airlines' earnings and cash flow in recent years. Last year, adjusted net income reached $2.5 billion, but free cash flow came in lower, at around $2 billion. (If loans and investments in affiliates are included in the calculation, free cash flow would have been just $1.4 billion.) Adjusted net income rose by $380 million in the first half of 2019, but free cash flow declined by $323 million.

High capital expenditures is the reason why United's cash flow lags its accounting earnings. Unfortunately, there's no end in sight to the current period of elevated capital spending. United's fleet has an average age of about 15 years, and replacement of its oldest planes combined with purchases of additional planes to fuel growth will pressure free cash flow for many years to come.

Based on annual free cash flow of $2 billion, United Airlines shares currently trade for more than 12 times free cash flow. That still makes the stock look fairly priced, in light of its potential for future earnings growth. However, the margin of safety for investors is smaller than it may appear at first glance.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.