On Thursday afternoon, United Continental (NASDAQ:UAL) issued an investor update in which the company cut its Q3 unit revenue guidance. United now expects unit revenue to increase by 2.5% to 3.5% for the quarter. The midpoint of United's new guidance is a full percentage point below the original 3%-5% range provided in July.
I've been very bearish about United's prospects for this whole year, so I'm not very surprised by the company's continuing underperformance. United's cost structure is uncompetitive compared with its peers, such as Delta Air Lines (NYSE:DAL).
Meanwhile, its service quality lags Delta's: On TripAdvisor, only 38% of reviewers would recommend United, whereas 57% would recommend Delta. Higher costs and inferior service are a recipe for long-term financial problems. United investors would probably be better off putting their money elsewhere.
Revenue hits a snag
United blamed two factors for its weaker-than-expected Q3 unit revenue. Part of the reduction is due to lower yields on trans-Atlantic interline tickets (tickets that include flight segments on two different airlines). In addition, higher competitive capacity in China hurt transpacific unit revenue for September.
United has already reported unit revenue gains of 3.5%-4.5% in each of July and August, so the new guidance suggests that September unit revenue growth could be quite weak -- perhaps 1%. This is troubling, because September is probably a better indicator for fall season supply demand trends than July and August, which represent the summer peak season. As a result, United's Q4 unit revenue could also miss investor expectations.
Slow march of estimates
United investors have plenty of experience with reducing their expectations. Back in August, I highlighted the extent to which earnings estimates for United Continental have plummeted over time. In mid-2012, analysts on average expected United to earn more than $6 per share in 2013. Those estimates have since been cut in half!
For Q3 specifically, I noted in my earlier article that EPS estimates had fallen from $2.24 to $2.03 during July. Based on United's new guidance -- which should be fairly accurate, coming less than a week before the end of the quarter -- the final EPS figure is likely to be even lower, perhaps $1.80.
United's weak earnings performance over the past two years sets it apart from the rest of the airline industry. United suffers from higher costs than its rivals, which it traditionally offset with a strong revenue premium. However, this revenue premium fell away in 2012, and it may never return, leading to permanent earnings underperformance.
For example, in the first half of 2013, Delta reported a 6.9% adjusted operating margin (this excludes restructuring costs). The comparable figure for United was 3.5%. Furthermore, Delta projected an operating margin of 11%-13% for Q3, whereas United's guidance implies an operating margin of roughly 8%-8.5%. United thus appears to be making no progress on closing its 300- to 400-basis-point margin gap with Delta.
No improvement on the horizon
United investors' best hope is that the entire airline industry continues to outperform the market, because United shows no sign of catching up to its rivals. This fall, Delta is beginning a major fleet restructuring program that will remove hundreds of inefficient 50-seat regional jets and older Boeing (NYSE: BA) 757 and 767 aircraft, replacing them with newer aircraft that are much cheaper to operate.
While United is also looking to become less reliant on 50-seat regional jets, its domestic fleet restructuring efforts are well behind Delta's. As a result, United's cost disadvantage is likely to become even worse over the next two years, putting further pressure on the company's margins.
United's perennial margin underperformance makes it an overly risky investment. The company can muddle along when times are good for the industry; today it is solidly profitable despite having much lower margins than Delta and US Airways (NYSE: LCC). However, if industry conditions worsen, United will probably be one of the first airlines to run into financial trouble.