United Continental (NASDAQ:UAL) stock has gone on a stunning run in the past week and a half. It traded around the $31 level for most of October, but since the carrier reported Q3 earnings on Oct. 24, it has jumped more than 15%, even hitting a new 52-week high at $36.80 on Monday.
The odd thing is that United's earnings report was dreadful. Revenue and EPS both fell short of analysts' reduced expectations. United is also projecting that cost increases for 2013 will come in at the high end of the original guidance range, while Q4 revenue trends are quite weak.
Right now, the market doesn't want to accept that United's problems are serious. The general attitude is well represented by airline analyst Mike Linenberg, who recently told clients that while United missed expectations in 2013, the company is still likely to catch up to the competition in the "long run." However, I believe United's high cost structure will keep United at the bottom of the industry in terms of profitability indefinitely.
The revenue premium disappears
Continental Airlines was historically known for having superior service compared to the other legacy carriers. By catering to deep-pocketed business travelers, Continental earned a revenue premium over competitors. The merger with United was supposed to improve that revenue premium over time by creating the top route network in the industry.
This strategy has not gone according to plan. In the first nine months of 2011, United's passenger revenue per available seat mile, or PRASM, was $0.1295. In that same period, No. 2 carrier Delta Air Lines (NYSE:DAL) generated PRASM of $0.1282. United's revenue premium over Delta was about 1%.
By contrast, in the first nine months of 2013, United's PRASM has improved slightly to $0.1354, while PRASM has jumped to $0.1418 at Delta. In other words, whereas United had a 1% revenue premium over Delta Air Lines in 2011, it now has a nearly 5% revenue deficiency. Other carriers have also posted better unit revenue performance than United over the last two years.
United's underperformance will only get worse in the near term. While other airlines have provided positive revenue outlooks for Q4 -- for example, Delta expects a 2% PRASM increase in October followed by strong performance over the holidays -- United recently projected that PRASM could be down as much as 2% year over year this quarter.
Some of United's revenue problems are due to temporary issues. For example, the company had underestimated the strength of last-minute demand for tickets, and so it sold too many advance tickets at lower price points. However, while United may climb back to revenue parity with Delta (and the new American Airlines, assuming its merger with US Airways (UNKNOWN:LCC.DL) is eventually approved) over time, there is no reason to believe its revenue premium will return.
As bad as the revenue trajectory has been for United, the company's cost structure is a bigger threat to its long-term success. Through the first nine months of 2013, its non-fuel unit costs (excluding profit sharing and other special items) totaled $0.0954 per available seat mile. This was 5% higher than the comparable figure for Delta.
Most of this cost gap has opened up this year. United's non-fuel unit costs will rise 6%-6.5% this year, up from an initial estimate of 4.5%-5.5% in January.
United's management has promised that unit cost growth will stay below the rate of inflation going forward. However, that may not be enough to keep pace with competitors, at least in the near term. American Airlines has cut costs drastically in the bankruptcy process, and expects to have the lowest costs among the legacy carriers following its expected merger with US Airways.
Meanwhile, Delta is in the midst of a $1 billion structural cost-reduction program, which is just starting to take effect. The centerpiece of that program is removing most 50-seat regional jets from its fleet and replacing them with much more efficient 76-seat regional jets and small mainline aircraft. This fleet change is just beginning this fall, and will continue through 2015.
United is also looking to reduce its reliance on small regional jets, but on a smaller scale. It also has very heavy capital commitments through 2015, with $6.4 billion in capital expenditures already committed in that time frame. This will probably prevent United from undertaking any additional fleet restructuring until 2016 or thereafter.
Lastly, United's salaries and related costs have jumped more than 9% this year, despite a decrease in capacity, primarily due to the implementation of a new pilot contract with substantial raises. United's labor costs will continue to rise going forward, albeit more slowly.
For example, last week, a variety of United work groups -- including ramp workers and customer service agents -- ratified a new contract that includes an immediate pay raise of 7%-29%, depending on position and seniority.
United still has to conclude joint collective bargaining agreements with its flight attendants and mechanics (roughly 30,000 workers in total). These new contracts will undoubtedly include pay raises. It's not clear if the pay raises for these groups are included in United's plans for keeping non-fuel cost growth below inflation.
Foolish bottom line
United stock has risen recently on the supposition that things can't get any worse. That's a very dangerous assumption to make. Not only has United's revenue premium evaporated over the last two years, but the company's costs are also rising faster than the industry average.
United will be hosting an investor day later this month, giving it a chance to present its long-term strategy for reversing these trends. I expect any new cost control initiatives to do no more than keep pace with competitors. That's not good enough, as it means that United will continue to have the highest cost structure and lowest profit margin in the airline industry.