On Thursday, United Continental Holdings (NASDAQ:UAL) reported strong results for the recently ended fourth quarter. Additionally, United -- like most of its peers -- expects to achieve solid margin expansion in 2014. This improving outlook has caused the airline's stock to soar by more than 50% since late October.
However, with United now trading for about 11 times analysts' 2014 earnings estimates, the company's earnings upside is already priced into the stock. In fact, analysts may be getting ahead of themselves in projecting that United will increase its profit margin by 150 basis points this year. Unless the company gets help from falling jet fuel prices, there is a serious risk that United will start missing analysts' earnings estimates again in 2014.
A solid quarter
United's adjusted earnings per share of $0.78 beat the recent analyst consensus of $0.65. It also marked a very strong improvement compared to its adjusted loss of $0.58 per share in the fourth quarter of 2012, when United was tripped up by cost pressures and the impact of Hurricane Sandy.
That said, much of the airline's fourth-quarter earnings improvement can be attributed to lower jet fuel prices and the easy comparison caused by Hurricane Sandy. United's consolidated fuel price (including the effect of settled hedges) dropped from $3.28 in fourth-quarter 2012 to $3.09 last quarter. Since the company used nearly 1 billion gallons of fuel last quarter, spending $0.19 less per gallon added up to more than $180 million in cost savings.
Additionally, United has stated that the dislocation caused by Hurricane Sandy reduced fourth-quarter-2012 earnings by approximately $85 million. Together, these two factors accounted for more than half of the $488 million improvement in United's adjusted profit for last quarter.
The outlook is choppy
Even without the fuel price advantage and absence of another major storm, United would have posted solid margin growth in the fourth quarter. Like most U.S. airlines, United pointed to strong demand during the holiday season as a key driver of revenue and earnings growth. All in all, the company has good momentum going into 2014, which should be a strong year for the airline industry more broadly.
That said, United's first-quarter forecast was surprisingly glum. The company expects PRASM (a common measure of unit revenue) to be flat to 2% in this three-month period. Meanwhile, unit costs will be about flat, as a 3.5%-4.5% increase in non-fuel CASM will be offset by a significant decline in fuel costs.
Of course, it's possible that United management is being overly conservative with its forecast. After all, the carrier delivered a 3.2% increase in PRASM last quarter after initially projecting a slight decline. However, United executives pointed to several factors -- including severe weather earlier this month, the calendar shift of Easter from March into April, and a tough year-over-year comparison -- that will weigh down unit revenue growth this quarter.
At the midpoint of United's forecast, the company will only achieve about 100 basis points of margin expansion this quarter. That would leave first-quarter EPS significantly below the average analyst estimate for a loss of $0.32 per share.
Many of the headwinds that could hold back first-quarter profitability will recede thereafter. However, this will not necessarily lead to faster margin expansion. This is because United will benefit in the first three months of 2014 from a big year-over-year drop in fuel prices that won't carry through into the rest of the year, based on the current outlook.
United's consolidated fuel cost (including settled hedges) was $3.28 in first-quarter 2013, but dropped to $3.02 in the next quarter. Unless jet fuel prices fall from today's level, fuel will go from being a significant tailwind in the first quarter to being a slight headwind in the second quarter.
Looking even further ahead, United will face challenging year-over-year comparisons later in 2014, especially when it goes up against the strong fourth-quarter performance it just reported. Furthermore, if industry profit margins grow significantly in 2014, at least some of United's competitors are likely to boost their capacity growth in 2015 and thereafter. That will make the competitive environment even tougher.
In short, while United is on a path to produce substantial profit growth in 2014, it may fall a bit short of analysts' targets unless fuel prices drop again. Even if it does manage to post full-year EPS of $4.36 (as the analyst community expects), United stock still looks pricey compared to its peers, because the company is not yet accruing income tax. When it starts accruing income tax again (in 2015 or 2016), that will reduce EPS by 35%-40% (all else equal).
Additionally, United's free cash flow will stay fairly low for the foreseeable future, as it expects capital expenditures to remain near $3 billion annually through 2017. As a result, while the company plans to announce a capital return program later this year, it is likely to remain very modest in scope.
United Continental may be seeing the first real signs of a turnaround in its business. However, its stock is now priced as if the way forward is free of obstacles for the company. That still seems like a dangerous assumption.