The top three airlines in the U.S. all produce about $40 billion in annual revenue. Yet investors have put much higher price tags on shares of Delta Air Lines (NYSE:DAL) and American Airlines (NASDAQ:AAL) than those of United Continental Holdings (NYSE:UAL).
Bulls see United Continental's lower valuation as an opportunity. While United has lower margins than Delta and American, many analysts see the three as being essentially alike. Thus, it should be a straightforward task for United to catch up to Delta and American.
However, there are a few very important differences between United and its two top rivals. This doesn't mean United is necessarily doomed to have lower margins forever. However, it does mean that catching up to Delta and American will not be straightforward whatsoever.
A big valuation gap
Delta's market cap is currently about $31 billion, and American is not far behind with a $26 billion valuation. United brings up the rear with a market cap of just $18 billion. This gap was even wider just a few months ago. While United's stock has underperformed its two main peers this year, its shares have made up a lot of ground recently.
United's better than expected second-quarter earnings report provided much of the impetus for this lift. The company posted a 51% jump in adjusted earnings per share last quarter, and also issued a solid forecast for the third quarter.
This was a big achievement, considering that United's profit margin has regularly lagged those of Delta and American by 5-6 percentage points recently. Just a few months earlier, United reported a massive first-quarter loss. The big second-quarter improvement led many analysts to conclude that United had finally turned the corner and was on its way to eventual parity with Delta and American.
If United was really a near-replica of Delta and American, it might be relatively easy for it to close its margin deficit. However, there are several important structural differences between United and the other two network carriers.
Focus on international flights
One key difference is United's exposure to international routes. In the second quarter, United generated slightly more than 40% of its $9 billion in passenger revenue from its international routes. By contrast, international flights accounted for just 33% of passenger revenue at Delta and slightly less than 30% for American Airlines.
The recent surge in airline profitability has been driven primarily by consolidation in the U.S. airline industry, which has led to tighter capacity discipline among the largest carriers. The international market is much more competitive, though -- especially in Asia, where United has much more capacity than Delta or American.
In Asia, United's profitability has been hurt by the rapid growth of various airlines -- especially Chinese carriers -- that aim to find a foothold in the strategically valuable U.S. market. With many of its routes contested by competitors whose primary goal is market share, not short-term profit, it's no wonder that United's profit margin lags those of its rivals.
Another point of differentiation is the competition the airlines face in their top hub markets. Delta absolutely dominates air travel in its top three hub markets: Atlanta, Detroit, and Minneapolis-St. Paul. The same is true for American Airlines in markets such as Dallas-Fort Worth, Charlotte, N.C., Philadelphia, and Miami.
By contrast, United has much greater competition in most of its hubs. For example, its largest market in terms of daily departures is Chicago, where it competes with a sizable American Airlines hub and Southwest Airlines' largest focus city. It also faces stiff competition in New York, Los Angeles, Washington, D.C., and Denver.
The only markets where United has a clear leadership position are Houston and San Francisco. Even there, its dominance does not approach that of Delta and American in their top hubs. Additionally, United's market share in those cities is gradually eroding due to the growth of Southwest and Virgin America, respectively.
United's lower market share in its hub markets stems from its strategic choice to locate its hubs in the top business travel markets. The goal is to gain a competitive advantage in bidding for corporate contracts. So far, that benefit has been outweighed by the higher level of competition in each individual market.
In addition, United also has smaller hubs than Delta and American. Last year, in Houston and Chicago -- its largest hub markets -- United and its two largest regional carriers together boarded about 15.5 million and 12.3 million passengers, respectively.
By contrast, Delta and its top regional carrier boarded more than 36 million passengers in Atlanta last year. Meanwhile, American Airlines and its main regional affiliate boarded 23.5 million passengers in Dallas.
This situation means that United on average offers fewer flights on smaller airplanes. Fewer flights means less convenience for passengers, which could impact revenue. Smaller airplanes have higher unit costs. The result is a less profitable operation.
Tying it all together
Here, I have highlighted three major structural differences between United Continental and its two main competitors: Delta Air Lines and American Airlines. First, United has a much higher exposure to international flights. Second, United has a lower market share in its hub markets. Third, United's hubs are smaller in terms of absolute passenger counts.
These factors reflect a key difference in strategy between United and its peers. United tries to compete in the top markets for business travel regardless of whether it can dominate them. By contrast, Delta and American each dominate a few cities where they drive lots of connecting traffic through their hubs.
United's smaller hubs and its higher exposure to international flights mean that it relies more on origin and destination traffic (rather than connecting traffic) than its peers. This is a double-edged sword.
On the one hand, origin and destination traffic tends to generate higher fares than connecting traffic. On the other hand, since United focuses its capacity on strategically important cities, it faces significant competition for origin and destination passengers. This means United is more likely to be drawn into pricing battles in order to fill empty seats.
United's track record over the last few years suggests severe execution problems, a flawed strategy, or both. While execution issues have certainly cropped up, there may be more to United's problems than a few easy-to-correct mistakes.
Delta and American benefit from large captive markets in their top hubs. In order to match their financial results, United must be the preferred carrier in its hub markets, where it almost always faces at least one significant competitor.
However, United has consistently found itself near the bottom of the airline industry in customer service ratings for the past two to three years. This is preventing United from being the preferred carrier in its hub markets. Either United needs to rise to the top in customer service rankings -- and stay there -- or its margins will continue to trail those of the competition for the foreseeable future.
Adam Levine-Weinberg is short shares of United Continental Holdings. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.