On the surface, mega-airline United Continental (NYSE:UAL) seemed to post a strong Q2 earnings report last week. United's pre-tax margin rose by 3.8 percentage points year over year, it posted a record profit, and it quadrupled its share buyback program. Yet investors apparently weren't impressed, as the stock has declined since the earnings report came out on Thursday.
Was this decline justified or did investors just miss the point? To better answer that question, let's take a look at five important insights conveyed by United Continental's management on the company's recent earnings call.
Energy demand stabilizing
Corporate revenue for the second quarter decreased by approximately 5% on roughly flat traffic year-over-year, largely due to a 30% reduction in revenue from oil and gas related corporate customers. We believe this decline has roughly leveled out, and we don't anticipate material deterioration for the remainder of the year.
-- United Continental Chief Revenue Officer Jim Compton
One major factor depressing United Continental's unit revenue performance has been a steep drop in demand from the energy sector. United operates one of its biggest hubs in Houston and thus has big exposure to the energy industry.
Oil and gas-related corporate revenue declined 30% year over year in Q2, which was even worse than what United's management had feared. This dragged down United's corporate revenue more broadly. Fortunately, demand seems to be stabilizing at that level -- at least for now.
The good thing about United's heavy exposure to the energy sector is that it provides a natural hedge. If oil prices start to rise again, pressuring United's costs, it will likely see a corresponding bounce-back in travel demand from oil companies, helping to offset those incremental costs.
Making smart network adjustments
We continue to improve our network with a focus on enhancing our core strengths. In June we announced our decision to move our p.s. service from JFK to our global gateway at Newark Liberty.
United Continental has been the most proactive airline in recent years in terms of cutting capacity in response to weak unit revenue trends. Recently, it has announced capacity cuts in core energy markets, Brazil, and transatlantic markets.
However, United's strategy isn't limited to cutting capacity. It's also trying to squeeze the most value out of its key assets. That's why its decision to stop flying to New York's JFK Airport and move all of its transcontinental premium service to its across-town hub at Newark Airport is so savvy. This will concentrate United's premium traffic at an airport that it dominates.
Ahead of cost targets
Project Quality, our $2 billion efficiency and quality initiative continues to play a critical role in our excellent cost performance. ... Based on our progress to date we now expect to achieve our goal of $1 billion in annual non-fuel cost savings by the end of next year, a full year in advance of our initial expectations.
-- United Continental CFO John Rainey
One of United Continental's biggest problems in the past few years has been an uncompetitive cost structure. However, the company laid out a target in late 2013 to reduce non-fuel costs by $1 billion and fuel costs by another $1 billion by 2017.
Since then, oil prices have crashed, creating a huge fuel price windfall and making it somewhat less urgent to boost fuel efficiency. However, that makes non-fuel cost discipline even more crucial. Fortunately, United is on the right track here. It expects to hit its target of $1 billion in non-fuel cost savings a year early, and Rainey promises that the company won't stop there.
Pensions are nearly fully funded
I would describe [pension funding] less as a cost tailwind and more of a cash flow tailwind. So year-to-date we've funded $800 million. Going forward... [y]ou could see us fund somewhere between $50 million to $150 million a year.
One advantage that United Continental has over its legacy carrier peers is a relatively small pension burden. Pensions have been a huge headwind for companies with big unfunded pension liabilities, because low interest rates have made those funding gaps even bigger.
By contrast, United is actually close to having a fully funded pension. It has contributed $800 million to its pension plans this year. That brings its unfunded liability down to about $1 billion. If interest rates rise in the next few years as expected, that could take care of the rest of that funding gap.
As a result, United will probably be able to drastically scale back its pension funding starting next year. That will free up more cash for paying down debt and returning cash to shareholders.
And here comes the cash...
Our new share repurchase program demonstrates confidence in our ability to generate and sustain meaningful free cash flow.
-- United Continental CEO Jeff Smisek
Having gotten its pension liabilities under control, and with its debt level approaching a medium-term target of $15 billion, United now plans to devote more of its cash flow to share repurchases.
A year ago, the company announced a $1 billion share repurchase program, to be completed within three years. Thanks to its surging cash flow and cheap stock price, it now plans to complete the buyback by the end of this quarter. It also announced a new $3 billion buyback that will run through the end of 2017.
In short, there weren't any red flags that popped up during United's earnings call. In fact, the company seems well positioned to keep posting strong profitability as it is proactively addressing the patches of demand weakness it faces. This makes the recent share price weakness somewhat surprising -- and it represents a potential buying opportunity for long-term investors.
Adam Levine-Weinberg owns 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.