In 2016, United Continental (NASDAQ:UAL) has encountered stiff pressure from activist investors looking to boost the airline's lagging financial performance. The company's recent problems have included poor reliability, frequent technical glitches, and subpar customer service. From an investor's perspective, United's high cost structure also makes the list as a key challenge.
Since late 2013, United has been working on a cost reduction project designed to cut $1 billion in non-fuel costs by 2017, with about half of the savings coming from higher labor productivity. This effort has been successful, but there is still more work to be done.
To keep up its cost momentum, United Continental is building on the industry trend of moving to larger and more densely packed airplanes. A few recent orders from Boeing (NYSE:BA) will support United's new fleet initiatives. The payoff should be a significant improvement in unit cost trends in 2017.
Unit cost headwinds creeping up again
Last year, United Continental posted a huge jump in profit. The steep drop in oil prices drove most of the improvement. However, United also benefited from a 0.7% decline in its adjusted non-fuel unit costs, following several years of rising costs.
The unit cost trend will deteriorate in 2016. United projected earlier this year that adjusted non-fuel unit costs would rise 1% this year, assuming no new labor contracts were ratified. However, it noted that tentative agreements with its pilots and maintenance technicians would add 2.5 percentage points to its unit cost increase if they were ratified.
The pilots ratified their contract in January. The technicians rejected their agreement and are now agitating for an even more lucrative contract. United's flight dispatchers also ratified a new contract recently, and United is working toward a few other labor agreements.
The result will be significant labor cost inflation in the next few years. The exact timing depends on when United irons out new labor contracts with each of its unions.
Big planes offset cost increases
To offset these looming labor cost increases, United is moving swiftly to increase its average gauge (the number of seats per plane). A year ago, it ordered 10 Boeing 777-300ERs to replace older Boeing 777-200s on international routes. The 777-200s will be reconfigured for domestic service.
United already has nine domestic-configured 777s. It uses them primarily for flights to Hawaii. These planes are outfitted with 344 seats, compared to 266 seats on the international 777-200s. United now plans to retrofit its domestic 777s by adding one seat to each economy-class row and installing flat-bed seats in business class. That will raise their capacity to 364 seats.
The international 777-200s being reconfigured for domestic service will receive the same 364-seat configuration. Adding 98 seats will reduce the unit costs for operating these planes.
United Continental also ordered 65 737-700s from Boeing this year, receiving a huge discount. The 737-700 is United's smallest mainline aircraft, with 118 seats. However, these planes will replace even smaller 50-seat regional jets, which have extremely high unit costs. United plans to reduce the size of its 50-seat jet fleet by more than 50% over the next few years.
Finally, United ordered another four 777-300ERs last week to help it retire its remaining Boeing 747s. United's 777-300ERs will reportedly have the same 10-across economy-class seating as the reconfigured 777-200s.
As a result, United plans to fit 366 seats on its 777-300ERs, based on seating diagrams published by Brian Sumers. That's only eight fewer seats than United has on the much larger (and costly to-operate) 747-400. This replacement project will therefore drive a huge unit cost improvement.
The promise of refleeting
In its original cost-cutting plan showcased in late 2013, United touted $1 billion in fuel savings from replacing older planes with new, fuel-efficient models. That's still an important part of its cost reduction efforts. However, with fuel prices having dropped by more than 50% since then, the benefit from adding new-technology planes to the fleet is a lot smaller.
By contrast, buying larger planes -- and adding more seats to existing planes -- reduces non-fuel unit costs in addition to cutting fuel consumption. With top-of-scale pilots now earning more than $300/hour, it's more important than ever to fit more passengers on each plane.
United's refleeting efforts won't have much of an impact on its unit costs this year. However, the first 10 Boeing 777-300ERs will go into service in the first half of 2017. The new 737-700s will also start arriving in 2017, enabling the next round of regional downsizing. This should drive meaningful improvements in United's cost structure starting next year.
Adam Levine-Weinberg owns shares of The Boeing Company and 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.