Since 2008, Newark Airport -- the largest (and arguably most important) hub for United Continental (NASDAQ:UAL) -- has been subject to strict flight limitations. Airlines are required to hold a "slot" for any arrival or departure, making it very difficult for new competitors to enter the market or expand there.
That's going to change in late October, according to an FAA order published last week. While Newark Airport will still have capacity constraints, it will be a lot easier for smaller airlines to expand there. That means more competition for United, which currently dominates the airport.
Newark is a key cog in United's profit machine
Newark Airport is one of three major airports serving New York City, and is United Airlines' main base in that important market.
When measured by the number of daily departures or daily seats, Newark Airport is the third largest hub for United, behind Chicago and Houston. However, due to the high proportion of international and transcontinental flights at Newark, United has 20%-25% more capacity there -- as measured by available seat miles -- than in Chicago or Houston.
Furthermore, Newark is United Airlines' most profitable hub, due to the slot limitations that have kept competition down. By contrast, United faces stiff competition in Chicago from discounters like Southwest Airlines (NYSE:LUV) and Spirit Airlines (NYSE:SAVE). In Houston, it's suffering from weak energy-sector demand -- and Southwest and Spirit are growing there, too.
Slot constraints have hindered competition
Under the current system, United Continental holds 73% of the slots at Newark Airport. Most of those slots came from Continental Airlines, which built up its dominance in Newark at a time when other airlines weren't very interested in flying there.
More recently, United has capitalized on this built-in market dominance to charge higher fares than it can command elsewhere. Last summer, the average domestic airfare at Newark Airport was 11% higher than at any of the other 12 busiest airports in the country.
Smaller airlines have criticized United (and the other legacy carriers) for limiting their access to key airports like Newark. Ultra-low-cost carriers including Spirit Airlines and Frontier Airlines don't have any slots at Newark Airport. Southwest Airlines has 18 daily slot pairs at Newark that United and Continental were required to divest as part of their 2010 merger, but it would probably like to expand further.
Federal regulators have also chimed in, opposing a proposed slot swap with Delta Air Lines that would have given United even more slots at Newark Airport.
What the FAA is doing
While Newark Airport still has more delays than average, an FAA study noted that the delays are much less severe than they were prior to the imposition of slot constraints in 2008.
Furthermore, the FAA also noted that the airport typically operates somewhat below its official capacity of 81 takeoffs/landings per hour. During the summer of 2015, Newark had an average of 72 scheduled commercial takeoffs and landings per hour during peak hours.
That's because airlines (and especially United) don't use all of their slots every day. On peak days during the peak season, the airport may be maxed out, but that's rarely the case. Airport slots are subject to "use it or lose it" provisions, but airlines generally don't have to use their slots every single day to keep them. As a result, other airlines haven't been allowed to add flights on days when United isn't using its full slot portfolio.
To fix this issue and improve competition, the FAA will designate Newark Airport as a Level 2 airport rather than a Level 3 airport as of Oct. 30. Whereas the Level 3 designation entailed slot-controlled operations, Level 2 airports have a less regimented "schedule facilitation" process.
As a practical matter, airlines will be able to propose new schedules that incorporate growth or retimed flights. However, the FAA will have to approve any changes and will work with airlines to ensure that their schedules are consistent within the airport's capacity limits.
United could face a double whammy
The good news for United Continental is that the FAA isn't making Newark Airport a Level 1 airport, which would allow airlines to do whatever they want. Also, there isn't much room to add flights on peak days, and airlines that want to grow would also have to secure scarce gate space.
Nevertheless, United won't have quite as dominant a position at Newark Airport by the time November rolls around. The FAA is likely to favor low-cost carriers in reconciling airlines' proposed schedules. This could drive a sharp increase in price competition at Newark.
At the same time, increasing the number of scheduled flights at Newark Airport will inevitably cause delays to worsen. So not only does United face potential revenue pressure from increased competition, it could also see an uptick in costs as schedules get disrupted on bad-weather days.
United Continental shareholders should definitely keep an eye on this upcoming change and management's plans to combat a potential increase in price competition at United's most important hub.
Adam Levine-Weinberg owns shares of Spirit Airlines and United Continental Holdings, and is long Jan. 2017 $40 calls on Delta Air Lines, and long June 2016 $30 calls on Spirit Airlines. The Motley Fool recommends Spirit Airlines. 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.