MIAMI — Despite reporting a record second quarter net profit of $1.2 billion yesterday, Chicago-based United Airlines continues to be plagued by a series of shortcomings ranging from operational foibles to persistent and widespread revenue weakness. Even as net profits rose 51.2% year-over-year (YOY) driven primarily by a 29.6% decline in fuel expenses, revenue fell 4.0% to $9.91 billion, accompanied by a decline in passenger revenue per available seat mile (PRASM) of 5.6%.
Many of the financial figures for the quarter were indeed impressive. For example, United recorded $1.8 billion in operating cash flow and $474 million free cash flow, with an 18.2% ROIC, though given the wide range of ROIC formulas, it is an open question as to how useful of a metric this is. On the cost side, non-fuel cost per available seat mile (CASM) in Q2 was up just 0.3%, driven partly by productivity improvements under the carrier’s Project Quality initiative. Ancillary revenues grew 7% per passenger to more than $23 as well, marking a bright spot in an otherwise dismal revenue report. And in a bit of good news for passengers, United’s regional fleet mix continued to improve as the carrier took delivery of 15 additional Embraer E175 aircraft in Q2, bringing the total fleet up to 60 airframes. These E175s have replaced more than 100 50-seat regional jets (RJs) that have left the fleet since the beginning of 2014. The substitution of the E175s offers a superior product to passengers and helps reduce CASM versus inefficient smaller RJs. Given all of this positive news, United also used the occasion to announce a new stock buyback (share repurchase) program, for $3 billion through the end of 2017.
However, these positive signs were more than outweighed by United’s substantial revenue weakness. PRASM decreased in every single operating segment, notably falling 10.9% in Latin America, 8.8% across the Pacific, and 6.4% across the Atlantic. Part of that was driven by United’s capacity increases (6.7%, 2.2%, and 2.1% respectively) in these markets, but the larger cause is a mix of unusual strength in the US dollar (weakening foreign currency by comparison) and general economic malaise across pretty much the entire world save the US and maybe India. Yet even in the domestic market there is persistent competition. LA, NYC, and Seattle (where United has larger than average exposure for an outstation) are bloodbaths (actually, as of this fall, United Airlines leaves JFK airport after 65 years of continuous service, shifting its Premium Service on nonstop flights to Los Angeles and San Francisco, to its hub at Newark). Meanwhile, Dallas and Chicago are particularly weak revenue environments right now due to aggressive competition from low cost carriers (LCCs).
Even more than those two, Houston is a market that has seen substantial weakness due to the worldwide collapse in oil prices. United’s exposure to oil and gas, with hubs at both Denver and Houston, exceeds that of other US airlines and accordingly, the downturn in the energy industry is having tangible effects on United’s overall operation. For example in Q2, corporate revenue from the oil and gas sector was down 30% YOY, which drove a 5% overall decline in corporate traffic. Fares in Houston, for business traffic in particular, are pretty soft, and things will only get worse when Southwest launches its Central American gateway at Houston Hobby in October of this year. In response to this mess, United plans to reduce capacity in so-called “Core Energy” markets by 9% and 8% in Q3 and Q4 respectively, and in Brazil by 7% in Q4. But that revenue is not easily replaceable in the current environment, though it should help PRASM some.
Even more worrisome are United’s operational woes. While executives on the Q2 earnings call touted the fact that United had 24,000 fewer flights cancelled in first half of this year versus 2014, those words rang hollow given United’s operational underperformance relative to its peers (Delta, American, and Southwest. While the first five months of the year were uninspiring operationally, June was a uniquely bad month. According to FlightStats, United had on time arrival performance of 70.4% for the month, far lower than American (74.6%), Delta (80.4%), or Southwest (73.8%). Its completion rate was also weak at 96.4%, versus 97.3% at American, 98.6% at Delta, and 98.0% at Southwest. While 2.2 percentage points worse than Delta may not seem like a lot, for an airline like United, it represents more than 50 flights per day, or 1500 flights per month. The drivers of this weakness were myriad, with weather and maintenance problems (particularly with Boeing 767-300ERs) in the long haul fleet at EWR cited as primary drivers.
United’s stalled labor integration may have also played a role. United’s flight attendants still don’t have a contract, and we understand that this is primarily due to cultural differences between the pre-merger United (PMUA) and pre-merger Continental (PMCO) work groups. The PMUA folks prefer better work rules with lower pay, while the PMCO team wants higher pay in return for less flexible work rules. United’s mechanics also still lack a contract, and it reflects poorly on management and employees alike that five years after the merger, the two airlines have not been able to combine more seamlessly.
As a whole, United has neither invested in nor built a culture of operational excellence. After positive signs in 2013 and 2014 coming out of the hellish cutover to SHARES in 2012, 2015’s operational performance has regressed to the mean. Project Quality was a necessary imperative to strip $2.0 billion out of a bloated cost structure, but 2015’s run-down in fuel prices has provided an opportunity for United to invest meaningfully into its operation even at the expense of some one-time cost increases, which it has so far declined to do. In a sense, Wall Street has rewarded the airline for prioritizing short term profits, as its share price is still up 24% in 2015, mostly on the underlying increase in margins due to plummeting fuel prices. But United is in no position to shirk on its operations either. Delta CEO Richard Anderson has stated that his company is winning incremental corporate customers in San Francisco and Chicago due to the operational SNAFUS with United, an effect that will only accelerate as American works out the kinks in its merger and if United’s chronic underperformance persists. United has the urgent need of investing to fix its operations, even if the investment is just $250 million. Shareholders may appreciate $3 billion in share buybacks, but for long run value maintenance, running a top-notch operation is far more important.
And on the revenue side, the drivers of United’s poor PRASM performance are mostly still in place. Foreign exchange pressures show no sign of easing given America’s relative strength in the global economy. The energy sector may also continue to suffer from the current glut of oil supply for a while to come. While shale producers are being forced out of the market, Iran’s emergence from economic exile should more than offset that production loss. In order to stem the revenue tide, more capacity reductions might be in order. Latin America’s macroeconomic indicators are weak given its dependence on resource extraction, so capacity reductions, especially off-peak are warranted. And overall capacity in Houston could stand to be drawn down by 10-15%, especially as Southwest flexes its muscles. Despite record financial returns, all is not well at United Airlines.