One of the primary historical criticisms of investing in airlines has been that the airline industry is a very capital intensive business. Many airlines historically have invested aggressively in new aircraft, leaving them saddled with heavy debt loads and minimal flexibility going forward. However, in recent years, some airlines have pioneered new, less capital-intensive operating models. Allegiant (ALGT) exclusively buys used airplanes that are being retired by other carriers, while Delta (DAL) has also become very active in purchasing (and leasing) used aircraft for its own fleet renewal projects.
By contrast, United Continental (UAL) is going forward with the same capital-intensive strategy as always. The company's management team believes that the maintenance and fuel savings from having state-of-the-art equipment justifies the cost of acquiring new aircraft. From an investor point of view, this seems doubtful. First, having an expensive fleet pressures United to maintain or grow capacity. In the past two years, Delta has been much more aggressive than United about cutting capacity, which in turn has generated notable revenue outperformance vis-a-vis United. Delta can cut capacity more easily because it owns many fully depreciated aircraft, which can be retired at any time.
Second, Delta's relatively modest capital expenditures plan will allow the company to begin returning cash to shareholders in early 2014. By contrast, United's combination of heavy debt maturities and high CapEx over the next few years will make it nearly impossible for the company to return a meaningful amount of cash to shareholders before the end of the decade.
The following chart, drawn from United Continental's most recent 10-Q, lists United's capital commitments as of Sept. 30. Most of these commitments are for the purchase of new Boeing 737, Boeing 787, and Airbus A350 aircraft.
United's total capital commitments sum to $18.4 billion, and the vast majority of that spending will occur between now and 2019. By contrast, United's depreciation and amortization expense has recently been around $380 million per quarter, or $1.5 billion annually. In 2013, United's capital expenditures will be essentially equal to D&A expense, but CapEx will ramp sharply thereafter. From 2016-2019 (the heaviest period of aircraft acquisition), CapEx is likely to exceed D&A expense by nearly $1 billion a year soaking up cash flows generated by earnings. Meanwhile, United has roughly $2 billion of debt maturing in each of the next three years.
United Continental's operating cash flow has been pressured over the past year by lower profitability and special charges. For FY12, high capital expenditures combined with minimal operating cash flow will result in negative free cash flow. While analysts expect rapid improvement in earnings (which would buoy cash flow), I believe labor integration bonuses and pay raises will dampen the pace of improvement. With heavy debt maturities from 2013-2015 and heavy CapEx from 2016-2019, United will be hard pressed to return cash to shareholders before the end of the decade. United's management team has made it clear that it sees debt reduction as a priority (which is very reasonable given the company's high debt load). Shareholders should understand the consequence of this: there will not be any money left over for dividends or share repurchases for the foreseeable future.
Near term cash flows are not the only factor that should be considered when choosing investments. However, value-oriented investors are ultimately buying stocks for the cash flows those companies produce. United Continental's capital intensive strategy has already "spoken for" more or less all of the cash flows that the company is likely to generate for years to come (and this already assumes a substantial increase in profitability over 2012 levels). This should be a big red flag for investors. Even with a projected increase in profitability, United will not have cash left over after meeting its capital commitments and paying down existing debt. Nevertheless, the company trades at a premium to network competitors such as Delta and US Airways (LCC). This premium is likely to disappear as investors rotate to competitors that have sufficient free cash flow to return cash to shareholders.
Disclosure: I am short UAL.
Additional disclosure: I am also long DAL.