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Summary

  • UAL reported another poor quarter with a $489 million loss.
  • UAL is seriously lagging its peers in key metrics like Passenger Revenue per Available Seat Mile [PRASM].
  • UAL has pursued a strategy that is destined to drive away its most valuable customers -- the high value flyers (HVFs) -- which will devastate its earnings.

As someone who spends a lot of time and money on airplane flights, I can add some first-hand perspective to my analysis of United Continental Holdings (NYSE:UAL). In fact, I'm writing this in seat 1A en route from SFO to Shanghai on UA857.

(click to enlarge)

Like the "Global First" seat shown above, UAL is overrated, overpriced, and utterly outclassed by the competition (e.g. here and here). UAL's numbers are bad, and they're going to get much, much worse -- for reasons you won't find in any analyst report, but which I'll describe in this article.

Another Lousy Quarter

Last week, UAL reported another disappointing quarter, with a whopping $489 million ($1.33/share) loss, which management blamed on bad weather. While the weather certainly didn't help the industry, it's hard to ignore the fact that Delta (NYSE:DAL), American Airlines (NASDAQ:AAL), and Southwest Airlines (NYSE:LUV) managed spectacular quarters in spite of it. Delta did so well it forecasted a 50% dividend increase this year and initiated a share repurchase.

One key metric for the airline industry is Passenger Revenue per Available Seat Mile [PRASM], which encapsulates both passenger load and yield. DAL and AAL crushed UAL on PRASM last quarter. And the trend is not good. UAL just updated its revenue passenger miles (RPMs) for April. Although the market greeted the miniscule improvement with enthusiasm, it looks pathetic compared to DAL's and AAL's numbers.

Metric

UAL

DAL

AAL

PRASM [YOY]

-2.1%

+3.2%

+2.9%

RPMs (YTD April)

0.6%

+4.0%

+3.7%

UAL's earnings call was an embarrassment. Analysts were openly skeptical about management's explanations for the lousy numbers, as well as the rosy predictions for next quarter. One analyst referred to "last year's many excuses," while another asked, "At what quarter can we all agree that it's not working?"

So what's really going on? Why does UAL continue to underperform so spectacularly?

The Failed Merger

With the United-Continental merger supposedly consummated over three years ago, it's stunning how UAL still harbors attitudes of separate (and mutually antagonistic) companies. Amazingly, I still hear pilots and pursers making pointed references to "your Continental crew." And I often encounter phone reps, and ticket and gate agents who complain loudly and publicly how someone from the "Continental side" (or the "United side") screwed things up.

After three years, UAL has failed to consolidate union contracts. So there are parallel union cohorts that vie against one another for seniority and privileges. If you fly on United much, you've probably heard flight attendants heatedly discussing these issues in the galley - rather than, say, actually looking after passengers. This contrasts starkly with AAL, where CEO Scott Kirby attributed a record quarter to "improved morale" after its recent merger. Given all of this, it's easy to see why United is dead last in customer satisfaction.

Dead Last in Customer Satisfaction

The "Colbert Report" recently featured a teleconference with Satan. Satan apologized for not appearing in person:

The only flight to New York was in coach on United, and I spend enough time in hell as it is. . . .

According to the American Customer Satisfaction Index [ACSI], Satan has it right. While most airlines' ratings have slipped over the last two decades, United fell faster and further than any of them, settling at dead last.

Airline

2014 Rating

% Change from First Year

JetBlue

79

-2.5

Southwest

78

0

Delta

71

-7.8

Others (not in this list)

70

0

American

66

-5.7

US Airways

66

-8.3

United

60

-15.5

According to DOT statistics, United scrapes bottom in nearly every category: worst in bumped passengers and second worst in mishandled bags, canceled flights, and overall passenger complaints. But as we'll see, that's just the beginning. UAL has made changes that are set to damage earnings even more.

UAL is Driving Away High Value Flyers (HVFs)

If you're the average guy who buys his tickets on Kayak or Expedia (NASDAQ:EXPE), you may be disappointed to hear that the big legacy airlines don't really care about the lousy service you experience. That's because they don't make much money on you. Instead, they garner their margins from a fairly small number of high value flyers (HVFs) -- the business travelers who buy tickets only a few days in advance and pay 4 or 5 times what you pay or shell out $5,000 for International Business or $10,000 for Global First seats. These are the guys like George Clooney in Up In the Air. From the time I spend both flying and talking with other frequent flyers, it is clear that UAL is starting to drive these guys away. This is a really big deal, and we're just seeing the initial effects. DAL and AAL are both garnering 6%-7% corporate sales growth, and it's all at UAL's expense. The sections below describe why competitors will eat UAL's HVF lunch.

PQDs and "Bulk" Fares: How UAL is Telling HVFs to Get Lost

This year, UAL followed DAL's lead and implemented a "Premier Qualifying Dollar" [PQD] scheme, which requires flyers to reach certain spending levels to achieve "elite flyer" status (rather than basing status on flight miles alone). This is actually a great idea: airlines need to focus on revenue, not miles. The problem is that UAL has implemented it poorly; it doesn't count tickets from corporate in-house travel agents [like American Express (NYSE:AXP)] toward PQDs. This is a big poke in the eye to the corporate traveler, who is paying as much (and often a lot more) than other fliers for these tickets. After spending tens of thousands of dollars a year on UAL tickets, a corporate flyer may find he has earned 0 status because UAL disregards his expensive Amex-generated tickets as "bulk fares." In-house travel agents are very common in mid-size companies, and these companies are precisely where a ticked-off, frequent-flying executive can easily change travel policies and switch to a different airline.

Alienating the HVF for a Few Bucks of Ancillary Revenue

United is also alienating HVFs with its aggressive sale of upgrades to non-elite flyers at time of departure [TOD]. Management probably sees this as a way to boost its "ancillary revenue" (the latest fad in airline management). But this move is set to backfire in a big way.

Here's what's happening: UAL is holding back more and more business and first class seats from HVF upgrades until the last minute and then selling them out from underneath the HVFs (for an idea of this, see diditclear.com). UAL attempts to maximize the upgrade sale with some clever price discrimination, offering the upgrades at different prices to different flyers. So for example, a flyer with no status may be offered an upgrade for only $50; whereas the HVF is offered the same upgrade for $100 (presumably because he will pay more or will be encouraged to buy a premium ticket next time). This works very nicely until the HVFs figure out that's what's going on (I have four different MileagePlus status levels within my family, so I'm able see exactly what's going on). Look at any Frequent Flyer online forum and you will find HVFs are absolutely furious about this: first their supply of free upgrades has evaporated; and then to add insult to injury, these upgrades go to non-elite flyers for half the price that was offered to them.

If you look at UAL's investor presentations, you can see they're proud of the ancillary revenue growth. But they're ignoring the cost. To garner an extra $50 or $100 from an infrequent flyer, United is risking the business of HVFs who may spend tens of thousands a year. As awareness of this policy spreads, the cost to United will be high. Whenever an HVF is denied an upgrade, he's likely to blame it on United selling it to someone else for a few extra bucks. It doesn't matter whether or not that's what actually happened. It's the perception that matters. By contrast, HVFs are much happier with their upgrade success at Delta and American, which are not emulating United's TOD upgrade scheme.

No More Real First Class

HVFs, particularly in the Pacific market, tend to value, and pay for, genuine premium service. Many are coming to realize that United pretends to have it, but no longer does. As a case in point, I don't need to look any further than the United Global First wine list on my tray table. The featured French red wine is "Chateau Greysac" - a mediocre Medoc that I bought for around $7 at Trader Joe's not that long ago. That's right: for a $10,000 fare, you get a $7 wine! Contrast that with Singapore Airlines or Lufthansa, which feature Chateau Latour and Dom Perignon. That matters a lot to brand-conscious Pacific customers. For dessert, UAL serves the same rock-hard, cheap vanilla ice cream and Hershey's (NYSE:HSY) syrup that it plunks on Business and Coach. The end result is that fewer flyers are willing to pay up for premium class seats on UAL. That helps explain why UAL's yield plunged 6.3% on Pacific flights last quarter.

United's "Dark Birds:" Bane of the HVF

While other carriers have rolled out power outlets and Wi-Fi services (Virgin is 100% Wi-Fi-enabled and DAL is nearly there), UAL lags desperately behind. In fact, with many of its newest planes, UAL has taken an enormous leap backward. Because of a problem with its seat vendor, it took delivery on a whole fleet of 737-900s ("dark birds") that not only have no Wi-Fi, but also have no power outlets in any class, and no in-flight entertainment whatsoever.

That's right: for the first time since the 1950s, a major airline is flying mainline planes that don't even have functional audio, let alone video. And it's using them on long-haul flights. I suppose the good news is that flyers are spared the smarmy videos telling them about the great service they're supposedly getting. Incidentally, if you're naive enough to pay for "BusinessFirst" on these planes: the last row of BusinessFirst seats doesn't recline - not even an inch. Now you get a sense of why HVFs are fleeing UAL.

Summary

HVFs and other flyers routinely complain about their airlines and bluster about how they're going to switch. Most flyers won't admit it, but they have tremendous inertia - it takes a lot get them to switch. And all airlines have exploited this tendency by cutting every cost they can get away with: it started years ago with Bob Crandall famously saving $40,000 by cutting olives from AAL's salads.

The problem for UAL management is that it doesn't have any other tricks to improve margins. It's just more and more cuts: cut the olives, cut the in-flight entertainment, cut the good wine, cut the HVF upgrades..... This works as long as competitors are making the same cuts, and you haven't reached the inflection point where flyers won't take it any more. But now the competitors are actually improving their services, rolling out better seats, in-flight service, and Wi-Fi. And more and more, HVFs are hitting that inflection point. The latest revenue and PRASM numbers from UAL are starting to reflect his. And it's only just beginning.

UAL stock has been buoyed by positive trends in the transportation industry. But it is now faltering and diverging from its peers, as its underperformance is becoming more obvious.

(click to enlarge)

I see myself as a harbinger of what UAL faces. Last year I spent nearly $50,000 on United tickets for my family and myself -- much of that on paid business or first class fares. You could say I'm worth an olive in AAL's salad. I'm the type of flyer airlines want. And I'm leaving UAL, taking all that revenue with me. That's all the more notable, since I'm only a year or so away from "million miler" status, which should be an incentive to stay. I suspect there will be many following me if UAL doesn't change course quickly.

Disclosure: I am short UAL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclaimer: I am not an investment advisor and do not give investment advice. Everything in this article is for general informational purposes and should not be interpreted as guidance to buy or sell any security.

Source: United Continental Holdings: Up In The Air Or Set To Crash?