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The largest U.S. airline United Continental Holdings Inc. (UAL) is slated to release its first quarter 2011 earnings on April 21. The current Zacks Consensus Estimate for the first quarter is a loss of 40 cents, representing a 27.44% improvement from the year-ago level.

United Continental had average positive surprises of 37.23% in the last four quarters of 2010. But we believe the first quarter of 2011 will be dampened by escalating fuel prices, lower capacity as well as the drop in air traffic resulting from the March 11 catastrophe in Japan.

In order to counter rising fuel prices, United Continental Holdings plans to cut its capacity approximately by 1% in May and 4% in September. With these reductions, the company expects its domestic capacity to decrease 5% and international capacity to increase 2% in the fourth quarter of 2011.

The massive earthquake and radiation leaks, which took a toll on Japan’s economy, affected demand of air travel in that country. In a move to control the situation, United Continental is expected to slash 10% of its Japanese capacity in April and 14% in May for flights operating between Tokyo and U.S. cities like New Jersey, Los Angeles, Seattle and Washington.

The company is cutting more capacity than its rivals, Delta Air Lines Inc. (DAL) and American Airlines, a wholly owned subsidiary of AMR Corporation (AMR), to combat the difficult situation arising from the Japan crisis as well as high fuel prices. The reduced capacity will restrict revenue growth going forward.

Fourth Quarter Flashback

United reported impressive earnings in the fourth quarter of 2010. Reported earnings were twice the Zacks Consensus Estimate. Despite higher fuel prices, earnings improved on increased fares and traffic, and a revival in the airline industry.

Revenue grew over the prior-year quarter and was ahead of the Zacks Consensus Estimate owing to higher ticket prices. Airline traffic, measured in billions of revenue passenger miles, was up 4% year over year. Capacity or available seat miles grew 3.8% and load factor (percentage of seats filled with passengers) increased 100 basis points from the year-ago quarter.

Agreement of Analysts

Estimates for the first quarter have been trending downward over the last 30 days. 5 analysts out of 11 have made downward revisions while 4 analysts moved in the opposite direction. Over the last seven days, two analysts reduced their estimates while none made positive revisions.

For fiscal 2011, out of 12 analysts, 7 revised their estimates downward over the last 30 days and 4 made a similar revision over the last 7 days. None of the analysts made any positive revisions to the estimates over the last 7 days while 2 revised their estimates upward over the last 30 days.

The analysts are concerned about the profitability of the overall airlines industry. Last month, the International Air Transport Association (IATA) cut the overall airlines profit outlook for 2011 to $8.6 billion from its prior expectation of $9.1 billion.

Persistently rising fuel prices since last December are a major headwind for the industry. Crude oil prices are currently trading around $110 per barrel, representing the steepest rise in more than 2 years. Oil prices have already risen more than 21% this year due to the ongoing political unrest in the Middle East. U.S. carriers are struggling hard to deal with increasing costs either by flying less or charging more.

Magnitude — Consensus Estimate Trend

The magnitude of loss for the first quarter has increased to 40 cents from 38 cents in the last 7 days and 32 cents in the last 30 days.

For fiscal 2011, the Zacks Consensus Estimate is $4.09, down from $4.20 over the last 7 days. The fiscal 2011 Zacks Consensus Estimate also dropped from $4.60 over the last 30 days. The Zacks Consensus Estimate for 2011 reflects a 4.09% loss year over year.

We believe Japan’s calamity as well as higher fuel prices will stall the ongoing recovery of the U.S. airlines, eating into United’s revenue and profitability for the year.

Our Analysis

We have recently downgraded our long-term recommendation on United Continental to Underperform due to the ongoing situations prevailing in the airline industry. Further, high unionization, competitive threats and capacity cuts might pose major risks to the company’s profitability going forward.

However, we believe United Continental will likely be able to have everything back in control as conditions stabilize in Japan. In all probability, the capacity cuts are temporary, and should last only for the next two–three months. Also, the company is combating rising fuel prices with higher fares and extra fees. United Continental hedges its fuel position, which protects it from rising fuel prices.

Hence, for the short term (1-3 months), the stock retains a Hold rating with the Zacks #3 Rank. Further, we believe United Continental will continue to benefit from merger synergies, global network, strong competitive positioning, low costs, fleet optimization and a strong liquidity position.

Source: United Continental Holdings: Earnings Preview