We are upgrading our long-term recommendation on the largest U.S. airline, United Continental Holdings Inc. (NYSE:UAL) to Neutral from Underperform.
United Continental is benefiting from industry consolidation as well as improved economic conditions. Though we remain concerned about escalating fuel prices, United Continental has so long been able to pass on the higher costs to its customers in the form of fare hikes.
United Continental is also well prepared to combat rising fuel costs by reducing flight frequencies, indefinitely postponing the start of flights as well as scraping unprofitable routes and less fuel-efficient aircraft from its fleet.
Additionally, the company is cutting its capacityby approximately 1% in May and 4% in September. With these reductions, the company expects its domestic capacity to decrease 2% to 3% and international capacity to increase 3% to 4% in 2011.
Further, the company hedges its fuel position, which protects it from rising fuel prices. For the remainder of 2011, United Continental has hedged 28% to 44% of its expected consolidated fuel consumption using a combination of calls, swaps and collars.
In the recently concluded quarter, United Continental’s earnings improved on increased fares and extra fees,despite higher fuel prices and capacity cuts. Adjusted earnings outpaced the Zacks Consensus Estimate by 4 cents and were 17 cents above the year-ago earnings.
Although air traffic for the quarter dropped slightly due to lower demand caused by the March 11 disaster in Japan, revenue improved owing to higher ticket prices and continued growth in ancillary revenue. Fuel expense rose more than one-third from the year-ago level in the recently concluded quarter leading to increased operating expenses.
We expect demand to recover as conditions stabilize in Japan. Moreover, a revival in the airline industry, reduced capacity, unit revenue growth, fleet and network optimization, hedging strategy as well as the merger benefits from Continental Airlines bode well for United Continental’s future growth.
On the other hand, United Continental is cutting its capacity more than its rivals Delta Air Lines Inc. (NYSE:DAL) and American Airlines, a wholly owned subsidiary of AMR Corporation (AMR), to combat demand and cost related issues. Further, high unionization, competitive threats and integration of Continental Airlines with United might pose major risks to the company’s profitability going forward.
Thus, our long-term rating is supported by the Zacks #3 Rank (Hold).