United Continental Feels The Pinch Of Higher Fuel Expense

Aug. 3.12 | About: United Continental (UAL)

United Continental (NYSE:UAL) has posted operational revenues of $9.9 billion in e second-quarter earnings, up 1.3% y-o-y, on 2.3% y-o-y increase in passenger revenues partially offset by decline in cargo revenues. [United Announces Second-Quarter 2012 Profit.] Further, passenger revenue increased from domestic and Pacific international operations, while it declined from Atlantic and Latin international operations. Also, unlike operational revenue, net income, including special charges declined 37% y-o-y to $339 million in the second quarter. The decline was a result of 5.6% y-o-y increase in fuel expenses, and integration costs related to the United-Continental merger.

On the whole, the airline posted average numbers in its second quarter earnings due to increasing competition on Latin international routes and higher fuel expenses. However, going forward it must maintain its margins and profitability as it runs a high level of debt.

Decline in passenger revenue from Latin international routes

At a time when most other airlines, namely Delta (NYSE:DAL), Southwest (NYSE:LUV) and JetBlue (NYSE:JBLU), have seen their passenger revenue from Latin international operations rise, United Continental has posted 3.4% y-o-y decline in passenger revenue from these operations. The airline increased its capacity marginally by 0.1% y-o-y and also posted a higher load factor on these routes. But its passenger yield, which indicates average fare per passenger per mile, for Latin operations declined 7.2% y-o-y. That is, lower average passenger fares on Latin routes resulted in the overall decline of passenger revenue from these routes. This is a direct consequence of an increasing focus on Latin international routes by low-cost carriers such as, JetBlue and Southwest. These airlines have added significant capacity on these routes over the past 6 months, post receiving the necessary approvals.

Also, passenger revenue from Atlantic operations fell 1.9% y-o-y owing to the euro-crises. However, passenger revenue increased 12.5% from Pacific international operations, and 0.6% from domestic operations, on a y-o-y basis. As a result, overall passenger revenue for the airline increased 2.3% y-o-y in the second quarter.

Cargo revenue decreased $51 million, or 16.1% y-o-y in the second quarter, due to lower volumes and yields on freight and mail.

And moderate growth in operational performance

Overall, the airline posted moderate growth in operational performance. Revenue Passenger Miles (RPM), an indicator of passenger traffic increased 0.5% y-o-y. Passenger Revenue per Available Seat Mile (PRASM) increased 3% y-o-y on a capacity decline of 0.6%, and increase in load factor of 0.9 points to 84.3%.

While expenses rise at a higher rate

Also, net income declined 37% y-o-y to $339 million in the second quarter, even though operating revenue increased 1.3% y-o-y. This is because operating costs increased 4.0% y-o-y, on higher fuel expenses and integration costs. Fuel expenses increased 5.6%, or $181 million in the second quarter of 2012, compared with the year-ago quarter. Fuel expenses increased as the airline incurred an average fuel price per gallon of $329.3, up 6.4% from $309.4 it incurred in the year-ago period. Also, the airline could not fully realize the benefit of comparatively lower crude oil prices on account of hedging losses. Excluding the effect of fuel price hedging, average fuel price per gallon in Q2 was $325.

And, integration costs of $137 million in the second quarter also continued to weigh on margins. In 2012, by the end of second quarter, the airline has incurred a total $271 million in United-Continental integration costs.

Must improve profitability in light of high debt

In addition, the airline has a high proportion of debt compared to its capital. At June 30, 2012, it had $12.4 billion of debt and capital lease obligations, of which $1.5 billion are due within the next 1 year. It also has several non-cancelable commitments for acquisition of new aircraft. As a result, it currently holds below investment grade credit ratings from S&P, Moody’s and Fitch. Thus, it is imperative that United Continental improve its margins and profitability in order to reduce its debt-to-capital ratio.

We currently have a stock price estimate of $26 for the airline, significantly above its current market price.

We are in the process of incorporating the second-quarter results and shall update our analysis shortly.

Disclosure: No positions