On Thursday morning, United Continental (UAL), the parent company of United Airlines, released a very disappointing investor update. United has been lagging the rest of the airline industry in terms of revenue and operational performance, and this underperformance shows very clearly in the investor update. For Q3, United is misfiring on all cylinders: RASM (revenue per available seat mile) is down, CASM (cost per available seat mile) excluding fuel is up, fuel prices are up, and fuel efficiency is down. On every dimension, United's financial performance is declining year-over-year.
I have been relatively bullish on United over the past year, and I remain fairly confident in the company's long-term prospects. As the integration of United and Continental progresses, I expect management to fix many of the recent operational problems and realize synergies from better capacity deployment. However, in the near term, I think Delta Air Lines (DAL) is the best positioned of the legacy carriers. Until United's performance bottoms out (I expect this to occur around the end of this year), investors looking for exposure to the airline sector should rotate to other companies, such as Delta.
The first number to jump out of the investor update was the expected PRASM (passenger revenue per available seat mile) decrease of 1-2% for Q3. This is perhaps the most important metric of revenue in the airline industry. United had already reported a 0.3% drop in PRASM for July and a roughly 1% drop for August. The new guidance suggests that September will be even worse: perhaps down 3-4%. It is thus easy to understand why United announced capacity cuts earlier this month. By cutting capacity, the company hopes to improve its pricing power going forward.
The rest of the investor update was fairly gloomy as well. CASM excluding fuel increased by roughly 3%, as expected. All-in jet fuel prices increased by 5 cents per gallon year-over-year to $3.18. One of the most unsettling data points was that fuel consumption increased slightly year-over-year even though capacity dropped by 1.4%. This translates to a nearly 2% drop in fuel efficiency. This is particularly concerning given that United has been investing heavily in retrofitting aircraft with winglets and buying new aircraft to save fuel. In part, the decline in fuel efficiency may be the result of United removing seats to increase legroom in the premium economy and business class sections. However, United needs to generate revenue gains from these products to justify the added fuel expense. This year's revenue underperformance suggests that United has not been able to do so recently.
I expect United to earn $1.30-$1.40 for Q3, below the current analyst consensus, but in line with several top airline analysts. While United announced relatively strong forward bookings, the company only reports on the number of seats sold, not the average ticket price. I think it is probable that PRASM will decline again in Q4, given the current trend, before resuming growth in 2013.
As a result of the weak data coming out of United Continental, I cut my holdings by slightly more than 50% on Thursday morning. While I believe that United's performance will improve over time, I expect to find lower entry points in the next 3-6 months. In the meantime, I think Delta is the most undervalued legacy carrier. Delta has outperformed the airline industry this year, and projected a 9-11% Q3 operating margin earlier this month. If, as I expect, oil prices decline this fall, Delta will be an even bigger beneficiary than United, as it maintains an older, less fuel-efficient fleet. Delta is also on track to cut its fuel costs through its purchase of an oil refinery earlier this year.
Investors looking to bet more aggressively on a decline in fuel prices could consider US Airways (LCC), which does not hedge its fuel costs. Smaller airlines with strong profitability and growth opportunities are also likely to provide above-market returns over the next few years. Hawaiian Airlines (HA) and Spirit Airlines (SAVE) are two well-positioned carriers in this respect.