United Airlines Stock: Q3 Earnings Overshadowed By Strategic Shifts

Summary

• United Airlines reported an adjusted net loss for the third quarter of 2021.
• United's Covid era strategies have left the company vulnerable in a highly competitive industry.
• United's Covid recovery strategies are risky and a departure from what has proven to work for legacy airlines.

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United Airlines (NASDAQ:UAL) reported its third quarter 2021 financial results on October 19, 2021. Now that the entire U.S. airline industry has also reported, UAL’s results can be seen not just in the context of the results of its own recovery from the pandemic, but also in the context of the industry.

In many ways, United’s results are in line with what the industry has historically reported. American (AAL), Southwest (LUV), and United all reported losses after government assistance to the airline industry was removed; in United’s case, that assistance amounted to about $1 billion in the third quarter on revenues of $7.75 billion. Of the four largest airlines, Delta (DAL) was able to post a modest profit of a couple hundred million dollars, excluding government aid. The general theme among all of the airlines was that demand appeared to be building for a strong summer only to be dashed less than halfway through the third quarter by a resurgence of Covid in the U.S. which pushed back office reopenings and suppressed leisure travel. United’s adjusted net loss of nearly one-third of a billion dollars is a substantial improvement from other periods during the pandemic, but it also highlights how fragile the recovery has been and how many threats remain for not just United but for the entire global airline industry as it rebuilds from the deepest and most prolonged crisis in its history.

UAL Income Statement 3Q2021 Source: UAL 8K p. 9

There were a number of positive developments late in the third quarter which will impact airline finances in the fourth quarter and beyond. In just a few days, the United States will eliminate country-specific travel restrictions which were put in place early during the pandemic. Tourists from Europe and the United Kingdom as well as Brazil and China, among other countries, have not been able to come to the United States for much of the past 18 months. In addition, there have been limitations on Canadian travel which are also being relaxed. As the United States airline with the largest international exposure, United knew early in the pandemic that it would be particularly hard hit by the closure of U.S. borders. While the borders are reopening only to vaccinated foreign tourists, United is counting on a strong international recovery to assist with rebuilding its finances. Still, there are a number of metrics which should be of concern to investors in the airline industry and particularly those with an eye on United Airlines.

Fuel and fleet

Perhaps the largest concern for UAL investors is the rapidly rising price of jet fuel. While Americans have seen gasoline prices increase over the past several months to multi-year highs, Delta’s fourth quarter guidance alerted airline industry investors to the threat that rising jet fuel could pose to the airline industry’s recovery; Delta’s third quarter fuel cost per gallon of $1.97 was the lowest of the big three, aided by a return of Delta’s refinery in reducing its own jet fuel prices. Southwest obtained benefits from fuel hedging, a strategy that LUV has used to ensure predictability of its costs, even though its hedges have cost it hundreds of millions of dollars over the past few years of relatively low fuel prices. However, United, like American among the big four, has no macro-strategy for reducing fuel prices. United’s third quarter fuel cost per gallon of $2.14/gallon was the highest of the big four. United’s fourth quarter guidance is for jet fuel at $2.39/gallon, at the high end of Delta’s 15 cent range and above Southwest’s fuel cost guidance range while American is expecting even higher fuel prices. In an increasing price commodity environment, timing is a significant factor in the price each airline pays. While United might not have had the best timing in its fuel purchases for the third quarter, it appears to be somewhat better positioned than American in the fourth quarter. United’s 9% higher fuel cost per gallon compared to Delta in the third quarter will ease to 5% or less in the fourth quarter compared to both Delta and Southwest. Few analysts, even the President, expect fuel prices to come down soon which means the airline industry could be moving into a period of sustained high fuel prices. While fuel efficiency has improved, the economy is still weaker and there is no assurance of how much business travel has been permanently lost after 18 months of limited ability to travel for many companies, limiting the ability to pass along fuel price hikes to consumers.

UAL Mainline Fleet Source: UAL 10K p 32

Compounding fuel price increases is the fact that United now has the oldest fleet among U.S. airlines. While I have long noted that fleet age is a fairly meaningless statistic, there are costs associated with certain less-modern fleet types. United operates the world’s largest fleet of Boeing (BA) 777-200 and -200ERs, including some of the first 777s that were built decades ago. The 777-200ER (which American and United both operate) has the highest fuel burn per seat in the U.S. airline widebody fleet. United also operates about 20 of those early-build 777s in a high-density configuration largely on domestic flights to offset the high fuel burn, but with the largest number of seats on any U.S. carrier scheduled passenger aircraft. American and United also each operate roughly a dozen and a half 777-300ERs which are also very fuel inefficient compared to new generation widebody aircraft. To compound United’s challenges, the company’s fleet of Pratt and Whitney (RTX) 777-200s are grounded after an in-flight engine failure. Boeing and Pratt and Whitney have completed some of the necessary revised procedures and replacements but they have not completed revisions to the cowling (engine cover); the FAA denied a request to allow the aircraft to return to service before all of the necessary modifications and reinforcements are made and fully approved. United also operates General Electric powered 777-200ERs, but they are one of the few large remaining PW 777 operators in the world which means that the cost to modify the PW engines has to essentially be funded by the UAL or Boeing or Pratt and Whitney for United’s benefit. United’s Pratt and Whitney-powered 777 fleet represent approximately one-fourth of United’s widebody fleet; their ability to restore their international network is dependent on returning those PW-powered 777s to service.

In addition to its 777 fleet challenge, United also contracts with regional carriers to operate nearly 500 regional jets; over 200 of those are 50 passenger models, the least fuel-efficient aircraft per passenger in the U.S. commercial fleet. Some of United’s 50 passenger jets are actually 70 passenger aircraft which have been reconfigured with 50 seats in a premium configuration, a pre-pandemic strategy to get around pilot contract limitations on the number of large regional jets (70-76 seats) while hoping that the premium configuration would generate enough revenue to offset the high operating costs per seat for those aircraft; it will be particularly challenging for the company to generate sufficient revenues, especially given that other airlines, including American and Delta have more efficient domestic fleets, the latter of which has nearly eliminated 50 passenger regional jets. Also, because of limitations in its pilot contract, United is operating its large regional jets with fewer seats than are normally used on those aircraft because of the reduction in system capacity. United’s regional jet fleet was heavily skewed to being less efficient than competitors but is handicapped by fewer seats as part of its Covid-era labor deals.

UAL Regional Jet Fleet, Source: UAL 10K p 33

In summary, United’s 777 and regional jet fleet are less efficient than some competitors, large portions of the 777 fleet are grounded, and high fuel prices will disproportionately impact United compared to other airlines.

Network and revenue

Early in the pandemic, United aggressively reduced capacity and costs and has done a comparatively good job of managing costs during the pandemic. Unlike other competitors, United never blocked seats but worked to demonstrate that airplane cabin filtration systems remove Covid particles. Consequently, they operated fewer flights, but sold every seat. By winter of 2020, United added short-term, seasonal service in a number of leisure markets they did not serve before the pandemic, although a number of those markets did not deliver satisfactory returns.

United’s key challenge has been and will continue to be that travel to/from East Asia largely remains heavily impacted by Covid restrictions with chances for a return to normalcy by the summer of 2022 quite low. United was the largest airline across the Pacific and also the largest airline between the U.S. and China; the number of flights between the two countries has been greatly reduced for both countries’ airlines by Chinese order during the pandemic and a restoration of pre-Covid route systems is highly unlikely. In addition, United, like American, committed to partnerships with Japanese airlines years ago that resulted in the U.S. DOT awarding increased access to Tokyo’s close-in Haneda airport to Delta, which does not have a Japanese partner. While American and United have operated from both Tokyo’s Narita and Haneda airports during the pandemic, Delta moved all of its rights to Haneda. DOT data shows that Haneda flights have generated a substantial premium to Narita which means that United’s Tokyo position (along with American’s) will likely be slower in seeing revenue recovery.

United also had a significant number of flights to New Zealand and Australia, both of which have locked down travel more aggressively than most of the world and which will result in a slower return of revenue when those markets do reopen. Offsetting passenger weakness, United has used its position in Asia/Pacific markets to operate dedicated freighter flights using passenger aircraft and has generated the highest amount of cargo revenue of the big three U.S. airlines during the pandemic, accentuated more recently because of supply chain challenges which have pushed up demand and prices for air cargo.

Early in the pandemic, United execs stated that they would not retire any widebody aircraft and would be positioned to grow their international network, in part because the number of transatlantic low-cost carriers has fallen and United expected a stronger pricing environment post-Covid. In addition, American retired about 50 widebody aircraft during the pandemic, saying that about that number of aircraft was not operating on a consistently profitable basis on American’s long-haul international system. Because of the clear loss of opportunities to Asia which are likely to persist throughout 2022 and seeing opportunities to grow, United has announced several aggressive expansions of its transatlantic system. They have re-entered the Africa market and announced a number of new routes as well as increased capacity on existing routes, resulting in the largest increase in new transatlantic routes and capacity in United’s history. Based on schedules for June 2022, United is increasing its transatlantic capacity by at least 10%, more than any other of the top five airlines compared to 2019. In fact, the majority of airlines have scheduled less capacity, down 16% on average across the Atlantic. United is not only bucking the trend of the majority of other airlines, it is replacing a significant portion of the capacity that the industry collectively is cutting. Because the Atlantic is highly competitive, airlines rarely walk away from profitable opportunities if they see them. United’s capacity increases can only be seen as a market share grab strategy.

UAL 3Q2021 Revenue by global Region UAL 8K p.16

Concern should not be focused just on the international network. United’s strategy of cautiously re-adding domestic capacity during the worst of the pandemic allowed for significant growth of competitors. Newark was United’s largest hub by local market revenue pre-pandemic; during the pandemic, JetBlue (JBLU) aggressively added a number of new routes and quickly grew to a solid #2 in a market where UAL had easily commanded 70%+ of the domestic market. Based on DOT data, United lost 25 points of market share (one-third) in Newark to Los Angeles and half that amount to San Francisco; both are top revenue markets for United. Southwest started service to Chicago O’Hare, UAL’s home airport, and Houston Hobby and DOT revenue shows that they have gained double-digit market share in just the first few months of operation in markets that are all major markets for United; as is typical for Southwest, they aggressively discount to gain share and add new routes from an airport as they become established. Southwest and United are aggressively growing in Denver and Southwest is growing its share at United’s expense; even pre-Covid, Denver is the only legacy U.S. carrier hub where the legacy carrier does not have the largest share of the local domestic market – Southwest does. Domestic share loss has not been limited to low-cost carriers, however. American pursued a high-volume strategy during the pandemic, even if that strategy has resulted in steeper losses for American. In Chicago, the only city where two legacy carriers operate a hub at the same airport, American has gained several points of domestic market share from United and it is doubtful that they will let go of those share gains. In contrast to American, Delta has continued with its premium revenue strategy which has allowed it to become the largest carrier by local market revenue in major markets like New York LaGuardia to Chicago O’Hare. While United loves to tout its international network and size, it is predominantly a domestic airline. The loss of share and increase in low-cost carrier competitive overlap with United should be concerning to investors in light of the domestic share loss which United has experienced throughout the forty-plus years of domestic deregulation.

There are clear risks with United’s strategy of aggressive growth. While there is global optimism that the impacts of Covid can be managed, there remains uncertainty about what might lie ahead. In addition, the degree to which market demand and revenue will permanently change is still unknown. United has been very optimistic that pre-Covid levels of demand will return and that optimism may prove unfounded, but a competitor CEO said just last week that they do not see a recovery to full business travel levels in 2022.

In addition to high fuel concerns and the fuel inefficiency of the marginal capacity which UAL will use to grow its network, United execs have said they will pass along fuel costs to consumers which history shows that is very difficult to do in periods of excess capacity which is where the domestic industry is right now. Federal government aid prevented a collapse of the airline industry, but it also has eliminated the removal of capacity on a long-term basis. United, like many carriers, is ready to not just re-add capacity it had pre-pandemic but to grow it. While other carriers might be more restrained in announcing new flights, there is almost always a competitive response when one carrier starts to “unbalance” the competitive balance that has existed in the industry. Obviously, some carriers are better positioned to be able to alter the competitive balance of the industry, but it has been true for all of the deregulated era of airlines in the U.S. that legacy carriers such as American, Delta, and United have never succeeded with dramatic, large-scale expansion outside of mergers and asset acquisitions. United has had the lowest market share in the metro areas where its hubs are located and their market share levels are set to further decline due to competitive forces which have accelerated since the pandemic began, partially because of United’s own strategic decisions. Even if the routes United has announced financially succeed – which is a risky assumption given high fuel and a potentially weak demand environment due as much to economic factors as to Covid - the chances are high that competitors will grow in United’s top domestic markets. United is also faced with potentially being forced to pull down its aggressive international expansion if its 777 fleet issues are not resolved; even if the 777s are resolved, UAL does not have the widebody aircraft on order to support the flights it is adding as well restore service to its transpacific network as those markets reopen.

Debt and commitments

While United has been aggressively expanding its international network, it made the conscious effort during Covid to overhaul its domestic fleet and to do so over a very short period of time. United surely recognizes that part of its cost inefficiency is related to its heavy reliance on regional jets. Pre-pandemic and now, United schedules more of its domestic flights on regional jets than on mainline flights, or flights operated with Airbus and Boeing aircraft by United Airlines itself. UAL’s reliance on regional jets results in the company having the smallest average aircraft size which results in fuel and labor inefficiencies compared to carriers with larger average aircraft sizes, including Southwest which has hubs/focus cities in nearly all of the metro areas where United has hubs. Southwest and United’s networks overlap more than between LUV and either AAL or DAL.

A big part of United’s strategy to rectify its excess reliance on regional jets and to increase its average aircraft size is to engage in aggressive aircraft acquisition. United already had hundreds of narrowbody aircraft on order prior to the pandemic with the Boeing 737MAX the largest part of its order book. United added to its MAX order book this year as part of its United Next strategy. Although United has a number of fleet types which are nearing what has been considered maximum lifespan for U.S. airlines, the company says it will use the majority of its order book to grow both the number of domestic flights as well as increase gauge (average aircraft size). In addition to its final 787 orders, United is poised to take 48 MAX aircraft in 2022 as part of its $5 billion capex while the capex number soars to $7 billion in 2023 with an eye-popping 130 new mainline aircraft. While United will be able to reduce its reliance on regional airlines, the sheer size of its capex is concerning, especially on the heels of the enormous debt that all airlines took on just to survive during the Covid era. While most airlines have committed to reducing their debt levels over the next couple of years, United will not have a chance to generate enough cash to begin to reduce its debt levels before they likely soar to levels that the U.S. airline industry has never seen.

UAL Aircraft Orders, Source UAL 8K p. 23

UAL Capex Source: UAL 8K p. 24

United’s aggressive refleeting is reminiscent of American Airlines’ aggressive fleet replacement a decade ago and yet American did its refleeting over a much longer period than United proposes. Most significantly, it is doubtful that United will gain a competitive advantage because other airlines have also been buying new, fuel-efficient aircraft and will continue to do so; UAL will just be buying at a much higher rate. UAL’s debt service costs in the third quarter and in 2021 year to date are nearly identical to AAL’s. AAL is slowing its capex and is committed to reducing its debt while UAL will continue to grow its debt and lease obligations.

While having industry-high debt levels, interest expenses, and fleet ownership costs is problematic enough, United’s massive domestic fleet expenses will prevent it from further replacement of its international fleet where fuel efficiency matters the most. Assuming it is able to return its PW-powered 777 fleets to service, United’s fleet of 787-9s and 10s which have industry average or lower total operating cost per seat, will be just 25% of its fleet. UAL will have one of the least fuel-efficient international fleets and there is very little financially that they can do to correct it given their already massive domestic financial fleet commitments.

Stock Performance and Investor Sentiment

U.S. airline industry stocks have generally moved fairly closely together during the pandemic. The collapse of airline equities early in the pandemic due to a fear of multiple bankruptcies led to a partial recovery when federal aid to the industry began to flow. UAL stock, as well as that of most of the industry, has flatlined during much of 2021 as investors have waited for industry recovery to reach the bottom line. UAL, like many airlines, was optimistic about an adjusted profit (excluding government aid) in the third quarter of 2021, but the demand reductions in the third quarter eliminated a profit for UAL excluding government aid. UAL stock remains in a similar position relative to the industry pre-Covid; its view by analysts is similar on a relative basis as well.

UAL Comp chart Source, Seeking Alpha

UAL Wall St. Rating and Price Target Source, Seeking Alpha

While I was optimistic early in the pandemic that UAL would be charting a path to continue its improving finances that began two years before Covid, I no longer believe that UAL will improve relative to the industry. I am concerned that their strategies are similar to strategies which AAL execs have been using for much of the past decade. I do not believe rapid growth, market share driven strategies will work post-Covid given that those strategies have not succeeded during the 40-plus years of domestic deregulation. Strategies that have worked are based on consistent, continual growth toward well-established goals. In addition, legacy airlines which have focused on volume and size have not worked compared to strategies focused on revenue maximization matched to cost control.

United has suffered from a lack of strategic consistency that stretches back decades. Their financial reports during the Covid pandemic are not set to improve their finances, but instead are inserting substantial risk into their future that will likely lead to reduced earnings in the mid-term and beyond.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. 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.