Will New Management Drive Unit Revenue Growth at United Airlines?

By Markets Fool.com

In the past few months, United Continental (NYSE: UAL) CEO Oscar Munoz has added three new top executives to fill out his management team. The biggest coup of all was poaching Scott Kirby from American Airlines (NASDAQ: AAL) to serve as United's president, a role with broad responsibilities across sales, planning, and operations.

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For the most part, Wall Street analysts were upbeat about Kirby's hiring. Deutsche Bank analyst Mike Linenberg recently described Kirby as a "kid in a candy store" as he tackles the task of improving United's unit revenue performance. However, while Kirby will undoubtedly make his mark on United, he faces a tougher task than in previous network restructurings he has led.

A lofty reputation

Scott Kirby and American Airlines CEO Doug Parker made their names more than a decade ago, when they led America West's takeover of larger rival US Airways.

In Q1 2006, shortly after the merger was finalized, unit revenue surged an astounding 28% year over year on legacy US Airways routes. This surprisingly strong performance allowed US Airways (then operating under bankruptcy protection) to report a quarterly profit, compared to a steep loss the year before.

Unit revenue soared as Scott Kirby remade US Airways' route network a decade ago. Image source: The Motley Fool.

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While Parker and Kirby won a lot of admirers with this performance, the strategy was simple. Since US Airways was going through bankruptcy, it had the ability to reject unfavorable contracts and smoothly downsize its network. The company cut its worst-performing routes, including a sharp downsizing in Pittsburgh, once a massive US Airways hub.

In subsequent years, Parker and Kirby further refined their strategy by cutting nearly every route US Airways served that didn't touch one of four key hubs: Charlotte, Philadelphia, Phoenix, and Washington-Reagan. This put US Airways in a strong enough position by 2013 that it was able to merge with American Airlines, creating the largest airline in the world.

There's no magic wand

American Airlines' performance over the past few years shows that while Scott Kirby is good at revenue management, he doesn't have a magic wand. In 2014, the first year after the American-US Airways merger closed, American's passenger revenue per available seat mile (PRASM) increased 2.2% year over year. That was only slightly better than United Airlines' 1.6% PRASM increase.

Last year, American actually underperformed United on the unit revenue front. PRASM fell 5.4% at American Airlines for the full year, compared to a 4.4% decline for United.

The subpar performance was largely caused by factors outside management's control, such as Southwest Airlines' rapid growth in Dallas (American Airlines' largest market). But it's also true that there was less low-hanging fruit. American had already cut most of the fat in its route network, defending just its key hub markets.

Looking at the options

Due to changing demand patterns, airlines almost always have some underperforming routes that probably need to be dropped. But to get United Airlines into the upper echelon of the industry in terms of profitability, the management team will need to make bigger changes.

There aren't many obvious targets for the kind of downsizing Scott Kirby led at US Airways a decade ago. United has seven hubs: Chicago, Denver, Houston, Los Angeles, New York, San Francisco, and Washington, D.C. They serve six of the 10 biggest regional economies in the U.S. (The lone exception is Denver, a city posting phenomenal economic growth.) Furthermore, United is the No. 1 carrier in five of its hub markets, and in and LA and DC, it is No. 2.

United Airlines doesn't have many weak points in its route network today. Image source: The Motley Fool.

It would be hard to justify United shrinking its footprint in the five markets where it is the top carrier. The main decision facing Kirby and the rest of United's management is whether to downsize or eliminate the smaller hubs in Los Angeles and Washington, D.C.

Obviously, those are both important markets for business travelers. On the other hand, they don't have clear strategic value within United's current route network. Instead, they siphon traffic away from United's stronger hubs in San Francisco and New York.

Thus, Scott Kirby and the rest of United's management team need to make tough choices about whether it's still worthwhile to maintain hubs in Los Angeles and Washington, D.C. United has scheduled an investor day conference for mid-November, and investors will likely learn a lot more about the company's future network strategy then.

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Adam Levine-Weinberg owns shares of United Continental Holdings and is long January 2017 $30 calls on American Airlines Group. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.