United Continental: Big Challenges Ahead, Despite Q3 Earnings Beat

By Markets Fool.com

On Monday afternoon, airline giant United Continental Holdings (NYSE: UAL) reported another strong quarterly profit. United's third-quarter adjusted pretax margin of 15.7% was down slightly from 16.6% a year earlier, but in line with the company's most recent guidance of 15.5% to 16.0%. Meanwhile, adjusted earnings per share came in slightly ahead of expectations at $3.11.

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United Airlines posted a solid profit for the third quarter. Image source: The Motley Fool.

However, United's profit slide is set to accelerate. Furthermore, its efforts to match rival Delta Air Lines' (NYSE: DAL) margin performance have run out of steam. The new United Airlines management team faces a monumental task to get profitability to an acceptable level.

Earnings growth slows, then stops

United Continental's profitability soared in 2015, thanks to falling fuel prices. Earnings growth slowed in the first half of 2016, though, and has now come to an end.

United continued to benefit from lower fuel prices in Q3, but that tailwind was more than offset by rising labor costs and continued unit-revenue declines. Passenger revenue per available seat mile (PRASM) slumped 5.8%, with the worst declines by far coming in the transatlantic market.

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If there was any positive to be gleaned from United's earnings report, it's that Delta's revenue performance was even worse. PRASM fell 6.8% year over year at Delta. As a result, United Airlines' pretax margin was just 2.5 percentage points behind that of Delta for Q3, compared to the gap of 5 percentage points or more that was typical a few years ago.

Steep profit declines ahead

On United's earnings call this week, executives noted that the company's unit revenue trajectory continues to improve. Unfortunately, the pace of improvement has been very slow. PRASM declined 7.4% in Q1, 6.6% in Q2, and 5.8% in Q3; it is expected to fall 4% to 6% in Q4.

Additionally, unit-cost growth will accelerate in Q4 as more new labor deals kick in. As a result, United's Q4 guidance fell well short of what analysts were expecting.

In fact, United Continental expects to post a Q4 adjusted pretax margin of just 5% to 7%. That would be down dramatically from the 10.4% adjusted pretax margin it achieved a year earlier. It's also about 8 percentage points below Delta's Q4 margin guidance.

Delta is poised to widen its margin advantage over United once again. Image source: The Motley Fool.

Even if you include the probable impact of Delta's tentative pilot contract, the projected margin gap for the coming quarter is just as severe as it was a few years ago. Furthermore, Delta executives seem to expect a much faster pace of unit-revenue improvement over the next few months, suggesting that United could fall even further behind in Q1 of 2017.

Big opportunities ahead -- but also significant headwinds

To be sure, United Airlines has some noteworthy opportunities to boost its unit revenue and hold down unit-cost growth going forward. On the cost side, the shift toward larger jets with denser configurations -- and away from costly 50-seat regional jets -- will offset rising fuel and labor costs.

As for revenue, executives discussed numerous positive factors during United's earnings call. These include tweaks to the revenue management system, changes in United's route network, the introduction of "basic economy" pricing and other market segmentation tools, and upgrades to its business-class offering. Route restrictions that will cap capacity growth in the U.S.-China market next year, and improving energy sector demand, will also help unit revenue.

Despite these upside opportunities, United's unit revenue performance isn't improving much so far. Some of these initiatives haven't been implemented yet, and will only start to take hold in 2017. But United also faces some very real headwinds that will dull the impact of its revenue initiatives.

For example, the FAA is lifting slot constraints at Newark Airport later this month. As a result, United will face a sharp increase in competition (especially from budget carriers) in one of its most lucrative hub markets. Budget-carrier competition has also continued to grow in transatlantic markets, leading to persistent fare weakness there.

In the long run, United Continental has a lot of potential to maintain or even grow its margins relative to the strong results it has posted in the past year. That's why I am sticking with my investment in United. However, investors do need to recognize the depth of challenges facing the company: Turning the business around won't be easy.

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Adam Levine-Weinberg owns shares of United Continental Holdings and is long January 2017 $40 calls on Delta Air Lines. 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.