How United Airlines Plans to Boost Earnings by $4.8 Billion

By Markets Fool.com

For the past five years, airline giant United Continental (NYSE: UAL) has consistently trailed its peers in terms of profitability, especially Delta Air Lines (NYSE: DAL). As a result, while both stocks have crushed the market over the past five years, Delta shares have nearly doubled United's in terms of total return.

Continue Reading Below

United Continental vs. Delta Air Lines Total Return Price, data by YCharts.

On Tuesday, United Continental's new management team laid out an ambitious plan to boost the company's earnings power by $4.8 billion by 2020, relative to 2015. This would allow it to overtake Delta in terms of profit margin. Let's take a look at the key pillars of this profit growth plan and whether it is realistic.

Squeezing out more revenue

United's management team sees the company's margin gap relative to Delta as mainly a revenue problem. To fix this, it will focus on three main areas over the next few years.

Continue Reading Below

First, United Airlines is following the industry trend toward greater segmentation. In other words, it wants to find new ways to offer low fares for the most price-sensitive travelers while charging more to customers who want all of the amenities of a full-service airline like United. It sees this as a $1 billion revenue opportunity between now and 2020.

The key to this strategy is a new basic economy fare that United will roll out in early 2017. Going forward, customers who buy the cheapest tickets won't be able to choose seats in advance or bring carry-on bags that would need to go in the overhead bin. United is also evaluating following Delta and American Airlines by putting premium economy seats on long-haul flights.

United Airlines will roll out basic economy fares next year. Image source: The Motley Fool.

Second, United Airlines is working to improve its revenue management system. While the details are complex, the company's automated system is no longer optimized to maximize the revenue produced by each seat. Fixing these problems could boost unit revenue by 2-4 percentage points, adding $900 million to United's top and bottom lines by 2020.

Third, United plans to boost the performance of several key hubs, primarily by implementing "banked" schedules that facilitate more connections. That should help the carrier to get its fair share of domestic revenue relative to Delta Air Lines and American Airlines. This initiative could add $600 million in incremental revenue by 2020.

Holding down costs

United's management also thinks there's plenty of room to reduce costs. The company expects roughly $1 billion of earnings improvement from improving its operational reliability, increasing asset utilization, and implementing new cost-saving technology.

Additionally, United Continental plans to continue its efforts to squeeze more seats onto each plane and to fly larger planes in the coming years. Both initiatives will tend to reduce unit costs. This could generate $1 billion in incremental revenue by 2020 (relative to 2015), including the impact of increasing the proportion of premium seats.

Actual earnings growth will be less than advertised

While United's management has highlighted a $4.8 billion profit growth opportunity, its actual pre-tax improvement is likely to be much smaller. For one thing, United is using 2015 as a baseline. Using this year as a baseline instead, the remaining opportunity would be $3.9 billion.

Furthermore, the airline industry probably reached peak profitability over the past year. In the next few years, legacy carriers like United and Delta will face stepped-up competition from ultra-low cost carriers, in both the domestic and transatlantic markets. Meanwhile, rising fuel prices and labor cost increases will drive unit costs higher.

United and Delta will both have to combat rising budget carrier competition. Image source: The Motley Fool.

United has already projected that its Q4 pre-tax margin will be just 5%-7%, down from 10.4% a year ago. And analysts expect earnings per share to plunge nearly 25% in 2017, despite United's projection that it will accrue another $900 million of incremental profit from its various earnings initiatives next year.

United Continental may return to earnings growth later in the decade as these initiatives gain traction and cost headwinds abate. But its pre-tax earnings growth relative to the past 12 months will likely be a small fraction of the $4.8 billion number it is throwing around.

Can United really catch Delta?

I am also skeptical that United will be able to overtake Delta Air Lines in terms of profitability by 2020.

United's management contends that more than 60% of the earnings improvement opportunity it has identified is unique to United Airlines. However, it is probably underestimating the earnings levers available to Delta (or perhaps overestimating its own opportunities).

For example, United estimated that half of its $1 billion fleet-related opportunity is unique to the company. Yet Delta has about 200 mainline planes scheduled for delivery between now and 2020: far more than United. While United has more room for improvement on the regional side of the business, its net advantage is probably a lot smaller than $500 million.

Additionally, Delta may benefit from having its top hubs in somewhat smaller metro areas where it is truly dominant. As ultra-low cost carriers expand in the coming years, they are likely to start with the biggest markets. This means that they would cannibalize United's business faster than Delta's.

For all its flaws, United's profit improvement plan should at least help it narrow the profitability gap with Delta over time. With United's market cap being 40% below that of Delta right now, this may be enough to drive the stock higher.

10 stocks we like better than United Continental Holdings
When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

David and Tom just revealed what they believe are the ten best stocks for investors to buy right now... and United Continental Holdings wasn't one of them! That's right -- they think these 10 stocks are even better buys.

Click here to learn about these picks!

*Stock Advisor returns as of November 7, 2016

Adam Levine-Weinberg owns shares of United Continental Holdings. Adam Levine-Weinberg has the following options: 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.