United Airlines Launches an Aggressive Domestic Expansion

By Adam Levine-Weinberg Markets Fool.com

United Continental (NYSE: UAL) is finally tired of surrendering market share to Delta Air Lines (NYSE: DAL), American Airlines (NASDAQ: AAL), and a host of smaller rivals. Under its new management team, United plans to fight back by growing and restructuring its domestic route network to enable more connecting opportunities for customers.

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It's important for United Airlines to catch up with Delta and American in the domestic market. That said, United's attempts to gain market share will not go unchallenged. As a result, this strategy shift isn't likely to reverse the recent declines in United's profitability.

The importance of connecting traffic

United Airlines has hubs in the five largest U.S. air travel markets: New York, Los Angeles, San Francisco, Chicago, and Washington, D.C. Yet United revealed at its investor day last fall that the carrier's Denver hub is actually its most profitable.

United's biggest hub markets aren't the most profitable in its network. Image source: United Airlines.

This highlights the importance of connecting traffic for a hub-and-spoke airline like United. It's true that for travelers flying between major cities, carriers offering nonstop service can charge higher fares. But some of the most profitable customers are those connecting at a hub to travel to or from a small city. That's because most small cities lack low-cost carrier service. American, Delta, and United are often the only options.

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There are three key aspects to running a successful connecting hub. First, you need to offer lots of flights to numerous destinations. Second, you need a "banked" schedule with tightly spaced waves of flights, in order to minimize connection times. Third, you need to have low airport costs.

Airport costs are largely out of an airline's control, at least once it has selected its hubs. However, United is working hard to fix what it can control.

New routes and better connections

United Airlines will build up its hubs by adding dozens of new flights starting this summer. This includes adding four more small cities to its route network: Champaign/Urbana, Illinois; Columbia, Missouri; Rochester, Minnesota; and Santa Rosa, California. United will also begin summer service on six domestic routes and offer more frequent flights on 15 other routes.

It will implement these flight additions while keeping its overall capacity growth modest. In the domestic market, United plans to increase capacity 1.5%-2.5% year over year in 2017.

Meanwhile, United Airlines is "rebanking" its flight schedules, particularly at its Newark and Chicago hubs. This will allow it to compete more effectively with American Airlines' hubs in Philadelphia and Chicago, respectively.

Regaining share won't be easy

Bulking up its domestic route network is essential to United's long-term competitiveness. But Delta Air Lines and American Airlines -- not to mention other competitors like Southwest Airlines -- aren't likely to let United Airlines reclaim its "fair share" of the domestic market without putting up a fight.

For example, United plans to add capacity in Atlanta and Detroit, two markets where Delta has absolutely dominant hubs. This could provoke a fare war. Similarly, United is starting service from Chicago to several markets where American Airlines currently has a monopoly. The two carriers have been in a long-running competitive battle in Chicago, so American is likely to respond in some way to United's growth there.

Thus, United may face severe fare competition in some markets as it tries to elbow its way into other airlines' territory. This could cause some short-term margin compression, which is unfortunate because United's profit margin is already under pressure. For Q1, it expects to report an adjusted pre-tax margin of just 0.5%-2.5%, down from 8.4% a year ago.

Additionally, rebanking flights will push unit costs somewhat higher. United will need more staff at its hubs to cope with higher peaks of activity.

Investors appear to be excited about the aggressive approach of United's new management team. United shares have roughly doubled since bottoming out in late June. However, it could take years for the company's new strategy to pay off -- assuming it succeeds. Turning around United Continental's domestic performance may be a lot tougher than investors currently expect.

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Adam Levine-Weinberg owns shares of Delta Air Lines. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.