Investors have known for a while that United Continental (NYSE: UAL) was working on some kind of "basic economy" fare to use as a weapon for competing against budget carriers like Spirit Airlines (NASDAQ: SAVE). However, the company was tight-lipped about the details.
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Legacy carriers like United face rising competition from Spirit Airlines. Image source: Spirit Airlines.
Last week, United Airlines finally explained how its basic economy fares will work. Customers who buy basic economy tickets will miss out on a lot of the features that were considered untouchable just a few years ago. This is already leading to outrage among consumer advocates.
However, United's basic economy fares are not as consumer-unfriendly as they may seem. And they will help the company bolster its profitability in the face of significant earnings headwinds.
Price competition is impacting profitability
Since the middle of 2014, domestic airfares have fallen steeply. Part of that reflects the rapid growth of Spirit Airlines and other ultra-low cost carriers. Falling oil prices also encouraged larger airlines to expand capacity more than they otherwise would have.
Indeed, in Q2 2016, the average domestic airfare across all carriers was down 11% compared to Q2 2014, or down 12% adjusting for inflation. During 2015, airlines were able to earn record profits in spite of this price-cutting, thanks to their fuel cost savings.
However, oil prices have started to rebound. Furthermore, airlines are facing steep labor cost inflation, as unions have bargained for higher pay in light of airlines' record profitability. Yet airfares are still declining. This is starting to put pressure on profit margins. For example, United expects its Q4 pre-tax margin to plunge to 5% to 7% from 10.4% a year ago.
New rules for the cheapest fares
When United Airlines implements basic economy in early 2017, its cheapest fares will come with new rules attached. Most notably, customers who buy basic economy tickets will only be allowed to carry on a small personal item that fits under the seat in front of them. Larger bags that would need to go in the overhead bin won't be permitted.
Going forward, United's cheapest fares won't come with a free carry-on. Image source: The Motley Fool.
Basic economy fares won't include advance seat selection, either, meaning that purchasers will almost always get stuck in a middle seat. Basic economy ticket holders will also be assigned to the last boarding group. Lastly, flight changes and upgrades will not be permitted.
Elite-level frequent fliers and cardholders for United's co-branded credit card will be able to avoid most of these restrictions when booking basic economy fares. Everyone else will have to pay extra for a regular economy fare if they want to choose a seat in advance, bring a large carry-on bag, or have the flexibility to change their plans.
Basic economy makes price-matching sustainable
It's virtually inevitable that a lot of customers will complain at first when United Airlines rolls out these changes. From a customer's perspective, United is taking away things that used to be "free" and forcing them to pay a higher standard economy fare to get them back.
This is true to some extent. Right now, United and its peers are matching the bargain fares offered by Spirit Airlines and other budget airlines in order to avoid losing customers. But while United is matching Spirit's fares, it is still including things like free carry-on bags and seat assignments that cost extra on Spirit Airlines.
This isn't sustainable. United's unit costs (on a stage-length adjusted basis) are more than double those of Spirit Airlines, according to both the MIT Airline Data Project and Spirit Airlines. No wonder its profitability is slipping! In order to continue matching Spirit's prices, United needs to get something in return from customers who opt for the cheapest fares.
United can't afford to offer lots of free amenities for the same price as Spirit. Image source: The Motley Fool.
By cutting down on carry-on bags, United Airlines will reduce the likelihood of running out of bin space. For many flights, this will allow United to avoid gate-checking bags, which requires extra labor. Gate-checking bags also slows down the departure process, hurting employee productivity and aircraft utilization. All of this adds up to a big cost-saving opportunity.
Similarly, disallowing seat assignments for basic economy tickets makes it more likely that there will be good seats available for customers who buy pricey full-fare tickets close to the day of travel. Today, customers who book at the last minute often get stuck in worse seats than people who paid dramatically less for their tickets.
Basic economy isn't all bad
Basic economy fares will bolster United's profitability in the face of rising costs and growing low-fare competition. Customers who opt for standard economy tickets will pay a bit more, while those who buy basic economy fares will save the company some money by not bringing large carry-on bags that slow the boarding process.
Meanwhile, travelers will benefit from lower fares than would otherwise be available. The concept of basic economy may seem customer-unfriendly relative to what exists today. However, customers will get more amenities and more legroom than they would get from Spirit Airlines, while paying the same price. That's not such a raw deal, after all.
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Adam Levine-Weinberg owns shares of Spirit Airlines and United Continental Holdings and is long December 2016 $30 calls on Spirit Airlines. The Motley Fool recommends Spirit Airlines. 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.