United Airlines Doubles Down on Its Dubious Growth Strategy

MarketsMotley Fool

Over the past decade, U.S. legacy carriers United Continental (NYSE: UAL), Delta Air Lines (NYSE: DAL), and American Airlines (NASDAQ: AAL) have gone from being perennial money losers to reliable profit machines. A shared commitment to keeping capacity in check was critical to the industry's renaissance.

However, under its new management team, United Continental has thrown that playbook out the window. After boosting capacity 3.5% in 2017 -- well ahead of GDP growth -- United plans to grow even faster over the next three years. This growth plan is already causing United's pre-tax margin to deteriorate. In the long run, the damage could be even worse if United's aggressive growth in smaller cities triggers a fare war with American and Delta.

Continue Reading Below

The crux of United's strategy

The core insights behind United Continental's growth strategy are relatively straightforward. The profitability of a hub-and-spoke airline depends significantly on how many connecting itinerary options it can provide. This means that having large hubs -- and building efficient schedules to maximize the number of available connections -- is critical to success.

Delta Air Lines' massive hub in Atlanta is the ideal example of how a hub should work. Delta operates roughly 1,000 peak-day departures there, serving more than 200 destinations. No matter where you need to go, there's a good chance you can get there with a connection through Atlanta.

United Airlines' mid-continent hubs in Chicago, Denver, and Houston are undersized, by comparison. United operates just 545 daily departures in Chicago, its largest hub.

United's growth strategy calls for adding flights at all three mid-continent hubs -- and to a lesser extent, at its coastal hubs. The focus will be on flying to more small cities, where fares tend to be higher due to minimal competition from budget carriers. However, this plan is far riskier than United Continental's management is willing to admit.

Will pilots bail out management?

The first major risk is that United Continental will be stuck operating its new small-city routes with 50-seat jets indefinitely. Whereas Delta and American have scaled back their use of these planes in recent years, United plans to increase its fleet of small regional aircraft by 31 planes during 2018.

United Continental's leadership recognizes that relying on 50-seat jets is unsustainable. They have higher unit costs than 76-seat regional jets, and customers hate flying on them. However, United's pilot contract limits its use of the vastly more profitable 76-seat jets.

United Continental President Scott Kirby seems to be awfully confident that the pilots will agree to relax this "scope clause" in upcoming contract negotiations without demanding much in return. That would be unprecedented. United's existing pilot deal allows the carrier to add 70 more large regional jets to its fleet if it simultaneously adds 88 100-120 seat planes to be flown by mainline pilots. (This mirrors a deal struck by Delta's pilots a while back.)

As long as Kirby sticks by his insistence that United Airlines can't operate these smaller mainline planes economically, the pilots aren't likely to let the carrier add more large regional jets. This could leave United at a permanent disadvantage in its new small-city markets.

Will Delta and American let United catch up?

Just looking at coastal international gateway hubs, United Continental has a higher profit margin than either of its rivals. Its margin disadvantage stems solely from its mid-continent connecting hubs being less efficient, according to management.

Unfortunately, catching up won't be nearly as straightforward as management has implied. First, United's hubs will never be as dominant as those of American and Delta. In Chicago -- United's No. 1 hub in terms of daily departures -- the carrier competes directly with a sizable American Airlines hub. In Houston, United operates an average of 482 daily departures, competing with American's nearby Dallas-Fort Worth hub, which has 762 daily departures.

United's only regionally dominant hub is in Denver. But with 375 daily departures, it doesn't come close to the scale of the largest American Airlines and Delta Air Lines hubs.

Second, United Continental's plan assumes that American Airlines and Delta Air Lines will cut capacity in markets where United is growing. Otherwise, the big uptick in capacity from United's arrival would cause fares to plunge.

However, given that this is a zero-sum game -- United has been forthright that it hopes to regain market share from its competitors -- it would be more logical for Delta and American to maintain, or even increase, their capacity in small cities. This would allow them to either protect unit revenue (by offering more frequent flights), or reduce unit costs (by using larger planes).

2018 is just the start

During 2018, much of United Continental's capacity growth will come on international routes and flights to Hawaii. This should reduce the risk of a domestic market-share battle with Delta Air Lines and American Airlines.

However, if United goes ahead with its growth plans for 2019 and 2020, its rivals are likely to respond in kind. That could lead to further margin contraction for all three legacy carriers. But United Continental is starting with the lowest profit margin, so it would be the worst-off of the bunch.

10 stocks we like better than United Continental HoldingsWhen 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 10 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 January 2, 2018

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.