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Wall Street Is Not Excited About United Airlines’ Growth Plan

Updated on
  • Expanded seat supply ignites fears of another fare war
  • Shares tumble as investors show unhappiness with CEO’s plan
United Reports 4Q Profit Above Market Estimates

United Continental Holdings Inc.’s plan to grow its way to better profits received a rough reception from analysts and investors impatient for a quicker pay off.

The airline’s decision to accelerate an expansion of its network raised fears of another profit-bruising fare war and triggered a decline in shares Wednesday. The strategy is in stark contrast to efforts by rivals to grow more slowly, which would make it easier to raise ticket prices as supply balances with demand.

United’s blueprint, which includes 4 percent to 6 percent growth in seating capacity over the next three years, amounts to “snatching defeat from the jaws of victory,” according to Duane Pfennigwerth, an Evercore ISI analyst who cut his rating on the carrier to hold from buy Wednesday.

“While United’s belief appears as high as ever in the view that restoring domestic share in its hubs is the shortest path to margin expansion, the biggest missing ingredient from its presentation was any evidence that it is working,” Pfennigwerth said in a note.

The airline’s shares fell as much as 11 percent to $69.60 by 11:06 a.m. in New York, its worst intraday decline since October, the last time Chief Executive Officer Oscar Munoz discussed his strategy with Wall Street. Wednesday’s drop dragged down a Standard & Poor’s index of major U.S. airlines the most since June 2016, making the sector the worst performer in the S&P 500 Index by far.

CEO Reaction

United expected the share drop, Munoz said on CNBC Wednesday morning, calling it a “buying opportunity.” He also rejected the idea that United’s surge in seating capacity in the next three years would spark a fare war among airlines.

“Nothing we talked about yesterday talked about pricing,” Munoz said, referring to an investor presentation United made late Tuesday.

Given time, the accelerated expansion will boost the carrier’s market share at United’s major hubs in Chicago, Houston and Denver, United President Scott Kirby said at a presentation in New York. He and Munoz are doubling down on their strategy of adding flights and using bigger jets on some routes to win back customers and, eventually, increase profit.

Investors, wary of the potential for reviving a fare war if other carriers match the growth, signaled they aren’t willing to endure another year of weak earnings as United tries to catch up to rivals. A round of discounting in 2015 hammered unit revenue, an industry gauge of pricing power, for two years.

Short-Term Positive

“In near term, we believe unit revenue trends will remain encouraging and could be supportive of shares,” said Savanthi Syth, a Raymond James Financial Inc. analyst. “The planned elevated capacity growth in 2019/2020 will raise concerns about supply and destructive competitive response." That’s likely to relegate the sector back to a short-term trading category, even for investors focused on the long term, she said.

United’s growth planned for this year may be less damaging, as it will focus on Hawaii and smaller markets in the continental 48 states to be served by 50-seat jets, which is unlikely to trigger intense price competition, she said.

Some analysts were more optimistic. The 2018 growth plans “shouldn’t drastically alter pricing this year” following 2017’s 3.5 percent expansion, said Andrew Didora, a Merrill Lynch analyst, “especially with the potential for corporate demand to accelerate with tax reform.” He views a decline in the shares “as a particularly good buying opportunity.”

Uneven Recovery

Investors worry that United's growth plans will weigh on a key gauge of pricing power

Source: United data compiled by Bloomberg

Exchanges with analysts at United’s Tuesday meeting evoked an even testier standoff in October, when Munoz and Kirby failed to reassure investors that they would firm up pricing power and rein in costs. That time, United plunged 12 percent, the most in eight years.

Hub Expansion

United opened Tuesday’s late-afternoon presentation on an upbeat note, announcing fourth-quarter earnings of $1.40 a share, which beat the $1.34 average of analyst estimates compiled by Bloomberg. Revenue rose 4.3 percent to $9.44 billion, in line with expectations.

Under United’s plan, the extra seats over three years will come at United’s major airports in a bid to make them more competitive with the fortress hubs of American Airlines Group Inc. and Delta Air Lines Inc. While United benefits from lucrative international operations at its coastal redoubts in San Francisco and Newark, New Jersey, profit margins at its mid-continent hubs -- Chicago, Houston and Denver -- trail rivals by 10 percentage points, Kirby said.

Adding flights connecting big airports with smaller cities is “the magic elixir,” Kirby told analysts gathered in New York. More flights on those routes should enable United to tap markets that tend to have higher fares than service between hotly contested major markets.

“We spent years shrinking while our competitors were growing” Kirby said. “We’re not going to accept a 10-point margin gap.”

The challenge is in the short term. The capacity increase will cut gains in unit revenue, which is passenger revenue per available seat mile, by half a percentage point, United said.

CEO Reassurances

Munoz offered reassurance by challenging investors to hold him accountable to meet new long-term earnings targets. The carrier projected earnings of $6.50 to $8.50 a share this year, compared with the $7 average of analyst estimates compiled by Bloomberg. Profit will rise to $11 to $13 a share by 2020.

Brandon Oglenski, an analyst at Barclays Plc, asked how analysts could trust the projections, saying the profit gap with rivals “is going to widen for a second year in a row” despite robust economic growth.

“So where is the confidence that you can instill in your investor base that we can believe those 2020 targets are actually achievable from here with a strategy that seems for the next three years to be a repeat of what we’ve already seen?” he asked.

United is focused on curbing costs, Munoz said, and its growth and profitability goals are “important and doable.”

Said the CEO, “What we have in front of you is a pretty darn good plan.”

— With assistance by Justin Bachman

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