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United Continental Makes Progress on Its Master Plan

A United Airlines plane on a runway

Earlier this year, United Continental (NYSE: UAL) caused consternation among investors after it revealed a three-year plan calling for aggressive growth . Whereas United and its peers have generally tried to limit their capacity growth to the rate of GDP growth in recent years, the carrier plans to increase capacity about 5% annually through 2020: approximately twice the expected GDP growth rate.

While ramping up growth to this extent is a risky strategy, it seemed to work out for United in the first quarter. The carrier posted solid unit revenue growth, while profitability came in ahead of expectations. Nevertheless, United Continental could face headwinds starting later this year as its growth rate accelerates and Southwest Airlines (NYSE: LUV) resumes its fleet expansion.

First-quarter results are better than feared

Last quarter, United Continental's revenue rose 7.2% year over year on a 3.6% capacity increase. Passenger revenue per available seat mile (PRASM) ticked up by 2.7%, while cargo and ancillary revenue surged by double digits.

Achieving a solid unit revenue performance like this was important, because United faced a $0.40/gallon increase in its average fuel price last quarter. This created a roughly 4 percentage point headwind to its pre-tax margin. On the bright side, adjusted non-fuel unit costs increased just 0.6% year over year.

A United Airlines plane on a runway

United Airlines produced solid unit revenue growth last quarter. Image source: United Airlines.

The net result was that United Continental's adjusted pre-tax margin slipped to 2% from 2.4% a year earlier. Excluding a roughly $50 million one-time revenue boost related to the MileagePlus loyalty program, United's pre-tax margin would have been around 1.4%. While this margin performance wasn't very impressive, it was still a lot better than the company's initial forecast for a roughly breakeven result.

More of the same expected in Q2

For the most part, United's second-quarter forecast implies a continuation of the trends seen last quarter. Capacity growth is set to accelerate modestly to a range of 4% to 5%, and United expects PRASM to rise 1% to 3% year over year. Meanwhile, on the expense side, fuel costs will surge again, but non-fuel unit costs are on track to increase just slightly.

These projections imply that United Continental will achieve a pre-tax margin of 9% to 11% in the seasonally strong second quarter, down from 13.2% a year earlier. The main reason there will be more margin erosion this quarter than in the first quarter is that the year-over-year fuel cost headwind will be greater.

This forecast is better than some investors had feared. Furthermore, United improved its full-year earnings per share guidance range from $6.50-$8.50 to $7.00-$8.50. This helped United Continental stock rise 5% on Wednesday .

It's too early to declare victory

United Continental's first-quarter results and second-quarter forecast were fairly encouraging in light of the sharp fuel cost headwinds the carrier is facing. While United is still suffering from pre-tax margin contraction, it remains solidly profitable. Furthermore, it is performing well on the metrics it can control: unit revenue and non-fuel unit costs.

Nevertheless, it is too early to declare United's strategy a success. First, United and other airlines have been benefiting since last fall from fleet constraints at Southwest Airlines. Last September, Southwest retired dozens of older jets before replacements were available. It has tried to compensate by scheduling more flights for before 6 a.m. or late in the evening, but most travelers have shunned these extra flights.

Thus, rivals like United have had opportunities to steal market share from Southwest Airlines recently. By the fall, Southwest's fleet will be back up to full strength, allowing it to compete more effectively.

Second, Southwest Airlines plans to start flying to Hawaii later this year, or in early 2019. That could put pressure on unit revenue in this key market.

Third, United's capacity growth will accelerate further in the second half of the year, with much of this extra capacity coming during off-peak periods. This could cause unit revenue to take a turn for the worse. (On the bright side, United will benefit from extremely easy year-over-year comparisons in the third quarter, which could boost its unit revenue growth then.)

On balance, United's first-quarter earnings report and second-quarter guidance were good news for investors. However, the company still has a lot to prove in order for shareholders to rest easy.

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

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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