United Continental Holdings Inc. (NYSE:UAL) has a rollercoaster history in the airline industry. The company went from being a pioneer airline in 1933, to filing for bankruptcy in 2002 because of its bloated cost structure. And although removing the massively underfunded pension plan helped alleviate the cost scenario, it was mainly the Continental merger in 2010 that restored this airline to its position as the largest player in the domestic market, surpassing Delta Air Lines Inc. (NYSE:DAL), Republic Airways Holdings Inc. (NASDAQ:RJET) and JetBlue Airways Corporation (NASDAQ:JBLU). Since investment gurus Ken Heebner (Trades, Portfolio), George Soros (Trades, Portfolio), and Jim Simons (Trades, Portfolio) recently bought this company’s shares, I’m curious as to what the future holds for United.
A Global Portfolio in a Tough Industry
Its vast offering of 5,400 daily flights to over 360 international and domestic destinations, and its position as founding father of the Star Alliance, which offer another 22,000 daily flights through its member airlines, have consolidated United as the U.S. airline industry leader. The luxury premiums of additional leg room, early boarding privileges and lie-flat beds attract a large group of high-end customers in the first-class and economy-plus segment, which accounts for 30% of total capacity. Thus, the company managed to reel in $38.3 billion in fiscal 2013, and the once large cost structure decreased by 5%, thanks to the merger with Continental. While the acquisition caused some integration issues during 2012, including a temporary shutdown of the reservation system which caused a decline in customer satisfaction scores, 2013 was a much better year for the airline, earning it top-tier status amongst its peers in quarter four.
Despite the structural challenges of the airline industry, with its minimal barriers to entry and 10% decline in capacity since 2008, United is focused on its future and regaining its financial balance sheet’s strength. Thus, 2014 will be characterized by investments in the product, with new aircraft and the remodelling of terminals set to boost the company’s ancillary revenue opportunities. Management hopes for 2013’s $2.8 billion in ancillary revenue to grow 8% during the fiscal year, and jump even further to $3.5 billion come 2017, which should help achieve returns on invested capital above its cost of capital. Furthermore, while the high oil prices and restrictive credit markets that currently protect the industry from overexpansion and an overload of new start-ups isn’t permanent, it should provide United with an advantage long enough to regain its profitability.
A Solid Recovery
While capacity decreased by 1.5% in 2013, due to the overall industry decline, this year's is projecting a 2% increase, in addition to a 2.4% rise in average prices. Moreover, operating margins expanded in quarter four of fiscal 2013 to 4.3%, closing at 3.3% for the overall year and posing a strong recovery in comparison to 2012’s weak 0.10%. Looking forward, this metric is expected to hit a peak 7.3%, before settling at 4.8% by 2017. Revenue, on the other hand, grew 7.2% versus the same period last year, with passenger volume and price boosts of 2.7% and 3%, respectively. And while fuel costs, as well as industry competition, still present the main risk factors for United’s profitability, the upward metric trend is expected to continue in the long term.
Returns on invested capital have also jumped to 6.9%, sporting a 6.7% year-over-year increase. Furthermore, the company’s latest success is evident in its stock price, which experienced a significant boost from 2012’s $19.45 to a current $46.7. Despite the stock's trading price premium of 212% relative to the industry average of 10.5x, I believe investors would be wise to turn to this company once the price has settled down, since long-term results are looking solid.
Disclosure: Patricio Kehoe holds no position in any stocks mentioned.