BA - Positive Developments Drive United Airlines Rating Upgrade

2024-01-03 09:15:00 ET

Summary

• The big 3 U.S. global airlines (American Airlines Group Inc., Delta Air Lines, Inc., United Airlines Holdings, Inc.) saw strong gains in 2023 due to cost-cutting measures during the pandemic.
• The low-cost end of the sector struggled, with some airlines losing money even during the peak summer period.
• United's growth plans for 2024 may be impacted by aircraft delivery delays and a need to align with industry conditions.

The year 2023 was a pretty good one for the airline industry, as global travel demand returned almost a year after post-pandemic U.S. domestic travel came roaring back. Most of the sector had healthy earnings, with the big 3 U.S. global airlines - American Airlines Group Inc. ( AAL ), Delta Air Lines, Inc. ( DAL ), and United Airlines Holdings, Inc. ( UAL ) - seeing the strongest gains in part because they had managed to cut costs during the pandemic and were able to drop large portions of their international revenue to their bottom lines. The lower-cost end of the sector struggled, with several names in that space losing money even in the peak summer period. Large wage increases sent labor costs soaring - initiated by Delta first for its pilots and later matched by all of the big 4 - including Southwest Airlines Co. ( LUV ); Delta expanded its pay raises to the rest of its largely non-union workforce early in 2023, while other more unionized airlines are still working through settling labor contracts with its non-pilot personnel.

United took a unique approach to managing through the pandemic by expecting demand to return very quickly, leading it to not retire aircraft as several carriers did and keeping its staff ready to return to increased demand when it returned. Since United has the largest international network among U.S. airlines and, relatively speaking, one of the smallest domestic route systems, United's break came in the summer of 2022 when transatlantic demand came roaring back with a vengeance and trans-Pacific demand - except for to China - began to strongly return. In reality, though, UAL's profit advantage over its competitors AAL and DAL - lasted for just one quarter, the 3rd quarter of 2022. The arrival of the 4th quarter led to a slowing of traffic, and by the peak summer 2023 travel period, American and Delta, as well as many foreign carriers, were prepared to capture international demand on top of a still strong domestic market.

Stocks of the big 3 were strong in the first half of 2023, with 50% runups not uncommon. By the summer, fears of softening demand ramped up due to fears of the impact of higher interest rates and higher fuel prices on consumer budgets. In reality, the domestic weakness was felt almost entirely by the low-cost and ultra-low-cost sectors of the airline industry. The big 3 noted that they were seeing a much longer peak international travel season, which helped to buoy their financial results in the 3rd quarter and is expected to help the 4th quarter as well as carry into the 1st quarter of 2024.

Other than rising fuel prices, the big 3 airlines seemed in a good position - but then cracks started to appear. AAL and UAL particularly saw large summer drops in their stock prices, and they regained little of what was lost in the remainder of the year. UAL ended the year up just 8.8%, below the DJIA (DJI), S&P 500 (SP500), and NASDAQ (COMP.IND). AAL came in just under UAL's year-to-date performance. Just two airlines - DAL and SkyWest ( SKYW ) - beat at least one of those indices, with DAL beating the DJIA with its 22.9% improvement. SKYW's eye-popping 227% jump beat all indices and most of the market due to that regional airline's ability to restart many of its routes for larger network airlines and restore its revenue.

So, what happened to United despite the strong runup in the first half of the year and the promise of strong growth for years to come? During the pandemic, United's CEO laid out United NEXT , a plan to aggressively grow the airline which cemented orders for over 500 narrowbody (single aisle, largely domestic) aircraft and 200 widebody international aircraft, mostly for the Boeing ( BA ) 787. UAL CEO Scott Kirby's plan was to aggressively grow in both the domestic arena by replacing regional aircraft - including the largest fleet of 50-seat regional jets (the least economical versions) in the world. UAL has traditionally had a strong market share in its hubs but underperformed share in most non-hub cities where AAL, DAL and LUV carry most passengers. Kirby also planned to continue aggressively growing its international route system where it - at least by capacity - overtook Delta across the Atlantic where the Atlanta-based carrier had long been the largest U.S. carrier.

In the 3rd quarter , Delta still managed to generate more revenue to Europe and Africa, the two regions plus Israel that both carriers jointly serve across the Atlantic, while United's larger revenue came from its service to the Arab Middle East and India, regions which Delta does not currently serve. Fourth quarter data has yet to be released, but it is likely that UAL will see a significant reduction in its revenues due to the war in Israel and Gaza that required all U.S. airlines to end service. UAL previously said that 2% of its system capacity was to/from Israel but they held out hope to be able to restore some of that capacity.

Some foreign airlines are slated to restart Israel service early in 2024, but no U.S. airlines have made that move. United moved quickly to redeploy some of its capacity from Israel to start new Pacific routes including Los Angeles to Hong Kong and San Francisco to Manila but it is doubtful those routes will mature sufficiently in the 4th quarter. United also added capacity to Australia but some of those routes did not do well; it is pulling its Los Angeles to Brisbane route early.

United's 3rd quarter 2023 earnings call provided interesting insights into 2024 including this statement

Capacity planning for 2024 will be even more important to achieve our financial goals. While we're not going to provide guidance for 2024 today, we have plans to let the 30% growth we've added to the Atlantic since 2019 mature in 2024 and expect to fly at similar level of capacity in '24 as '23. We also plan on little to no growth for the first half of next year on domestic flying. This preview of our 2024 capacity, I think, will allow United to continue to produce top-tier results as we align with industry conditions. - Andrew Nocella, UAL EVP and Chief Commercial Officer, UAL 3rd quarter 2023 earnings call .

Let's unpack this statement and determine the investor implications.

First, no other airline has provided 2024 capacity guidance; airlines are very careful about giving data in advance because it allows analysts to model finances which has implications for the stock price. United's comments could be construed to be an indication to competitors of their intentions before the normal schedule.

More significantly, United has committed to one of the most aggressive growth plans among U.S. airlines with its massive fleet orders. Delta and United grew at similar rates for much of 2023, and UAL execs have noted that DAL and UAL are driving nearly all of the industry's profit growth - which is rooted in their capacity growth. But did United just decide that its growth for 2023 was no longer necessary in 2024, or were there other factors?

Aircraft Delivery Delays

In its 2022 10K , based on December 31, 2022, in 2023, UAL expected to receive 149 new aircraft, including over 130 Boeing 737 MAX aircraft as well as one dozen Airbus A321NEOs. United is one of the few U.S. airlines that updates their fleet plan each quarter, allowing investors to see the current fleet as well as planned changes. By the time they filed their investor update less than 3 weeks later with their 4th quarter 2022 earnings, United ratcheted down their new aircraft deliveries. Using fleet tracking sites such as www.airfleets.net , it is possible to determine fleet activity on a near continual basis and before airlines make public statements.

Based on fleet activity as of January 1, 2024, it was clear that United's original fleet for 2023 fell short by dozens of aircraft. Differing numbers of aircraft on different financial documents create some confusion, but UAL appears to have received somewhere around five dozen fewer aircraft in 2023 than it planned, with most of the undelivered aircraft being MAXs. It isn't a surprise that Boeing continued to face delays in delivering its aircraft in 2023. In addition, United is one of the key customers for Boeing's 737 MAX 10, the largest version of the MAX family and the largest single aisle product in Boeing's lineup.

However, the MAX 10, like the MAX 7, the smallest version of the same family, has not been certified as a result of the aftermath of the crashes involving two foreign-operated MAX jets in 2018 and 2019 and the resulting review of the certification process for Boeing jets. At the time of the second MAX crash, the first MAX 7 had already been built and was waiting for certification while the MAX 10 was in production. Boeing has revised certification dates multiple times, but now expects the MAX 7 to be certified early in 2024 with the MAX 10 to follow later this year. Southwest, the largest customer for the MAX 7, will receive dozens of MAX 7 aircraft that have been built but cannot be delivered until after Boeing is able to make necessary modifications and pre-service checks.

Based on its latest update, Southwest expects to receive its first MAX 7s in the next few months but is not scheduling them for flights until late in 2024. Southwest converted many of its MAX 7 orders to the larger and already-approved MAX 8 and has been taking those aircraft during the now five-year-long delay. However, because the entry into service date has changed multiple times, Southwest has not been able to replace every delayed aircraft with the larger variant, resulting in slowed aircraft deliveries and reduced growth.

United now faces a similar situation with the MAX 10. While Boeing updates its intentions to deliver aircraft on a regular basis, it has to notify and negotiate new deliveries with each customer. It is likely that United's 737MAX delivery schedule for the next 3 years or more will be reduced compared to the detail that United provided in its most recent 10K. However, UAL only provides aircraft model details by year for the upcoming two years.

UAL will update its final fleet with its next 10K in about six weeks - not all aircraft are picked up by fleet tracking sites since an accelerated number of aircraft deliveries happen at the end of the year and airlines place new aircraft in induction procedures which could take several weeks. United also had planned to receive its first A321NEOs, but its relatively small order for 12 aircraft in 2023 was cut to as low as 3 aircraft. United specified the Pratt and Whitney Geared Turbofan to power its A321NEOs, and that engine has been hit by the RTX unit's massive inspection and parts replacement program. While Pratt has resolved the problem on new deliveries, it has had to divert parts resources for repair and replacement efforts. Other suppliers in the aircraft supply chair are pressuring both Airbus (EADSF) and Boeing's plans to accelerate production in light of the huge demand for new aircraft from airlines around the world.

While U.S. airlines typically do not announce aircraft retirements and have the flexibility to delay or accelerate the retirement of specific aircraft, it became apparent that United offset its delayed deliveries by keeping some older aircraft in service longer, a strategy that Southwest has used repeatedly for the past several years. Since airline schedules peak at certain periods of the year, airlines can use certain aircraft during certain less-peak periods of the year and then increase their usage during peak periods to prolong the aircraft's life without reaching thresholds for major overhauls. Even when United begins to receive MAX deliveries close to its original projections, its fleet plan will be altered when it has to accelerate aircraft retirements. United's fleet has the oldest average age among U.S. airlines so it will have to retire scores of aircraft each year. Early data indicates that United probably retired less than 15 aircraft in 2023. But United's fleet isn't the only reason it will slow its growth.

UAL targets capacity stability

The United executive's statement also indicates that United sees the need to slow capacity growth in some markets. It particularly noted that it will add minimal capacity across the Atlantic in 2024, indicating that it cannot sustain that capacity on a year-round basis. Even though travel to Europe peaks in the summer and usually results in strong financial performance, assets including personnel have to be used on a year-round basis, which limits the amount of international capacity an airline can add. United apparently believes it does not believe that adding more transatlantic capacity will be beneficial in 2024 even though both American and Delta as well as foreign airlines are adding capacity. One outcome could be that Delta retakes its position from United in 2024 as the largest airline across the Atlantic. In turn, United's transatlantic margins should improve, which would be beneficial for UAL stockholders. Based on DOT data, DAL's transatlantic margins led UAL's in 2023. United should benefit from allowing its current capacity to mature.

The other region where United indicated it would slow capacity growth is in the domestic market, and that is directly related to its delivery delays. UAL's comment that it will have limited if any domestic growth in the first half of 2024 indicates that it either expects a low number of deliveries or will take its aircraft retirements early in the year and use deliveries later in the year to fuel its return to growth. Given that DAL and UAL each were responsible for growth percentages in the mid-teens in the summer of 2023, pulling out some of that growth by one party early in the year will limit industry capacity growth and also likely lead to higher average fares; domestic average fares began to decline in the second half of 2023, so it is prudent for UAL to slow its capacity growth. While Delta has not released its capacity plans for 2024, it is expected to put between 50 and 70 aircraft into service net of retirements, and Southwest is expected to have similar plans. While United will likely place a similar amount or more of aircraft in service in 2024 as a whole, UAL's apparent plans to shift that capacity to the 2nd half of 2024 will benefit not just UAL's margins but also those of the entire U.S. industry.

United did note that it intends to add capacity to its Pacific network, which is delivering good margins and is expected to continue to support further capacity growth since the Asia/Pacific was the last global region to reopen after the pandemic.

Changed industry dynamics

One final consideration in UAL's decision to slow capacity growth is apparent in the phrase "align with industry conditions." Ultra-low-cost carriers in the U.S. have been particularly hard hit by the Geared Turbofan inspections. Spirit ( SAVE ) expects that up to 20% of its fleet might be out of service for months at a time. Pricing in the domestic industry is likely to be strong with limited discounts, esp. during the peak Spring Break period with so much lower priced capacity not just at SAVE but with other carriers out of service.

United noted in its NEXT strategic plans that part of its plan to fill its domestic planes that are added as it replaces regional jets with larger mainline aircraft is to increase the sale of economy basic fares, which are those competitive with ultra-low-cost carriers. Most other airlines are reducing the percentage of economic basic seats, so UAL was going to move contrary to the industry; by having fewer ultra-low-cost carrier seats in the market, UAL could have become the low-fare leader, not a good position for an airline that wants to expand its margins based on premium revenues.

Managing costs

United's apparent attempt to slow its growth has implications for its costs. Because airlines generally use growth to help keep unit cost growth down, UAL will have to make sure its costs do not grow as it slows its capacity growth or at least shifts it to the 2nd half of 2024. United has been one of the most aggressive in pilot hiring along with Delta, and both hired more than 1500 pilots in 2023. Delta has told its pilots that it will slow its pilot hiring in the 2nd half of 2024 but maintain its strong pilot hiring in the first half of the year. The timeline from hiring to working on the job is the longest for pilots, so it is likely that slowed growth will lead to reduced hiring for other workgroups. Aggressive pilot hiring and growth is costly, as more senior pilots have opportunities to upgrade to higher-paying aircraft which results in a training cascade. Slowed growth could, therefore, result in better cost management.

Slower growth is good news

I wrote several times in 2023 that United's aggressive growth was problematic from a financial standpoint, including for the balance sheet stress it creates. UAL's capex was expected to exceed $8 billion for several years, far higher than any other airline. Since UAL neither generates more revenue nor more profits than other airlines, its growth was certain to result in increased indebtedness. UAL used portions of its cash on hand to reduce the amount of debt it used to finance its 2023 capex.

UAL's executives have stated that they intend to match DAL's higher margins, which is part of why Delta's market cap is the highest among U.S. airlines. Increasing yields and slowing growth are certain to help increase United's margins. The industry itself will benefit, and some of the competitive skirmishes that would have occurred because of United's aggressive growth will likely be pushed further forward. In addition, mergers of JetBlue/Spirit and Alaska/Hawaiian are on the table, and both mergers are likely to result in a stronger pricing environment. Pushing United's growth into periods when the pricing environment will be stronger will help boost UAL and industry margins.

While United will provide its updated guidance and 4th quarter and full year 2023 earnings later this month, currently estimated for January 22, 2024, comments so far indicate that UAL wants to boost its margins and increase industry fares in 2024, which should drive improvements in its stock price.

Based on these expectations, I believe United Airlines Holdings, Inc. stock has returned to a BUY rating.

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