-- This article was written by Lou Whiteman of The Deal
United Continental Holdings (UAL) is a perennial underperformer that tripped up again last week when it released first quarter earnings, but the airline's troubles have gotten so bad that some are beginning to wonder whether the only way to save the company is to tear it apart.
Chicago-based United on April 21 reported adjusted earnings per share that topped estimates, but actually saw its shares trade down afterwards because of its guidance that passenger revenue would continue to weaken in the months to come.
United has largely been a laggard since its 2010 merger with Continental Airlines, but a new management team installed last year has made progress towards curing some of the labor and integration headaches that for years plagued the airline, causing investors to hope going into earnings season that the worst was finally behind it.
The poor guidance has caused some company followers to question that assumption. Wolfe Research analyst Hunter Keay concluded after reviewing United's first quarter results that the airline has "no obvious plan" to cure what he sees as a structural disadvantage, saying "we do not see the current strategy" closing the airline's margin gap versus its competitors.
"Last year one could attribute UAL's poor revenue performance to an unreliable operation," Keay wrote. "But UAL is now running its best operation run since the merger and the gap is widening."
Keay highlighted issues involving the United route map, including a predominance of coastal hubs that mean longer flight lengths and awkward north/south connections, especially along the East Coast. United's hubs tend to be in large markets with significant rivals, leaving the company with more competitive battlegrounds than rivals and generally lower market share at its so-called strongholds.
The solution, to some at least, is a revamp or perhaps a slice-and-dice of United's sprawling U.S. network. United takes great pride in its expansive route map, but if the company is unable to generate returns that match those of rivals, what's the point?
"UAL may have the best network for passengers but we doubt it's the best network for shareholders," Keay wrote.
United Continental today is almost without question a stronger and more viable competitor than either pre-merger United or Continental would be on their own, and there is unlikely to be a call for the two companies to completely unravel that deal. Instead, the push by critics is for a more drastic dose of what airlines do whenever they merge: retreat from weaker markets to focus on areas of strength.
The idea is not exactly new. As far back as two years ago, Imperial Capital analyst Bob McAdoo called on United to drop its hub at Washington, D.C.'s Dulles International Airport, which routinely ranks as the airline's least profitable.
Dulles, McAdoo noted at the time, is just 211 miles from United's far more lucrative Newark, N.J., hub, and a shutdown would follow the trend airlines have used mostly successfully to bring down costs post-deal. Delta Air Lines (DAL) cut out of Cincinnati and Memphis after acquiring Northwest Airlines and gaining a hub in Detroit, and American Airlines (AAL) shuttered the St. Louis hub it gained when it bought Trans World Airlines.
United has already applied this strategy elsewhere, downsizing the Cleveland operation it bought when it merged with Continental in favor of its large Chicago presence.
Today, Dulles would still be a likely target. Legacy United, in the days before it had Continental's Newark stronghold, had established a largely-international presence there that it hoped to support based on government travel, but that business has proven to be less lucrative than the corporate trans-Atlantic flying out of the New York area.
Dulles is also located a very long 30 miles from downtown Washington, a trip that can easily take more than an hour by taxi in rush hour, putting it at a disadvantage for local business compared to Reagan National Airport, from where you can look across the Potomac River to the Washington Monument.
Others would like to see United reconsider its scale at Los Angeles International, especially given the airline's success in building a trans-Pacific operation up the coast in San Francisco. Los Angeles is both overcrowded and the center of a buildup by Delta and others, meaning United could likely attract significant interest if it were to sell assets or leases there.
Denver, too, has been under the watchful eye of United management, and could be targeted for more of a downsizing. The airport offers a relatively favorable location for collecting and distributing West Coast traffic but is plagued by weather issues. Also, United faces intense competitive pressure there from hometown Frontier Airlines Inc., as well as a large Southwest Airlines (LUV) presence.
But United sources have mainly downplayed the idea of dramatically reducing the airline's footprint. They argue that, in an age where large-scale domestic consolidation is complete, United, American and Delta, thanks to international alliances, can all offer business travelers access to the entire globe. As a result, they insist, factors such as quality real estate, along with in-flight amenities, are growing in importance.
"There is expense in operating out of Los Angeles and New York, but there is also strong demand from customers to fly in and out of those cities," one source said. "Long-term cuts would make the airline weaker, not stronger, and that is not good for shareholder value."
The coastal hubs that mean longer flights are also ideal gateways for more-lucrative international traffic, perhaps helping to offset any added costs from the increased flying time.
More broadly, many at United would dispute Keay's assertion that the issues plaguing the company are structural, and cannot be overcome with time. The airline is in the early stages of a restart under new CEO Oscar Munoz, making peace with some key labor groups and more recently reaching a settlement with two activist investors that involved revamping the board and adding considerable additional airline experience.
United vice chairman and chief revenue officer, James E. Compton, during last week's call with investors, responded to a question from Keay about potential divestitures or breakups by saying, "I think it's way too early for anyone, particularly me, to answer."
Cowen & Co.'s Helane Becker in a note points out that United Continental's capacity is already down since the 2010 merger, and argues that should United shrink, that capacity would likely be backfilled by "another potentially irrational operator," resulting in market share lost to United and potentially an even worse revenue environment depending on the level of the new entrant's recklessness.
Management said it intends to host an investor call in late June to go over its plans to boost revenue and prove skeptics are wrong about the airline's structural issues. Executives also said they will list initiatives that will likely include reworking the fleet and restructuring new fares to boost revenue.
A fleet revamp, in which the airline retires its aging and expensive 747s and phases out less-efficient regional jets, would be a start. From there, perhaps investors can get a clearer view of what kind of earnings this slumbering giant can deliver and make a more clear-headed judgment about whether a breakup is in order.
"United is in a difficult spot and needs to prove they are not broken," Becker wrote. "We are willing to wait to hear what management says to investors in June."
If the company fails to deliver by then, all bets are off.
-- This article was originally published by The Deal, a sister publication of TheStreet that offers sophisticated insight and analysis on all types of deals, from inception to integration. Click here for a free trial.