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Morningstar | United Finds Success With Domestic Network Initiatives; Margin Expansion a Work in Progress

U.S. legacy airlines consistently generated returns below cost of capital until a postrecession shakeout and wave of consolidation allowed four carriers--Southwest Airlines, American Airlines, Delta Air Lines, and United Airlines--to capture nearly 80% of the domestic market, ushering in record profit margins and consistent economic profits. Airline profit margins peaked in 2015 at record levels on the back of falling oil prices, rationalized supply, and elevated fares.After merging with Continental in 2010, United focused on supporting margins by rightsizing its network and embarking on a host of cost-cutting initiatives. However, these decisions bore consequences domestically, and United lost ground to American and Delta, failing to reinforce fortress hubs like those airlines. While United doesn’t own as much domestic market share as peers, it holds a leading presence on Pacific routes and carries a large percentage of traffic through Western markets such as San Francisco and Denver. Whereas prior management chose to shrink the network to profitability, CEO Oscar Munoz and president Scott Kirby have taken the opposite stance. In shifting strategies, United aims to improve network breadth, or connections to small cities, increase daily flights to spokes from hubs, and take advantage of the benefits of upgauging. With this strategy, United expects to increase system capacity 4%-6% a year over the next two years. Moreover, United aims to catch up with Delta and American by offering nonstop service to regional markets. While we like management’s hub optimization strategy, we think United still has a long row to hoe to right its operations. If United’s domestic optimization strategy proves successful, we expect to see a positive spillover effect in its frequent-flier program, which we believe currently contributes nearly 50% of United’s operating income. We believe United’s frequent-flier program will continue delivering a solid boost to operating margins and help the company remain profitable through our midcycle period.