United Airlines - Company Comment
United Airlines is riding strong volumes led by soaring international results.
Record revenue and income puts UAL back at 2019 profitability levels with LTM upside from here as it raised guidance and can rely on its expanded international capacity to drive higher cash flow.
United joins Delta in looking to return to investment grade on an unsecured basis in 2024 even if Delta is further along in balance sheet repair while American is a more distant third.
The healthy results of the Big 3 majors did not surprise anyone, but from here the key questions for financial risk will be around the pace and form of debt reduction.
Another key variable is the timing and game plan around debt refinancing and extension that will grow UAL’s unencumbered asset base and enhance financial resilience to deal with any cyclical conditions or market “events” in the future.
In this commentary, we look at United Airlines (UAL), who posted a great quarter with the same drivers that we recently covered with Delta’s 2Q23 results (see Signals & Soundbites: Delta 2Q23…Bellwether Bliss 7-16-23). UAL posted bullish travel volumes, healthy unit revenue, a higher premium mix, and soaring demand in the international markets.
The numbers for 2Q23 are back in the same zone as the 2Q19 period, and that is an impressive achievement with higher revenue and operating profits in 2Q23 vs. 2Q19. The company is well positioned to eventually meet its goal of becoming an investment grade unsecured borrower again, but it is going to take some time to reassure on total debt reduction (vs. net debt) and reduce the layers of secured borrowings in its complex capital structure. The company is targeting an annual 14% pretax margins by 2026 and even hit 15% adjusted margins in the 2Q23 period.
Hitting (and holding) IG caliber Debt/EBITDAR metrics will remain a function of a record earnings streak still unfolding for the largest US global carriers. “The denominator” (EBITDAR) and cash liquidity build in net debt are the key drivers for now, but the majors have a lot of debt to pay down after explosive growth of the liability structure back in 2020. UAL cites its 2.4x “Adjusted net debt/EBITDAR” at the end of 2Q23, which is down from 11.1x at LTM 2Q22. That is quite a swing.
The leverage numerator (total debt) is still an eye-opener with total “footnote debt” for 2Q23 ($30.3 bn) at almost double 2019 levels ($14.5bn) or almost $15 bn higher. Net debt (net of cash and S-T investments) is a much healthier increment at only $1.6 bn higher. We look at this “fun with metrics” exercise in the balance sheet section at the bottom of the commentary. UAL is materially stronger now, but those debt lines need to get paid down steadily.
The net debt perspective and what ratios are most important in a sector with notoriously volatile earnings gets back to stockholders, bondholders, and counterparties having a view on cash deployment and the pace of UALs expected debt reduction and balance sheet refinancing actions (secured to unsecured, more unencumbered assets).
We expect sustained debt reduction from any combination of redemption and retirement to refi-and-extension. The yield curve trends from here will be a decisive factor in the willingness of issuers to extend and lock in new coupons. Paying down $1 bn of high-cost floating rate debt in 2023 was a start.
As the company covered across some of its big bang fleet announcements in 2021-2022, UAL is full speed ahead to execute on its global ambitions under the “United Next” plan. That will entail adding capacity and next generation aircraft to take full advantage of its global network and strong domestic base of hubs for international connection volumes.
The fleet overhaul is a cornerstone of their game plan with widebody commitments to press their capacity advantage in many international markets. That will be a balancing act with adjusted debt reduction very much a priority at the same time they pursue an ambitious capex program. We look at some of those issues in the balance sheet and capex section further below.
UAL trying to chase Delta in execution and financial strength…
The above chart looks back to late 2013 for relative stock returns across the Big 3 global carriers plus Southwest (The Big 4). The running stock return time series starts on 12-11-13, a few days after American emerged from Chapter 11 as a newly combined leader at the time pro forma for its merger with US Airways. We see Southwest still in the lead over that time frame with Delta #2, United #3, and American a very distant #4 in this group. The recent Southwest operational problems and lack of big international P&L is evident in the pattern.
The 3Q23 outlook is strong for UAL with revenue expected to be up 10% to 13% YoY. International margins are ahead of 2019 and domestic is now running back around 2019 numbers. The International business is a key factor in the relative performance.
UAL is leveraging its dominant position in San Francisco and strong LAX hub presence to expand Pacific capacity. Overall, 3Q23 capacity is expected to be +26% for International and +13% for domestic. While a clear leader in San Francisco, UAL is also well positioned in its LA hub (LAX) where American has a small market share lead around 19% with UAL and DAL in a tight band above 16%.
The Pacific edge has been a long held competitive advantage for UAL since it acquired Pan Am’s Pacific operation in the mid-1980s. The current expansion presses that leadership role. UAL indicated that “Excluding mainland China flying, United's transpacific network will be 50% larger than all other U.S. airlines combined.”
UAL has been heavily talking up its international operations to make its case to the market. With respect to its Atlantic operations, which generated more than 21% more incremental passenger revenue than the Pacific in 2Q23, UAL has stated that it is running Atlantic operations that are “32% larger than the airline's 2019 schedule and 10% larger than the next largest U.S. carrier.” That international capacity edge is a very clear positive attribute in this market as it restores its finances.
A little airline industry background music…
Before we get into the UAL operating metrics and balance sheet story further below, we take a quick look back across time. The question as we head into the post-pandemic era of the airlines is whether balance sheet strength and commitment to reinvestment will become a permanent fixture of the strategy once they clean up their highly layered capital structure and eliminate all remnants of the bailout by Washington. Paying down as much debt as possible and unencumbering as much of its asset base (ex-fleet financing) is the natural game plan to maximize financial flexibility to react in the future.
Airlines have always been an adventure across the cycles with booms, busts, and bankruptcies a routine feature since the Carter Administration era deregulated the industry (fares and routes). The 1980s saw intense competition, changing business models, waves of entrants and painful exits by numerous carriers. My first asset management employer (private placements) seemed to have a parking lot in the desert, so the industry legacy is a pretty tough one as the 1980s proved to be a survival of the fittest decade that is still shaping the industry today.
Chapter 11 has been in the timeline of most of the majors (including United), but the list is a long one that includes numerous liquidations in fact or in substance. Delta, American, and a range of airlines that rolled into the Big 3 via mergers or asset sales each had a trip to the court steps. The Chapter 11 and 7 names and distressed mergers make for a long list.
Anyone who has traveled a lot since the early 1980s for business or leisure could play a game of trivial pursuit on which airlines died when and what were the trigger causes (fare wars, excessive leverage, weak competitive cost structures, etc.) The history of mergers and consolidation to bolster hub and route competitiveness have had mixed effects, and the hope is that the dirge music is slowing down now as demographics and infrastructure and tight labor markets bring a converging set of variables on costs and travel capacity. Stability has a shot.
The low cost carrier impact is still a debate in domestic trends…
Southwest grew on the back of a distinctive business strategy as it exploited the uneconomic costs and uncompetitive carriers. The financial stress at airlines such as US Airways with shorter stage lengths and high costs made for easy targets in the 1990s. LUV rolled into routes where high-cost US Airways got beaten up and pulled back. The Low Cost Carrier (LCC) strategy was perfect for less congested airports where LUV could meet its rapid turnaround metrics and maximize hours in the air.
From smaller airports near major metro areas where it could dominate (Dallas Love, Houston Hobby, Chicago Midway, Burbank for LA, Oakland for Bay Area, Baltimore-Washington, etc.), LUV’s ability to compete on fares and costs gave LUV and LCC-type operators an advantage. More airlines and start-ups copied the LUV business model, and the few major LCCs left have generated more merger controversy now with names such as Frontier (ULCC) and Spirit (SAVE) in various merger battles that have the DOJ all riled up on antitrust.
The LCC model has a direct bearing on the legacy Big 3 majors such as UAL for a number of reasons, and that is especially for the domestic operations. “Cost convergence” as a theme is making the rounds and was cited on the UAL call. The issue is labor and pilot shortages and the potential for LCCs generally and Southwest in particular to see its labor groups (associations or otherwise) use the Big 3 labor deal templates as a guide.
As we mention in the earlier Delta commentary, the pilot negotiations over at Southwest are getting very tense (rising strike risk). UAL struck a deal this month that is going into the ratification process. The same for American, who responded to its initial pre-ratification deal by then matching the United deal. Delta earlier struck its deal and set the curve. To what extent these Big 3 deals influence the Southwest negotiations will be something to watch. Among theories making the rounds is the labor issues and supply-demand for pilots undermine the growth prospects of LCCs. That in turn favors the major legacy names as cost differentials could narrow.
UAL and the international edge…
International flight connections in the US through major hubs are still the domain of major carriers such as United with its leading international share and growing international capacity in 2023. The global markets (especially Trans-Atlantic) are what separates the legacy global carriers from the domestic players, who are underperforming in equities and need strategic deals to grow (Frontier, JetBlue).
UAL has arguably the best international story line in aggregate. UAL has the advantage of a very strong Pacific operation, where passenger revenue rose 160% YoY in 2Q22 on ASM growth of 116% and RPMs of +172%. For the Atlantic operations, Passenger Revenue grew by over 38% on ASMs of +19.9% and RPMs of +22.5%. Those two segments alone were responsible for 70% of incremental passenger revenue growth in 2Q23 with both higher than domestic. Overall, UAL International ASMs were over 45% of capacity. International business customer revenue grew by 40%.
We bring up these other histories since the path from here raises some questions as major hubs are at or near flight capacity. That means congested airport growth slows and international routes and slots have substantial asset value as growth opportunities. That still favors the majors.
More consolidation is not likely given the domestic M&A and DOJ battles in takeovers, but the recent action has made clear how important international routes can be to boosting revenues and diversifying business risks by markets. That has shown up in the stock markets as very competitive and high-quality airlines with a domestic focus (LUV, JBLU) have struggled in relative terms. DAL and United have been big winners in the post-pandemic recovery as evident in the time series.
The above chart posts the running stock returns across multiple time horizons. We line up the carriers in descending order of 1-year total returns. That time horizon thus captures the aftermath of the 2Q23 results through this past week for the Big 3 US global carriers (AAL and UAL this past week, DAL the week before).
We see UAL and DAL well out in front with AAL and ALK fighting for a distant #3 spot, but those four are ahead of the S&P 500 and the S&P 500 equal weighted index. Low cost king Southwest has had a very rough flight across the time horizon of the past 1 year and 3 years. JetBlue has been feeling the competitive pressures as well.
Shocks are supposed to encourage balance sheet strength…
One theory after all of those mixed histories and then the pandemic would be that history and the unpredictable shocks of oil, war, and a deadly contagion would promote a desire to maximize financial flexibility. Maintaining stronger balance sheets could be seen as a core part of the strategy for shareholders. The priority should be getting into a comfort zone well into the BBB tier on an unsecured basis. That at least makes sense as the fleet replacement cycle and balance sheet repair process unfold.
The history of the airlines is an event-filled ride. When I was covering some of these major carriers on and off from the 1980s period into the early 2000s, the volatile oil markets and hypercompetitive nature of the industry saw the fall of the major carriers from high quality ratings to the speculative realm. The financial erosion unfolded steadily for some, and “then all of a sudden” for others.
The industry was going through rapid structural changes, and the question now is whether so much has happened that the relative volatility will subside. The industry never fails to surprise (usually in a bad way). The question in the US is whether infrastructure and tight labor is enough to drive some status quo periods as the post-consolidation, post-pandemic industry still works through the shock of the pandemic effects.
The idea goes something like this: the post-deregulation wars are over—the migration from hub-and-spoke to the growth of RJ-heavy and lower capacity point-to-point travel has evolved—the LCC wave is seeing cost convergence and running low on growth opportunities—consolidation and bankruptcy have left fewer players--there are not enough pilots—the beat goes on. The main priority for the biggest majors is to exploit the opportunity to grow internationally.
The history is just that—past events—but there are ample reasons to expect the “strategic volatility” to subside even if fuel cost volatility is a constant. So much has happened that is almost impossible to replicate. The fare wars on select routes in the 1980s are the stuff of legend from some long-deceased carriers. Some of the fares got so low back then that it violated the “variable cost” rule from Econ 101. The battle for flights from NYC to Boston that I recall (I was from Boston living in NYC) included some special one-way fares in low double digits.
Over the timeline, New York Air (tied into famed junk issuer Texas Air), the Eastern Airlines shuttle, the Pan Am Shuttle, Trump (bought Eastern Shuttle), US Airways (bought the shuttle from Trump), Delta (bought Pan Am Shuttle), American, Piedmont, and even World Airways (out of Newark) turned up the heat on various NYC-Boston fare battles. Those kinds of fare battles are very rare in the industry now.
In the early 1990s, the leaders such as Delta and American were in the single A credit tier. Southwest was a lowly weaker BBB bursting onto the scene when that post-1990 game clock started. High cost US Airways and its rollbacks were tailormade for LUV to fill the void at secondary airports and across the Sunbelt and West Coast high frequency routes (Burbank to Oakland etc.). Fare wars kept flaring up including a major fare battle in 1992, “Value Pricing” led by American.
The pricing carnage of the 1990s and new LCC competition (among a range of other new millennium events from 9/11 to oil spikes) sent today’s Big 3 on a steady journey down to HY and eventually over time into Chapter 11. Recounting the wave of bankruptcies, mergers, labor strife, and mixed results on M&A integration are for another day.
United 2Q23 by the numbers…
The above chart gets into the guts of the operating metrics. The industry has specialized measures the airlines include each quarter, but they boil down to variations of unit revenues (PRASM, TRASM), unit costs (CASM, CASM-ex) with some reflecting fare structures (yield) and others reflecting fleet utilization and efficiency.
You can look at passenger revenues or total revenues. You can look at costs with fuel or without fuel and adjusted for other special items. They break out the details, so they can be skimmed each quarter for variances. There are more metrics than what is listed above, but these are the main event line items.
Following the lines and framing directionally what is doing worse and/or doing better is a standard quarterly drill. For a sample of where UAL stands after 2Q23, they are very much back in the game in meeting 2019 operational performance and key benchmarks. If we look where capacity (ASMs) stands in 2Q23 vs. the peak earnings power of 2Q19 before the pandemic, the 2Q23 ASMs are slightly higher at 73.5 billion vs. 73.2 bn in 2Q19 (we include full FY 2019 metrics in the chart above, but we reviewed the 2Q19 numbers).
For paying passenger volume metrics, we see RPMs at 63.5 billion in 2Q23 or slightly edging out RPMs in 2Q19 of 63.0 billion. The consolidated load factor in 2Q23 was 86.4% in 2Q23 vs. 86.0% in 2Q19. The important international load factor for UAL was 84.6% (2Q23) vs. 84.0% (2Q19). However, the domestic load factor is lower in 2Q23 at 87.0% vs. 87.5% in 2Q19. More passengers were flown in 2Q19 at 42.6 million vs. 41.9 million in 2Q23 with period end aircraft at 2Q23 totaling 1,325 vs. 1,344 at the end of 2Q19. In other words, the majors are back.
Given the high-profile service meltdowns, weather cancellations, overbookings, delays, luggage SNAFUS, and airport congestion problems, these very favorable operating metrics are impressive even if they mask bigger service quality challenges. More bluntly, that pissed-off passenger is still paying a high price and sitting in a seat in the air flying to the destination (or in a long line rebooking).
UAL’s solid profitability came in the face of some severe operational problems and notably at its Newark Hub, where the runway configuration and greater vulnerability to weather has been getting some bad financial media press.
Fuel cost trends are easy to scan, and the 2022 fuel spikes and the volatility of jet fuel costs over past cycles is part of the history across the decades. As we covered in the Delta 2Q23 commentary, fuel remains an overriding line item as evident in the “CASM-ex” line vs. CASM. Fuel needs to be recovered when oil prices are soaring and can result in some interesting trends for fares on the way down.
The main question is “How much of declining jet fuel prices flows into profits or lower fares?” The quarterly performance of the majors highlights how a lot of the price declines dropped to the bottom line with demand and fares so high.
The above chart covers balance sheet trends and capex and liquidity trends. All the lines matter, but total debt and net debt matter the most. As we covered with Delta, COVID blew open a gaping cash flow hole that needed to be filled with debt that includes some government liquidity support (grants and loans) and a lot of secured funding deals.
UAL cites net “adjusted debt” to LTM EBITDAR of 2.4x where net debt includes a range of financial liabilities. If we use just the traditional footnote total debt (ex-leases) as a metric to frame Total debt vs. EBITDA, the number is around 3.9x. Using net “footnote net debt + leases” (as in ex-Pension/OPEB) we get down to around 2.1x for Net debt/EBITDAR. No matter how you slice it, UAL is moving in the right direction very quickly subject to the current profitability backdrop.
UAL’s interim disclosure on debt line items is less granular than Delta, but the mix in broad terms from the 10-K is around 86% secured and 14% unsecured. The highly encumbered and layered capital structure is not new to the industry given the history of bankruptcy and crises whether after 9/11 or in the volume collapse of the pandemic. There has been no shortage of crises and funding innovation across time from aircraft securitization (EETCs) to soft assets to pledge and monetize (securitized products from revenue streams such as UAL’s MileagePlus, etc.).
The good news is that the counterparties in the major carrier peer groups are showing a very strong rebound in financial risk that will continue into the remainder of the peak travel period in 3Q23. The record $3 bn in cash flow in 2Q23 combined with a highly liquid balance sheet (cash + short term investments of $19.1 bn) reduce the risks of high current maturities and capex commitments. The bond market is strong and the ability to use creative structures such as EETCs will reduce the risks of funding the expansion.
UAL cited its net “adjusted debt” reduction from year end 2022 of $3 bn and from 2021 of almost $6bn, but we focus on the unadjusted debt number more and look at items like Pension/OPEB and leases separately. Total debt is down by $3 bn since the end of 2021 and net debt by $3.8 bn from 2021 to 2Q23.
Pensions took a move lower on discount rates and an “actuarial gain” of $2.2 bn in 2022, leaving an unfunded GAAP pension shortfall of $714 million at 12-31-22 vs. $1.8 bn in 2021. Contributions to the pension plan in 2022 were minimal. The pension plan “drain rate” (benefit payments % ending assets) was over 13% in FY 2022, so that is a hefty rate of asset liquidation.
The positive scenario of sustained high volumes into 2024 with the benefit of expanded capacity and favorable unit revenues vs. costs feeds the bullish scenarios where free cash deployment to debt reduction leads the way. There will be opportunities to refinance and extend secured exposures with unsecured debt that will make the case for investment grade more defensible as more unencumbered assets get back in the mix. Deliveries of more efficient mainline aircraft with higher capacity all roll up into a very good free cash flow story line.
Fleet replacement and capex rule the cash flow statement…
The headline mega-orders for widebody and narrowbody aircraft back in December 2022 after major orders in 2021 are part of a multiyear fleet overhaul that will shift the mix toward higher mainline capacity but come with the risk of slowing balance sheet improvement with the major outlays to fund these purchases. UAL is making progress and current earnings rates are helping bring leverage down, but the earnings history in the airline sector are notoriously volatile. That raises risks but higher capacity brings rewards as well and especially to expand international volumes.
Forward capex commitments are broken out rigorously each quarter in the 10-Q with more detail in the 10-K. Capex commitments include $6.8 billion for the last 6 months of 2023, $6.9 bn for 2024 and a fresh peak of $8.2 bn in 2025. The process in aircraft financing follows a very well-worn path that includes sale-leasebacks and securitization. With an improving counterparty credit story at UAL and new aircraft in the future transaction flow, the depth of that aircraft leasing market and EETC demand is likely to remain solid given the backdrop for yields and shifting asset allocation patterns toward fixed income.
The general flavor of the fleet trends is more mainline vs. regional, a material widebody replacement cycle, expansion for international, and less single class RJs in order to upsell customers.
Premium leisure demand has been very strong in another sign of consumer spending and post-pandemic syndrome. UAL has delivered some comprehensive presentations on the fleet topic, and its Dec 2022 order for 100 787 widebodies and 100 737 MAX aircraft made a big splash around growth plans and its mainline fleet replacement cycle.
The redeployment from the RJ fleet to more mainline aircraft brings better margins and more capacity. The narrowbodies of choice are the higher capacity A321 and MAX 10. As of 2Q23, the aircraft firm commitment details include 392 737 MAX, 70 A321neo, and 50 A321XLR. For widebodies, the list includes 100 Boeing 787s and 45 A350s. The fleet topics are for another day.
At the very least, growth in capacity is coming alongside higher volumes, higher margins, rising free cash flow and lower debt.