United’s third quarter earnings call did not go over well with Wall Street, and last week’s fourth quarter call? Well that didn’t go well either. This time, the airline ran it as an investor update, and President Scott Kirby used the time to school everyone on the rationale behind the airline’s strategy for growth. This was a fascinating discussion, and it’s a complex issue. Wall Street still wasn’t impressed, but I keep going back and forth on it. In fact, I ended up effectively having a conversation with myself trying to decide whether I liked the plan or not. So, I figured I’d just clean my mental ramblings up and put them here for all to see.
Let’s start with the easy part: what this isn’t about. It’s not about international and it’s not about the coastal hubs at all.
Right. United has spent years growing and refining its international network, building joint ventures, and strengthening coastal hubs. According to United, its international gateways outperform those of its peers. (That’s not a surprise when you have Newark and San Francisco, two of the best possible international hubs in the country.) It’s also not about those coastal hubs on domestic flights, apparently. Here’s the telling stat from the presentation.
So it’s really about the middle and it’s about domestic flying.
Yeah, the three hubs to focus on appear to be Chicago, Denver, and Houston. According to Scott, this whole thing is about geography and “natural share.” An airline should be able to achieve a certain market share just by existing in its hubs, all else being equal. So if someone is flying from Des Moines to Dayton, United should get a naturally-large share thanks to its Chicago hub. That, of course, requires there being enough seats and flights to serve those passengers, and that’s one place where United is falling down.
“Falling down” is probably an understatement. This is a self-inflicted wound.
Scott definitely ripped into his predecessors’ strategies, that’s for sure. He says the airline was so focused on shrinking to profitability over the last several years that it can no longer get its natural share. This is a function of several different issues.
- It doesn’t serve as many small cities as it should and as its competitors do. (“Breadth” according to page 17 of the presentation.)
- It doesn’t have enough daily flights to its spokes from each hub. (“Depth”)
- The connectivity of the hubs hasn’t been set up properly, so opportunities were lost just by scheduling poorly. (“Connectivity”)
- It serves bigger markets with aircraft that are too small. He loves using Newark-Atlanta as an example of a market that Delta had mainline on while United used 50-seaters. And Delta crushed United.
People have been talking about United’s underperformance for years. Most people have shaken their heads considering how good United’s hubs are generally considered to be.
United Has THE BEST Hubs (said in a Trumpian voice)
Scott looks at United’s domestic hubs and sees the best possible hubs in the US, but I’m not as convinced. Yes, United has hubs in the cities that have the most local traffic demand, and they are geographically-positioned well for connections. (Let’s not talk about the lack of ability to serve the Southeast. The rest of the country is well-served by United’s hubs.) The problem here is that these hubs may have the most local traffic, but that’s why low cost carriers flock to them when they can get gates/slots. So United finds increasingly that nonstop routes are taking a beating on fare levels. Delta doesn’t have that problem nearly as much in places like Minneapolis and Detroit. Same goes for American in Charlotte. More local demand is a double-edged sword.
And if the low cost carriers are making fares low on the biggest nonstop routes, then that means United is looking to escape to markets without that competition. And that means…
…connections are more desirable. Scott said awhile ago that connections were becoming much more attractive than nonstops for airlines. That’s strange to get used to that idea, but the reasoning is sound. Smaller connecting markets are the least likely to see low fare competition. They don’t have a ton of volume, but that’s why United wants to supersize the hubs. The more connectivity you have, the more seats you can fill in small markets. So you can support Rochester, Minnesota (Scott’s favorite example in the presentation) if you can get people from there to a ton of places frequently. It’s all about connectivity. That also, by the way, means doing a better job of banking the hubs to maximize connectivity to these small markets.
This is different than when a low fare carrier enters a market. It’s not a stimulation play.
Correct. When you think of an airline going into a new market, it usually goes in with the idea of bringing low fares and stimulating traffic. That is absolutely not what United wants. United wants to go in with the same fares that are in those markets today, but because of this whole idea of “natural share” that Scott likes, he thinks that United will then naturally start taking its allotted share of traffic. This won’t stimulate markets. This is just about stealing share from Delta and American.
But American and Delta are going to fight back, right?
This to me seems to be the biggest flaw in the plan. United can get its natural share if Delta and American don’t respond. But Delta and American will respond to defend their turf, and this could turn into a fare and capacity war. That’s what’s scaring Wall Street right now. They think this could be a sign that things aren’t really different this time around. This could hurt revenues depending upon how the big three all react.
But this time it’s about more than just fare revenue.
That is true. There isn’t likely to be a war on checked bag charges or any other ancillary fees, so the revenue is more stable than it used to be. The biggest pot of all when it comes to ancillaries, however, might be in the credit card world. Scott thinks that people pick their airline credit cards based on the airlines that have the most utility. If you live in, say, Lynchburg, Virginia, you’ll be most likely to get the American card because there is no other game in town. If you live in Columbia, South Carolina, you may choose between American and Delta. But United won’t really be in your consideration set. This is a big concern, because credit cards mint money for the airlines that hawk them. And United thinks it can really boost credit card signups in smaller markets if it offers better service.
It’s easier to get a new signup than to switch someone from an existing card.
That’s definitely one of my concerns here. American and Delta have probably snapped up most of the people in Columbia, SC who want an airline credit card by now. For United to get people to switch, that’s a tougher battle. I’m sure it will result in more signups for United, but I’m not sure how bullish to be on this.
So now United is talking about 4 to 6 percent growth annually over the next three years which is a lot. How is the airline going to fund all this flying?
There are two key ways to grow here. One way is pretty simple – United is going to just fly its airplanes harder. Scott had a great graph showing how much United backs off in off-peak seasons.
This is why we’ve seen load factors go through the roof — airlines have just stopped flying when planes aren’t full of good revenue. But the way Scott looks at it, these airplanes and all the airport infrastructure are cheap to fly from a marginal cost perspective. In other words, if you think of most of the costs as being fixed, the only additional cost incurred by flying the airplane is fuel, crews, and maybe a little bit of other stuff sprinkled in like snacks and all that. Talk to a casual observer and they’d say “sounds pretty obvious to me.” So-called “utilization flying” isn’t a new idea by any stretch. This feels like just another swing of the pendulum.
This should mean more consistent schedules seasonally (and maybe there’s even hope that the airline will stop changing departure times and flight numbers every day), but it also means that connectivity will be better for people in small cities all year long instead of just during the peak season.
That’s not going to fund all this growth.
Truth. The other part is an influx of small airplanes, and that sounds bat-shit crazy. Remember how hard the airlines worked to shed 50-seat regional jets? Well, United is bringing ’em back, baby. To be fair, this is temporary, I think. United stole Air Wisconsin away from American as a regional feeder, and with that comes a fleet of 50-seaters. United can’t grow in the 70- to 76-seat range now due to pilot scope restrictions, and the airline has nothing on order in the 100-seat range either. So 50-seaters it is. Nobody likes flying those airplanes, but these will be going into small markets where the option is 50-seater or no United service. This strategy will have to evolve in the next couple of years because it’s just not competitive.
Fleet is a huge piece of this.
Yeah, and United is not well-equipped. It is maxed out on 70/76-seaters unless it orders something to be flown by mainline in the 100-seat range. There was a plan to order a bunch of 737-700s, but when Scott arrived, he killed that bad plan quickly and moved to bigger airplanes. Meanwhile, Delta has a fleet of 717s and an incoming fleet of C-Series aircraft that really help the airline turbocharge the hubs. United has none of that, and it’s going to have to do something.
So is this going to work?
It all sounds well and good on paper, but there is risk. American and Delta won’t just sit there and let United take its “natural share.” This could result in pricing and capacity wars which would not be good for any airline. (The public will gladly take it, however.) I also don’t think it’ll be as easy to woo new credit card holders as Scott made it sound. And then there’s the fleet problem. I can certainly see where the strategy came from, and why the airline is giving it a shot, but I’m not convinced it’s going to end well. That being said, I’m also not convinced it’ll end poorly, so… this internal conversation hasn’t helped one bit.