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Earlier this year, United Continental (NYSE: UAL) caused consternation among investors after it revealed a three-year plan calling for aggressive growth. Whereas United and its peers have generally tried to limit their capacity growth to the rate of GDP growth in recent years, the carrier plans to increase capacity about 5% annually through 2020: approximately twice the expected GDP growth rate.
While ramping up growth to this extent is a risky strategy, it seemed to work out for United in the first quarter. The carrier posted solid unit revenue growth, while profitability came in ahead of expectations. Nevertheless, United Continental could face headwinds starting later this year as its growth rate accelerates and Southwest Airlines (NYSE: LUV) resumes its fleet expansion.
First-quarter results are better than feared
Last quarter, United Continental's revenue rose 7.2% year over year on a 3.6% capacity increase. Passenger revenue per available seat mile (PRASM) ticked up by 2.7%, while cargo and ancillary revenue surged by double digits.
Achieving a solid unit revenue performance like this was important, because United faced a $0.40/gallon increase in its average fuel price last quarter. This created a roughly 4 percentage point headwind to its pre-tax margin. On the bright side, adjusted non-fuel unit costs increased just 0.6% year over year.
United Airlines produced solid unit revenue growth last quarter. Image source: United Airlines.
The net result was that United Continental's adjusted pre-tax margin slipped to 2% from 2.4% a year earlier. Excluding a roughly $50 million one-time revenue boost related to the MileagePlus loyalty program, United's pre-tax margin would have been around 1.4%. While this margin performance wasn't very impressive, it was still a lot better than the company's initial forecast for a roughly breakeven result.
More of the same expected in Q2
For the most part, United's second-quarter forecast implies a continuation of the trends seen last quarter. Capacity growth is set to accelerate modestly to a range of 4% to 5%, and United expects PRASM to rise 1% to 3% year over year. Meanwhile, on the expense side, fuel costs will surge again, but non-fuel unit costs are on track to increase just slightly.
These projections imply that United Continental will achieve a pre-tax margin of 9% to 11% in the seasonally strong second quarter, down from 13.2% a year earlier. The main reason there will be more margin erosion this quarter than in the first quarter is that the year-over-year fuel cost headwind will be greater.