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United Continental Holdings Inc (UAL): Is This Airliner Shooting Itself in the Foot?

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A price war is brewing between United Continental Holdings Inc (NYSE:UAL) and Virgin America on two lucrative transcontinental routes. Since the merger of United and Continental several years ago, United has been the only carrier flying from Newark Airport (just outside New York City) to San Francisco and Los Angeles. However, earlier this month, low-cost carrier Virgin America began service on both of these routes, breaking United’s monopoly.

To stimulate demand and market its flights, Virgin America decided to undercut United Continental Holdings Inc (NYSE:UAL)’s prices when it entered Newark. United responded with a full-blown price war to defend its turf in the Newark-San Francisco and Newark-Los Angeles markets. While United needed to match Virgin America’s prices to maintain its competitiveness, the extent of its reaction will have a noticeable negative impact on its profitability. The ability of a relatively small competitor like Virgin America to disrupt a global carrier like United highlights the continuing risks of the airline industry for investors. Moreover, United Continental Holdings Inc (NYSE:UAL)’s response suggests that capacity discipline is not nearly as engrained as airline industry bulls believe.

Background
United’s San Francisco, Los Angeles, and Newark hubs are all located in major markets for both business and leisure travelers. The transcontinental routes from Newark to San Francisco and Los Angeles became highly profitable monopoly routes after the United Continental merger. For a long time, United Continental Holdings Inc (NYSE:UAL)’s strong position in all three hubs and the difficulty of securing slots at Newark Airport deterred competitors from entering the market.

However, the American Airlines bankruptcy allowed Virgin America to buy slots and begin service three times a day on both routes. The Newark-San Francisco and Newark-Los Angeles routes appealed to Virgin America for a few reasons. First, the carrier already has a major presence in San Francisco and Los Angeles. Furthermore, Virgin America specializes in long-haul flying and offers more passenger amenities than United. Virgin America has joined JetBlue Airways Corporation (NASDAQ:JBLU) in offering free in-flight satellite TV and other entertainment options, which are particularly nice to have if you’re going to be on an airplane for six hours. Lastly, Virgin America recently achieved the top ranking in the Airline Quality Rating survey, whereas United was last. When competing directly with United, Virgin America can try to win customer loyalty by providing a clearly superior service.

Price war?
When Virgin America began service to Newark, United Continental Holdings Inc (NYSE:UAL) could have just matched the fares and hoped for the best. Additionally, it could have trimmed its own capacity, in the hope of retaining some pricing power. Instead, United slashed fares even more and added flights! United Continental Holdings Inc (NYSE:UAL) added five daily round trips on each route for the summer season, moving total industry capacity from 11 daily round trips to 19 on the Newark-San Francisco route, and from nine daily round trips to 17 on the Newark-Los Angeles route. According to Virgin Group founder Richard Branson, United stands to lose as much as $150 million from its actions on these two routes alone. (For comparison, United earned an adjusted profit of $589 million in all of 2012.)

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