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

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United’s management has steadfastly claimed that they are not trying to drive Virgin America out through unfair competitive practices. However, their claims that Virgin America’s lower prices “stimulated demand” ring hollow. With capacity rising around 70% to Los Angeles and nearly 90% to San Francisco, it seems highly unlikely that there will be enough demand to fill those seats at rational prices.

Indeed, on the company’s recent earnings call, United Continental Holdings Inc (NYSE:UAL)’s management highlighted the new competition and additional capacity on these routes as a factor that will hurt Q2 unit revenue. At first, it may seem surprising that two routes could have a noticeable impact on the results of a global carrier like United. However, by this summer, those two routes will account for 3% of United’s total capacity, so a 30% drop in unit revenue on those routes would lead to a nearly 1% drop in system revenue, and a corresponding decrease in margins.

Foolish bottom line
To some extent, it makes sense for legacy carriers to defend their market position on major hub-to-hub routes. That said, United seems to be shooting itself in the foot by cutting prices and adding capacity at the same time. Virgin America’s higher-quality service would attract some customers regardless of United Continental Holdings Inc (NYSE:UAL)’s response. Rather than minimizing the damage, United’s move to boost capacity will probably lead to even lower average fares and more empty seats, eroding profits during the peak season.

In the next few years, we’re likely to see Virgin America, JetBlue Airways Corporation (NASDAQ:JBLU), and other low-cost carriers continue their growth, which will occasionally lead them into new competition with legacy carriers. If the legacy carriers follow United’s example by cutting fares and raising capacity whenever new competitors arise, the recent trend toward industry consolidation will not lead to higher profitability. This is a significant consideration for investors who are interested in buying airline stocks today.

The article Is United Airlines Shooting Itself in the Foot? originally appeared on Fool.com and is written by Adam Levine-Weinberg.

Adam Levine-Weinberg is short shares of United Continental Holdings (NYSE:UAL) and is long September 2013 $33 puts on United Continental Holdings. The Motley Fool has no position in any of the stocks mentioned.

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