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United Continental Holdings Inc (UAL) May Have a Free Cash Flow Problem

While earnings per share, or EPS, can be a handy statistic for investors to use to evaluate the performance of stocks that they own, it does not always tell the whole story. Ultimately, free cash flow is the holy grail for investors. Free cash flow is calculated by taking the amount of cash generated from operations and subtracting capital expenditures. In short, it represents the amount of profit left over after a company has made necessary investments in the business. Free cash flow is a particularly important metric for shareholders because it represents money that potentially could be returned to them through dividends or share repurchases.

United Continental Holdings Inc (NYSE:UAL)On a straight P/E basis, United Continental Holdings Inc (NYSE: UAL) looks fairly cheap even though it hit a new 52-week high last Friday. The Friday closing price of $27.38 is just 7.4 times the average analyst estimate for 2013 EPS, and 5.6 times the average estimate for 2014 EPS. However, free cash flow tells another story. United Continental Holdings Inc (NYSE: UAL) is facing a period of heavy investment that will probably sap free cash flow through the end of this decade. This poor free cash flow outlook makes United a questionable investment candidate compared to peers, particularly Delta Air Lines, Inc. (NYSE:DAL) .

Operating cash flow: a baseline
Over the past three years, United Continental Holdings Inc (NYSE: UAL) operating cash flow has been very inconsistent. This has been the result of two factors: profit instability caused by integration problems and rising oil prices, and one-time merger integration costs. In the past three years, operating cash flow has ranged from a low of $935 million last year to a high of $2.4 billion in 2011. If we add back United’s approximately $600 million of special charges in 2011, United would have generated as much as $3 billion in operating cash flow.

If we assume a return to that level of operating cash flow in 2013 and modest growth through the end of the decade (a bullish assumption, given United’s poor performance recently and the turbulent history of the airline industry), United Continental Holdings Inc (NYSE: UAL) may produce $25 billion in operating cash flow through 2019: an average of $3.57 billion a year. However, shareholders will see very little of that money.

Heavy capital commitments
The reason why shareholders may fare poorly even in the relatively bullish scenario outlined above is that United has very heavy capital commitments over the next seven years, as can be seen in the following table:

Year Capital Commitments
2013 $1.8 billion
2014 $1.5 billion
2015 $2.0 billion
2016 $3.0 billion
2017 $2.5 billion
2018 ~$2.5 billion*
2019 ~$2.5 billion*
Total ~$15.8 billion

Data from United Continental’s 2012 10-K (p. 139); * denotes author’s estimate.

United Continental Holdings Inc (NYSE: UAL) has thus committed to spending nearly $16 billion in capital expenditures over the next seven years. Nearly all of those commitments relate to aircraft acquisitions. The company currently has 247 aircraft on order, most of which will be delivered by 2019 (the exception is United’s order for 100 Boeing 737 MAX 9 aircraft, for which deliveries run through 2022).

However, capital expenditures will be higher than the level of commitments suggests. The commitments refer primarily to aircraft purchases, but United will need to upgrade old aircraft from time to time (such as United’s current project to add Wi-Fi service on all its aircraft). The company will most likely have to invest in IT systems and ground facilities as well. Capital expenditures could fly even higher if United chose to exercise any of its aircraft purchase options.

For 2013, United Continental Holdings Inc (NYSE: UAL) has projected that capital expenditures will total $2.5 billion, $700 million ahead of the committed expenditures. Assuming that capital expenditures will exceed commitments by just $500 million annually thereafter, we would reach the following capex estimates:

Year Capex (estimate)
2013 $2.5 billion
2014 $2.0 billion
2015 $2.5 billion
2016 $3.5 billion
2017 $3.0 billion
2018 ~$3.0 billion*
2019 ~$3.0 billion*
Total ~$19.5 billion

Data from United Continental’s 2012 10-K (p. 139); * denotes author estimates.