Fun fact: What airlines refer to as costs is not an absolute measure of how much a carrier spends. A massive global airline like United can spend a lot more money from quarter to quarter and still keep its costs in check so long as it grows capacity during the quarter.
No U.S. airline is on a better financial trajectory than United Airlines. But investment analysts are paid to worry, and they have asked whether United is spending too much money, a habit that could hurt the company if this long-rumored economic downturn occurs sooner rather than later.
But speaking Wednesday on their third quarter earnings call, United’s executives said they have a simple plan to combat cost creep. Over the next six years, they said, United will use bigger planes in place of smaller ones, a strategy called “increasing gauge.” Larger jets allow United to add more seats per flight.
“We have large hubs in big cities across the country, and because of that, we should be the airline with the highest gauge,” United President Scott Kirby told analysts. “But at this point, we’re not. In fact, United is seven-to-eight years behind our large competitors in gauge growth with approximately 13 percent fewer seats per domestic departure compared to Delta.”
Adding seats per departure decreases unit costs because what the industry calls “cost” is not a true measure of spending. Instead, airlines use a metric called cost per available seat mile, or CASM, roughly equivalent to how much money they spend to transport one seat for one mile.
When an airline adds capacity on a flight, by adding seats on an existing plane, or substituting a larger aircraft, this cost metric comes down, even if the carrier’s total spending does not. Airlines generally do not include fuel in this calculation, so if the price of oil spikes, carriers still can compare their costs from quarter to quarter.
United knows this metric is closely watched by investors, so last year its executives promised they could grow the airline over a three-year period without raising unit costs. On Wednesday, they said they still will reach that goal, or at least get very close.
“We are very proud of the cost control we’ve delivered, and will continue to deliver through next year,” Chief Financial Officer Gerry Laderman said. “We expect the three-year compound annual growth rate for non-fuel unit costs to be just 0.3%, which would be a remarkable and industry leading achievement.”
In the short-term, costs will be a little higher. For the fourth quarter, United told investors that costs per available seat mile, not including fuel, will increase 3.5 percent, year-over-year. For all of 2019, United expects an increase of about 1.2 percent, also year-over-year.
United’s unit costs have gone up, executives said, because the airline is doing a bit less flying than expected. It has grounded its Max flights for most of 2019, and also dropped some flights to two geopolitical hot spots — India and Hong Kong.
It has been more than four years since CEO Oscar Munoz took over from Jeff Smisek and more than three since Kirby left American for United, but the airline’s top executives say they’re still fixing many of the errors of the previous regime, including this aircraft size problem.
Under Smisek, United often sought to shrink itself to better profitability, at a time when analysts were obsessed with what they called “capacity discipline,” hoping fewer seats in the market would lead to higher margins at all airlines.
But times change, and a few years ago, most airlines got back to growing.
So now, several years after American and Delta learned the benefits of up-gauging, United is embarking on a similar strategy. Where possible, a regional jet flight might switch to a larger Airbus A319, or an Airbus A319 flight might swap to a bigger A320.
Still, it will take some time before United can do as much up-gauging as its competitors. To get full benefit from the strategy, the airline will need to take delivery of more larger domestic aircraft, including the Boeing 737 Max 9 and Max 10.
“As our fleet mix shifts to a higher percentage of larger gauge mainline aircraft instead of regional aircraft, we will begin closing that gap in earnest starting next year,” Kirby said. “And we’re planning for approximately 3 percent more seats per departure by the end of 2020. We expect gauge growth to continue to the middle of the next decade.”
Of course, substituting larger aircraft is not the only lever airlines have to decrease unit costs. Carriers can also add seats to existing aircraft.
United is further along with this strategy, having added seats to most of its planes over the past four years. One of the last aircraft types left for retrofit is the Boeing 757-200. United expects to soon increase its seat count by seven.
Not Obsessive About It
Some analysts obsess over unit costs because the measure can be a strong proxy for profitability. Investors often punish airlines that report higher-than-expect unit costs, like over the summer, when they sold off Spirit Airlines’ stock after the airline predicted CASM for the third quarter would increase 7 to 8 percent.
But there are limits to this cost focus, as United executives made clear Wednesday. Sometimes, an airline can squeeze higher margins by removing seats from aircraft and charging more money for a more comfortable experience.
United is doing this on two fleet types. One is a subfleet of Boeing 767-300s now flying from Chicago and Newark to key European business destinations, including London. United has taken a plane that usually seats 214 passengers and put only 167 seats on it, with larger-than-usual premium cabins.
On those airplanes, United’s cost per available seat mile is rising about 25 percent, Chief Commericial Officer Andrew Nocella told analysts. But the airline expects unit revenues on those airplanes will increase at a higher rate than costs.
United expects similar results from its CRJ-550, a regional aircraft that usually fits 70 seats. United will have only 50, also in a premium configuration.
On the aircraft, Nocella said, unit costs will rise in the “high single digits, relative to what otherwise could be, but we think the [revenue] gain related to that is more than that.”
Cost Still an Issue
While airlines have some tools to control unit costs as absolute costs rise, they can’t completely fix the numbers by up-gauging or adding seats.
United may have cost increases that could affect its bottom line. Most notable is labor, as unions representing workers surely are noticing the same trends as investors. For the third quarter, United reported net income of $1 billion with pre-tax margin of 11.9 percent, an increase of 2.3 points against the same period last year.
As labor contracts come up for renewal amid this high profitability, United’s employees will want big raises, commensurate with the airline’s recent success. United’s pilots could be first to make big requests, as the airline and pilots are currently negotiating a contract extension.
Still, executives downplayed the effects of these raises, saying they can pay employees more money and hit targets.
“We will of course continue to make the anticipated increases in compensation for all of our employees,” Kirby said told analysts.
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Photo credit: Over the next six years, United will use bigger planes in place of smaller ones, allowing them to add more seats per flight. kikkuru0606 / Pixabay