United Airlines Network Initiatives Have Strong Upside... If they Could Just Implement Them

It has been over a year since United announced planned network initiatives at their 2016 investor day. Earnings improvements were to be $600M annually by end of 2020 with $100M coming in 2017 and $300M in 2018. As the initiatives have been delayed, so have the increased earnings, leaving Wall Street skeptical of their ability to achieve what was promised. As a result, the stock dropped 12% following the Q3 earnings call, a strong sign of waning confidence.

While Wall Street's confidence in the coming earnings improvements have taken a hit, there is some debate on what exactly lacks confidence. Is the problem that the opportunity to improve the network doesn't really exist, or is it that they have been unable to execute what they know they need to do? The difference is critical to the valuation of the airline. Either the improvements will not come and the 12% devaluation is warranted, or they are only delayed, which represents a potential 12% upside once United realizes the benefits.

A large portion of the network initiatives involve re-banking their domestic hubs. Looking more closely at domestic connecting flows, we can see just how much the United domestic network has yet to develop. While American and Delta have strong connecting flows, United is limited to a narrow East-West corridor with lower volumes overall. This also shows the large gaps in United's domestic market, particularly in the massive southeast market, but also in markets that United have a strong domestic presence such as Texas.

United's answer has been to reorganize their hubs to encourage more domestic traffic. As seen in this slide from the 2016 investor day, United is aware of their lagging domestic performance. While the network has been focused on international connections, they have seen challenges as the overall domestic market outperformed. How much improvement can be made, and what benefit will United see to their bottom line? To answer this, we will take a detailed look at United's hub at Chicago O'Hare. With Chicago being United's largest and best positioned domestic hub, it stands to offer the most benefit.

Over 60,000 people connect each day through other hubs that would have been better served through Chicago.

Comparing the Hubs

When comparing United's Chicago hub with the largest hubs of their competitors (Dallas for American and Atlanta for Delta) the different operating philosophies become obvious. Chicago does see some alignment of arrivals and departures into banks, however there are odd peaks of arrivals and departures that do not coordinate with one another. The morning departure peaks around 7 and 9 am are departing more seats than arrive before it. Likewise, the afternoon arrival peaks aren't matched with equivalent departing peaks and seem better designed to connect international traffic on other carriers. In fact, a mid-day bank from 11:00am to 1:00pm seems the only true domestic bank for United in Chicago. While efficient for international connections in the morning and evening as well as direct O&D traffic, Chicago is not producing the opportunities to develop domestic connections.

Comparing American's operation in Dallas, the contrast to United's Chicago hub is drastic. A rather beautiful example of hub banking, DFW is the epitome of a domestic hub. Six distinct banks can be identified, leaving us hard-pressed to find room for any more. Each peak of arriving seats is matched by an almost identical peak of departing seats, maximizing the connecting opportunities, and thereby the revenue opportunities.

While not as elegant as American's hub design through Dallas, Delta is running a much larger operation through their Atlanta hub. With four distinct banks, Delta has maximized the number of markets that are crammed into a 3-hour window of connectivity. The arriving and departing seats are still harmonized with each other creating the largest connecting airport in the world.

After seeing how American and Delta manage their largest domestic hubs, it becomes obvious just how much improvement there is for United at Chicago. Once the world's busiest airport with airlines taking advantage of Chicago's geographic position to make it the country's most powerful domestic hub, United's Chicago hub has slipped to fifth place. Atlanta remains the worlds dominant hub yet still moves three times the domestic connecting traffic as Chicago. Chicago's fall from prominence is impressive, yet the untapped opportunities are plentiful. Considering United's domestic hub in Chicago is performing below even Minneapolis, a metropolitan area with one-third the population, there is a lot of "low hanging fruit" for United in Chicago.

Using Hubs to Avoid Low Cost Competition

The hubs with more connection opportunities were also able to generate higher connecting yields.

When you look at the detailed connection opportunities from flight perspective, you start to see a correlation with higher yields. The hubs with more connection opportunities are also able to generate more options to capture higher connecting ticket prices. With 579 Arrivals in three banks, Chicago is only producing an average of 84 possible connections per flight. Dallas has an increased number of flights with better timing resulting in a higher number of possible connections, and Delta has produced the most inter-connectivity with a whopping 132 possible connections per flight through Atlanta. As a result, Delta is also producing the highest yields across their connecting customers; an indication that Delta is using their market diversity to find better yielding markets.

As Low Cost Carrier competition grows in the domestic market, the ability to build connections around markets LCC presence becomes a strategic advantage. While non-stop markets have traditionally produced higher margins, they have also attracted the interest of the LCCs with their higher traffic. This is the effect happening when United mentions the higher exposure to LCC competition. As LCCs enter United's markets, they have little ability to collect higher paying passengers from markets without competition to offset the impact due to weak domestic hubs.

Yet it is important to point out that the LCCs have not necessarily decided to pick on United more than the other legacy carriers (although United does pose a juicy target). United has been unable to leverage their domestic network to find smaller, yet higher yielding markets as well as Delta and American. The design of the Chicago hub when compared with Dallas and Atlanta is a perfect example.

Not only is Delta and American siphoning traffic from United in Chicago, they are siphoning the choicest high-yield traffic.

Eating Chicago's Lunch

Beyond LCC competition, Chicago's lack of domestic connectivity has created opportunity for other legacy hubs.

Chicago is a well positioned hub for domestic connectivity, even if it is underutilized for that purpose. By looking at connecting traffic that flies a longer route than it would have through a Chicago hub, we can start to see which hubs are taking advantage of United's lack of domestic connectivity at ORD. Over 12,000 people connect each day through Atlanta that would be better served through Chicago. Delta enjoys over one third of it's 18,000 daily Minneapolis connecting passengers at the direct expense of United in Chicago.

While the lost passenger numbers are impressive, the premium United is forfeiting to competing hubs is staggering. With average yields all well above what United is able to produce through Chicago, not only is Delta and American siphoning traffic from Chicago, they are siphoning the choicest high-yield traffic.

The Opportunity for Chicago... and United

As bad as this all sounds for Chicago and United, the opportunity is massive. As United begins to build Chicago back into a domestic hub, they will enjoy the benefits that Chicago brings with it's population base and geographic advantage. Re-banking the operation (as United has announced they will do in Chicago), will add to the possible domestic connections and increase options for the revenue planning team to find the best prices for their seats. In addition to this, there are more cities that can be added to the Chicago network to further boost domestic connections and traffic.

The map above shows markets with greater than 50 passengers per day which would be better served through United's Chicago hub that are not served today. There are several markets of note that were recently announced by United as additional destinations from Chicago: ELP, ILM, and FAT (Fresno is off the map to the west but also fits the criteria). This is good news in that United is recognizing where the opportunities are to increase their domestic performance, and are starting to make those changes. The bad news is that American just announced several of these cities with flights through their Chicago hub, including MYR, and BGR. This illustrates just some of the headwinds United is against in their quest to rebuild Chicago into a domestic hub... American is doing the same thing.

As large as the opportunity may be for Chicago and United, it also represents some significant challenges. Firstly, Chicago is a congested airport. When Chicago saw itself as a top connector in the U.S., it also saw itself as having some of the worst on-time performance. As a result, the hub was de-peaked, or shifted to a rolling hub to deal with the operational challenges. Since 2008, O'Hare has added three runways, producing a much more efficient airport for hub operations, and greatly reducing the impact a re-banking initiative may have on operational performance. The excessive delays that plagued Chicago's status as a reliable hub in the past will now no longer exist.

Regardless of O'Hare's expansion, now that United is looking to re-bank in Chicago, some operational challenges are sure to resurface. While runways are no longer the limiting factor, the short supply of gates and the complexity of aligning and staffing the operation to the higher levels needed are challenges United will be forced to overcome. Most importantly is the presence of American, who will hardly play nicely with United to allow them full use of the airport during their new banks. These reasons are legitimate and part of why United has so far, been unable to execute on this initiative. It is worth pointing out, as well, that it's not for lack of trying. United's challenge in Chicago is much larger than American's in Dallas or even Delta's in Atlanta, where they control the lion's share of the traffic and can essentially reorganize at will.

Signs for Cautious Optimism

Expect a one cent increase in Chicago connecting yield and an $80M - $100M annual benefit in earnings from this initiative.

United will re-bank Chicago, and the initiative will be successful. The new revenue management system is a positive sign and will be key to any re-banking efforts as they optimize available market capacity in response to fluctuating ticket prices. Based on our internal revenue and QSI modeling, opportunities for Chicago suggest a best case of $210M in earnings improvements, nearly identical to the amount American claimed they would see in Dallas. However, when we begin adjusting for the operational challenges and competitive response as United starts adding markets through Chicago, the predicted benefit is reduced. As United begins selling new domestic markets through Chicago to their network, Delta and American will certainly respond by adjusting fares to keep their share of the traffic. On these markets, United will not only be competing with American through Chicago, but also Delta through Atlanta, Detroit, and Minneapolis, and American through Charlotte and Dallas.

As a result, my expectations are tempered by the competitive response of American and Delta and the unique operational challenges in Chicago. Because of these challenges, I expect an $80M - $100M annual benefit in earnings accompanied by a one cent increase in connecting yields; a solid step for United as they begin their network transformation.

United will rebuild Chicago into a strong domestic hub, and it will be successful.

Of course this all assumes United is able to execute on the initiative. Delayed for over six months, United has drawn question to whether or not this can be executed. As pessimistic as Wall Street has been on United's ability to deliver on these initiatives, I do not share in the pessimism. All of the challenges are known to the United team, and as evidenced by their investor day presentation, they are aware of the opportunity. The 12% drop in stock price reflected Wall Street's frustration with the delay in improvements, but the network improvements will come and United will begin to close the earnings gap with American and Delta. United will rebuild Chicago into a strong domestic hub, and it will be successful. They just need to start.