On Wednesday afternoon, United Airlines (UAL -2.96%) posted second-quarter earnings results that fell short of analysts’ expectations. CEO Scott Kirby also warned that the airline industry faces three big challenges: operational constraints (mainly related to staffing) that are limiting capacity, record fuel prices, and the threat of a recession in the near term.
Despite these headwinds, United provided strong guidance for the third quarter. Furthermore, the airline said it is on track to expand its adjusted pre-tax margin to around 9% next year and roughly 14% by 2026. Nevertheless, United Airlines stock plummeted 10% on Thursday, falling toward the low end of its recent trading range.
If the company meets its financial targets, United Airlines shares will probably skyrocket over the next few years. However, United’s targets look awfully aggressive, making the stock appropriate only for the most risk-tolerant investors.
Subpar Q2 results
Last quarter, United generated 6% more revenue than in Q2 2019, despite operating 15% less capacity. On the flip side, United’s adjusted nonfuel unit costs jumped 17% over the same period, largely because of the capacity reduction. Furthermore, the company paid a whopping $ 4.18 per gallon for fuel in the second quarter, up from just $ 2.16 three years earlier.
As a result, while United Airlines recorded its first quarterly profit since 2019, its adjusted pre-tax margin came in at just 5%. That put it at the bottom of the pack among the five largest US airlines and fell far short of its Q2 2019 adjusted pre-tax margin of 12.4%.
In addition, United’s adjusted earnings per share (EPS) of $ 1.43 missed the analyst consensus by more than 25%. That contributed to United Airlines stock’s slide on Thursday.
On the bright side, United Airlines projects that its adjusted operating margin will reach 10% in the third quarter: up from 8.2% in Q2. The carrier plans to increase capacity sequentially – driven primarily by the return of Boeing 777s that had been grounded for over a year – enabling revenue growth (relative to 2019) to accelerate to 11%. Equally importantly, fuel prices have started to moderate. United anticipates that it will pay an average of $ 3.81 per gallon this quarter.
Looking further ahead, management claims that United is likely to achieve the aggressive margin targets it laid out last year, calling for adjusted pre-tax margin to rebound to 9% in 2023 and reach 14% by 2026. That would imply adjusted EPS of roughly $ 10 next year and perhaps $ 18 in 2026.
Value stock or value trap?
Based on these assumptions, United Airlines stock trades for less than four times its projected 2023 earnings and just two times its 2026 earnings target. That might make the stock look like an incredible bargain.
However, most Wall Street analysts are skeptical that United can achieve and sustain this level of profitability – and for good reason. While cost pressures will likely ease in 2023 and beyond, management may be underestimating how much unit revenue will recede from today’s level as industry capacity rebounds and pent-up demand from the pandemic becomes satiated.
Meanwhile, United Airlines is going on an aircraft buying binge. It expects to spend $ 5.2 billion on capital expenditures in 2022, with over $ 4 billion of that coming in the second half of the year. Capex is set to surge to $ 8.5 billion or more in 2023 and will remain elevated compared to historical levels for several more years.
United Airlines probably won’t be able to cover all of this capex from its cash flow, especially if its margin targets prove overly optimistic. That will weaken its already shaky balance sheet.
Thus, while United Airlines stock is cheap, it isn’t quite as cheap as management would have investors believe. Furthermore, shareholders are shouldering a huge amount of risk because of the company’s sky-high capex and subpar balance sheet. United Airlines stock could still pay off over time, but it’s an incredibly risky investment, even by the airline industry’s standards. Most investors would be better off looking elsewhere.