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United Continental Is Forging Ahead With a Bizarre Plan to Grow in Los Angeles

Adam Levine-Weinberg, The Motley Fool

Los Angeles International Airport (also known as LAX) is unique among American airports. Most big hubs have one or two dominant airlines. But LAX is a major base of operations for each of the five largest airlines in the U.S. This has led to epic congestion there -- and a brutal competitive environment.

A few years ago, United Continental (NYSE: UAL) was the largest carrier in Los Angeles, but it has slimmed down since then. Meanwhile, American Airlines (NASDAQ: AAL) and Delta Air Lines (NYSE: DAL) have expanded significantly at LAX, becoming the top two carriers there.

However, United's new leadership team now appears determined to grow again in Los Angeles. This bizarre decision is likely to cause further profit erosion for the company.

What United Continental wants to do

After years of gradually trimming its schedule in Los Angeles, United has returned to growth this fall. In late October, the carrier began operating one of the longest routes in the world: a nonstop flight between Los Angeles and Singapore. Next month, United will add extra flights on routes between Los Angeles and several destinations in Hawaii.

A United Airlines plane, with a coastline in the background.

United Airlines is starting to grow in Los Angeles again. Image source: United Airlines.

In 2018, United plans to continue its growth at LAX by adding more short-haul flights. Cities under consideration for new routes include Eugene, Medford, and Portland in Oregon and Spokane in Washington. "The key to making Los Angeles work is really having lots of connectivity and feed here," said company president Scott Kirby at an employee meeting in late September.

Kirby claims that United earns higher margins in Los Angeles than Delta and American, even though it is the least profitable on a global basis. Clearly, he believes that the carrier can build on its success in Los Angeles by facilitating more connections there.

Why the plan makes no sense

Even if it's true that United Continental is more profitable than American Airlines and Delta Air Lines in Los Angeles, this can probably be traced to the latter two carriers' aggressive growth there. New routes tend to be less profitable initially, while adding new markets can spark price wars with the airlines already serving those routes.

Thus, United's profitability at LAX could deteriorate rapidly once it starts to grow. Furthermore, United only has preferential rights to 22 gates in Los Angeles. The company will have to spend a huge amount of money on a new terminal if it wants to continue expanding.

More broadly, expanding in Los Angeles makes no strategic sense for United Continental, which operates a much larger hub a little more than 300 miles away in San Francisco. According to the company, United operates 273 daily departures in San Francisco, where it has access to dozens of gates. By contrast, it has just 138 daily departures from Los Angeles.

Maximizing the number of connecting opportunities is critical to profitability in a hub-and-spoke model. United's management is drawing the wrong conclusion from this general rule. Even if United adds 50-100 flights in Los Angeles, LAX will still be an undersized hub. To make matters worse, this growth could easily spark a price war with American and Delta.

Cannibalizing a better hub

For the past few years, I have firmly believed that United Continental ought to shrink in Los Angeles while growing aggressively in San Francisco. Unlike LAX, San Francisco has the potential to become an enormously successful connecting hub.

Unfortunately, United appears to be moving in a different direction. It already serves virtually every destination it might add from LAX with flights from San Francisco. By growing in Los Angeles, United will primarily steal connecting traffic from its own hub in San Francisco.

In a best case scenario, United Continental's upcoming growth in Los Angeles will make its LAX hub even more profitable, with a modest negative impact on the carrier's San Francisco hub. But the worst case scenario could be disastrous: Growth in Los Angeles could lead to lower profit margins there while also torpedoing the San Francisco hub's profitability. Based on United's track record, investors shouldn't feel good about the company's odds of success.

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Adam Levine-Weinberg owns shares of Delta Air Lines. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.