United Airlines Holdings, Inc. annual report, FY2010

Business context and reporting period

United Continental Holdings, Inc. (UAL) filed this combined Form 10-K for the year ended December 31, 2010, with United Air Lines, Inc. and Continental Airlines, Inc. as subsidiaries. The merger closed October 1, 2010; UAL consolidated Continental only from that date, and both airlines continued operating separately pending integration. Accordingly, reported 2010 results include Continental’s fourth quarter only and are not directly comparable with 2009. References to “Q4” below mean the quarter ended December 31, 2010, not the full reporting period.

Financial and operating performance

• Reported operating margin was approximately 4.2% and net margin approximately 1.1%. Revenue growth reflects both recovery in fares and demand and Continental’s inclusion from October 1; excluding the merger impact, management reported revenue growth of 20.4%.
• For the full year, passenger revenue was $20.298 billion, cargo revenue $832 million and other operating revenue $2.099 billion. Passenger revenue excluding the merger impact rose 20.7%, as higher fares, stronger business and premium-cabin travel and improved traffic supported results.
• Fuel expense was $6.687 billion, or 31% of operating expense. UAL’s average fuel price excluding hedge effects was $2.35 per gallon, up from $1.84 in 2009. Fuel hedges had a reported $375 million fair-value asset at year-end.
• Consolidated load factor was 83.1%, versus 81.2% in 2009; available seat miles rose 20.5% and revenue passenger miles rose 23.3%, with merger effects included. Mainline cost per available seat mile excluding special items, fuel and related taxes was 8.29 cents, compared with 7.94 cents.
• Year-end unrestricted cash, cash equivalents and short-term investments totaled $8.680 billion, including $611 million of short-term investments. Operating cash flow was $1.907 billion; capital expenditures were $371 million. Investing cash flow of $3.320 billion included $3.698 billion of cash acquired in the merger. Ending cash and cash equivalents were $8.069 billion.
• Debt and capital lease obligations were approximately $15.4 billion. Contractual obligations totaled $71.312 billion, including debt and lease payments, regional capacity-purchase commitments, pension and postretirement obligations, and aircraft and other capital commitments. Current debt maturities were $2.411 billion.
• Q4 revenue was $8.433 billion, operating loss $82 million and net loss $325 million, compared with Q4 2009 revenue of $4.193 billion and net loss of $240 million. Q4 2010 included $493 million of merger-related costs.

Material changes versus prior comparable period

• UAL moved from a 2009 net loss to 2010 profitability, principally as travel demand, fares and premium traffic improved after the recession. The 2010 reported revenue increase is substantially affected by the merger and should not be read as organic growth.
• Operating expenses rose to $22.253 billion from $16.496 billion, including higher fuel expense, merger and integration costs, and expenses associated with increased operations. Fuel expense increased 35.6% on the reported comparison.
• The October merger added Continental’s assets, liabilities, employees and pension obligations. Year-end total assets were $39.598 billion, versus $18.684 billion in 2009; goodwill of $4.523 billion was recorded in acquisition accounting.
• United changed its frequent-flyer breakage estimate and accounting method prospectively from January 1, 2010. UAL estimated this increased 2010 passenger revenue by approximately $250 million, or $1.21 per basic share ($0.99 diluted).
• UAL’s balance-sheet liquidity increase was substantially merger-related: management attributed $4.2 billion of the year-over-year increase to Continental cash acquired and $1.9 billion to operating activities.

Outlook, management commentary, risks and unusual items

• Management expected $1.0–$1.2 billion of net annual merger synergies on a run-rate basis by 2013, including $800–$900 million in incremental annual revenue and $200–$300 million in net cost synergies; approximately 25% of gross synergies were expected in 2011. Significant additional integration expenses were anticipated, with timing and total cost uncertain.
• For 2011, management expected modest capacity growth: mainline and consolidated capacity each up 1%–2%, domestic consolidated capacity down 0.5%–1.5%, and international capacity up 4.5%–5.5%. Plans could be reduced if fuel prices rose significantly. First Boeing 787 delivery was expected in the first half of 2012, subject to delivery uncertainty.
• Management said recovery was improving but could not predict its durability. Fuel-price volatility, intense fare competition, economic weakness, seasonality, operational disruption, regulatory and environmental costs, and foreign-exchange exposure were identified risks. A $1-per-barrel crude-price change was estimated to affect 2011 annual fuel expense by about $100 million, absent refining-margin and hedge effects.
• Integration risks include labor negotiations, systems and reservations migration, fleet and network integration, and service disruption. About 72% of UAL employees were union-represented; joint pilot negotiations continued, and the timing and cost impact of new agreements were uncertain.
• Debt covenants included a $1.0 billion minimum unrestricted cash requirement and a 1.5-to-1 fixed-charge coverage ratio under United’s credit facility. Credit-card processors could require substantially larger reserves if cash, liquidity ratios or credit ratings fell below contract thresholds. All three registrants were reported in compliance with debt covenants at year-end; ratings were below investment grade.
• Other items to monitor include a possible issuance of up to $500 million of 8% PBGC contingent notes if defined EBITDAR triggers are met; a dispute with the PBGC over whether the merger triggered a redemption offer on its $597 million of notes; and a pending appeal in the antitrust challenge to the merger. The filing states the PBGC matter’s outcome is uncertain.
• The EU aviation emissions trading scheme was scheduled to require allowances from 2012 and was being challenged. The filing warned that climate rules could materially raise costs. Management also cited potential additional pension funding, asset impairments, and liquidity pressure from aircraft commitments and collateral requirements.
• Special items included $564 million of UAL merger costs, $136 million of aircraft impairments and $29 million of route impairment, partly offset by a $64 million goodwill credit. Independent auditors issued an unqualified opinion on UAL’s financial statements and internal controls; management reported effective disclosure controls.

Most important facts for investors to verify

• Separate merger-driven reported growth from comparable standalone performance, and assess progress against synergy targets alongside integration spending.
• Confirm liquidity available to the parent and operating airlines, covenant headroom, 2011 debt maturities, and potential credit-card reserve increases; cash acquired in the merger is not recurring operating cash generation.
• Evaluate fuel-price sensitivity, hedge coverage and collateral exposure, including the extent to which hedges protect costs without creating downside or liquidity risk.
• Track labor settlements, integration milestones, capacity plans and aircraft delivery schedules, and the effect of pension funding obligations.
• Review the $250 million frequent-flyer accounting benefit and other unusual items when assessing underlying earnings; reported 2010 results include only three months of Continental and are not a full-year combined comparison.