Why Are The Airlines Splurging and Spending Money On Premium Services?

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After a decade of making heavy losses, the US airlines have finally started minting money. The prolonged weakness in crude oil prices has enabled the industry to come out of its age-old stigma of being a poor investment. However, the airlines are not taking this success for granted. Most of the US airlines are judiciously investing their excess cash flows in revamping their existing fleet, improving their capital structure, and returning value to their shareholders (Read: Is American Airlines Making The Most Of Its Increased Cash Flows?). But, some of these airlines have gone a step further and are investing huge amounts of money in building premium amenities and services for their elite customers. Let’s have a closer look at what these airlines are up to, and how this will impact their business in the long term.

US Airline Profitability

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What Are These Airlines Investing On?

The US airlines have generated a remarkably high amount of cash flows over the last one year on the back of low crude oil prices. Apart from re-fleeting their aircraft, and creating a leaner balance sheet, these airlines are investing a lot of time, effort, and more importantly, money, on enhancing the flying experience for their premium customers. For instance, the three legacy carriers – American Airlines, United, and Delta are offering chauffeur driven luxury cars to their elite passengers to avoid the limelight while travelling from the Los Angeles International Airport. In addition, these airlines are developing a number of world-class amenities at their key airports. Delta, for example, is set to launch its flagship Delta Sky Club at the San Francisco International Airport (SFO) in August 2015, offering a variety of facilities such as shower suites, private work areas, Wi-Fi, etc., apart from an open-air experience with premium food, cocktails, and a runway view. The Atlanta-based airline had also expanded its presence at the John F. Kennedy International Airport (JFK) by investing more than $1.4 billion to build a state-of-the-art terminal and 11 new gates at the airport, earlier this year.

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Walking on Delta’s footprints, United is also generously spending money on pleasing its elite clientele. The airline is upgrading the customer experience in its United Clubs by offering a new complimentary food menu, and by undertaking extensive renovations at some of its existing Clubs. Furthermore, the legacy carrier aims to re-train its Club agents to deliver high standards of services to its members. The Chicago-based airline also plans to build new Clubs in Atlanta and San Francisco to serve more customers.

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American Airlines is not far behind in this race. In fact, the Fort Worth-based airline has taken this to another level by building a special pet cabin for its first-class fliers in some of its flights. The airline has also built private check-in areas for VIP passengers at airports in Los Angeles, Chicago, Miami, and New York. Earlier this year, the network carrier started offering higher points for premium fares, i.e. more expensive tickets would be entitled to higher points per mile. Consequently, the passengers can convert into a premium customer faster than usual. This is incentivizing the passengers to fly with American as opposed to its competitors and gain access to the airline’s premium services. Smaller airlines are also catching up on this trend. JetBlue entered the game with its premium Mint service offering a wide range of facilities such as comfortable fully-flat beds, on-board entertainment options, free broadband connectivity, and custom amenity kits, etc., on its transcontinental flights from New York.

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Are The Airlines Wasting Money Or Is It A Well-Reasoned Strategy? 

Since the airlines recognize the sensitivity of their profits to crude oil prices, they are making every effort to improve the sustainability of their earnings. So, in order to maximize their profitability per seat, the airlines are investing a huge fortune into developing their premium offerings. While this may seem irrational to some investors, we see this as a far-sighted plan. Here’s why we think so:

Business-class or elite travelers are less price sensitive compared to economy passengers. There are two major reasons for this – either these travelers attach more value to comfort than to money or their travel bills are paid by their employer or clients. In either case, it is a positive for the airlines. According to industry experts, the airlines make a large share of their profits from these business-class seats, while the economy seats hardly cover the fuel and labor costs. The chart below explains how the premium passengers have remained price inelastic post the economic slowdown in 2009-2010.

Premium Seats

Furthermore, the premium passengers contribute a notable share of the total number of passengers for most of the airlines. Premium passengers have accounted for more than 5.7% of the total passenger traffic on average over the last 5-6 years. Thus, if these airlines manage to capture the premium travelers’ market while improving their profitability per seat, they could witness a noteworthy rise in margins.

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Moreover, the investments on premium services have a trickle-down effect on all passengers. For instance, United, American, and Delta have restored free beer and wine for economy passengers on long-haul flights. Also, most of the new airplanes ordered by these airlines under their re-fleeting program include facilities such as charging outlets, wireless Internet, and better on-board entertainment options for all seats. Thus, these huge investments are likely to enhance the value for economy customers as well. This will provide sustainability to the earnings of these large carriers, which is very important, particularly in the times of oil price volatility, such as today.

Finally, as long as the oil prices remain depressed, these airlines have the luxury to dig in their own pockets and spend the surplus cash flows on improving their long-term profitability. As the air travel growth continues to remain close to its 20-year average of 5%, we see these investments as a calculated risk taken by these airlines, which is likely to yield returns in the form of higher earnings in the foreseeable future.

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