The US airline industry, that hit the headlines with record first quarter profits on the back of low crude oil prices, is now experiencing a slump as investors anticipate a revival of the old dynamics of the industry. The downfall began last month, when low-cost carrier, Southwest Airlines, increased its capacity guidance for 2015 from 7% to the 7-8% range. While this revision was consistent with Southwest’s ongoing expansion plans in Dallas, things became worse when Doug Parker, Chief Executive Officer (CEO) of American Airlines – the world’s largest airline – commented that the airline would not lose its passenger base over price competition, and will match the fares of low-cost airlines. This induced panic among investors, as they feared that this would trigger a price war among the airlines. The investors believe that competing on prices would undermine the airline’s ability to charge profitable fares, pull down their profits, and push them back into the shackles of heavy losses. Thus, the worried investors sold-off stocks of major airlines, wiping out nearly $12 billion of market value of the airline industry in a single trading day.
Source: Google Finance
What forced American to change its stance?
Until recently, American Airlines and Southwest were the only two airlines that had a significant presence in Dallas. While Delta also operates in Dallas, it does not own any gates and operates through gates leased by United. However, Delta’s agreement is set to expire in July, and United has already subleased these gates to Southwest going forward. Southwest has agreed to honor Delta’s arrangement with United till it expires. However, to promote competition, the Department of Transportation (DOT) has issued a letter allowing Delta to use these gates even in the future. This has resulted in a cold war between Delta and Southwest that has prompted the low-cost carrier to lower its air fares in an attempt to push Delta out of Dallas.
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While it may be reasonable for Southwest to compete on air fares to expand its market share in Dallas, American Airlines seems to be paying a heavy price for this. With the termination of the Wright Amendment in October last year, Southwest has been adding non-stop flights to and from Dallas Love Field, increasing its daily departures to 166 compared to 118 last year. Further, the airline plans to reach 180 daily departures by August of this year. These rapid expansions have been threatening American’s dominant position in Dallas and creating a pricing pressure for the airline. Since the Dallas-Fort Worth route accounts for more than 10% of American’s revenue, Southwest’s revised capacity guidance forced the legacy carrier to change its decision to maintain capacity restraint and to engage in price competition.
Will American Change Its Stance Again?
Over the last couple of years, the US airline industry had resurrected from its heavy losses through consolidations and capacity restraint followed by large network carriers – American, United and Delta — while the smaller airlines continued to expand their capacities at a high rate. This coupled with the sharp fall in oil prices, reassured investors about the changed fundamentals of the industry, resulting in high valuations for these airlines. However, the change of stance by American came as a shock to the market, as investors expect other legacy carriers to follow American’s footstep, which would create an oversupply of seats in the market and force these airlines to engage in price wars. This would take the industry back to its older days of heavy losses.
However, we believe that the situation is not as severe as it appears. Southwest has been lowering its air fares to make it difficult for Delta to operate in Dallas. There could be only two possible outcomes of this price war – either Southwest will lose its gates to Delta and end up altering its expansion plans in Dallas, or the airline will be successful in pushing Delta out and expand its operations in Dallas. If the former scenario comes true, American will be able to maintain its dominant position in Dallas without much capacity expansions. In case the latter outcome becomes a reality, Southwest would no longer lower its air fares, improving the pricing power of these airlines.
Even if Southwest continues to keep its prices lower, it would not be profitable for American to engage in capacity expansions, as aggressive capacity additions will pull down the airline’s unit revenue. This is clearly evident from the airline’s latest traffic results, which shows that the airline has increased its total capacity by 1.3% in April and 2.1% in May  to battle the competition from smaller carriers. While this capacity expansion failed to contribute much to the airline’s passenger traffic, it weighed heavily on its passenger revenue per available seat mile (PRASM), a measure of unit revenue. In consequence, the airline reduced its second quarter unit revenue guidance from a 4-6% fall, to a 6-8% decline, and its pre-tax margin expectations from 17-19% to 16-18%. This implies that the airline’s efforts to fight competition with capacity additions are negatively impacting its margins. Thus, in the broader scheme of things, it is not advisable for an airline of American’s size to lose sleep over losing a small market share versus a drastic fall in its unit revenue. Therefore, we expect that the airline would not continue with these capacity additions for long and would move back to its capacity restraint position soon.
However, if American decides to add capacity and engage in price wars, it might weaken the investor confidence in the industry, further lowering the stock prices of these airlines. We had analyzed this scenario in our previous article, highlighting the potential downside to American’s stock price in case it chooses to resort to rapid capacity expansions. In this case, we estimate a price estimate of $48 per share for American Airlines based on our analysis. (For details, read Scenarios That Can Impact American Airlines’ Stock Price)
Opportunity to Buy?
Despite an optimistic outlook on the back of lower oil prices and stronger demand, the stock prices of most airlines crashed by more than 10% on average due to the recent comments by top executives of Southwest and American. Unnerved by the negative reaction of the market, Southwest reversed its capacity guidance back to 7% growth for the year within a couple of weeks. To calm the investors, Doug Parker also clarified that the market has learnt from its past mistakes and would be rational when expanding capacity. While the two airlines are trying hard to reassure investors, it might be a strenuous task. It may take an exceptional second quarter performance to bring back investor confidence in the industry.
While investors’ faith in the fundamentals of the airline industry have been uprooted, this may be an opportunity for the airlines to buy back their own shares at lower prices and return higher value to its shareholders. The CEO of American also emphasized that the airline would continue to focus on stock buybacks and dividends, while Southwest has already accelerated its stock repurchase program to leverage the low stock prices. Since the majority of the airlines had improved their balance sheets over the last year because of the weak global crude oil prices, the industry may be working towards a notable second quarter earnings to reassure investors.
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