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Airlines aren’t exactly the most profitable industry as it is known. Many aren’t able to turn a profit after expenses save for a few select names like Southwest (LUV) and AirTran. Our Managing Director of Industrials Jay Van Sciver recently took an in-depth look at the industry and highlighted three main underlying issues:

  1. Airlines get screwed by competitors that are emerging from bankruptcy and, as a result, have lower costs.
  2. Some investors are mistaking the benefits of a weak competitor in AMR and “optimistic accounting” for industry improvement // this one should definitely be changed because I don’t think airlines have been squeezed by inflation
  3. Consolidation is unlikely to meaningfully improve performance for legacy carriers.

INDUSTRIALS: Planes Feeling the Pains - AIRLINES slide2

Regarding bankruptcies, the name in the headlines is American Airlines (AMR). It was the last legacy airline to go into bankruptcy and thus, had the opportunity to eliminate numerous expensive and restrictive collective bargaining agreements and other sources of higher costs relative to competitors. Companies like Delta and United/Continental will have a tough time ahead competing with American going forward. Van Sciver outlines some of the cost reductions AMR may effect in bankruptcy below: //benefits will piss people off since they are firing people and screwing the industry

Key Collective Bargaining Agreements Inclusions for AMR

  • Restrictions on domestic codesharing: This is a substantial disadvantage since it curtails the breadth of route offerings and the value of loyalty systems
  • Limitation on operating more than 47 regional jets with >70 seats, force AMR to use less efficient/less flexible 37/44/50 seat regional jets.  These jets make up just ~8% of AMRs fleet vs. 32% for US Airways and 36% for Delta.
  • Limitations on the performance maintenance work on weekends and maintenance outsourcing
  • Restrictions on the sale of the first class seat next to the relief pilot rest seat on long haul flights
  • Requirement for flight attendant rest area on 777s in the main cabin
  • Other legacy carriers are not winning, they are just beating AMR

All of that was in addition to the highest labor costs in the industry by far.

Writes Van Sciver:

AMR was the highest cost large competitor prior to its bankruptcy, leaving it unable to compete effectively on price.  Now that AMR’s costs are coming down through bankruptcy, it will become more competitive.  Historically, that has pressured industry margins and driven airline equity underperformance. “

In the short run, changes in fuel prices can impact profitability.  In the long run, all competitors are price takers for fuel and other commodity inputs.  The advantage of lower fuel prices tend to be competed away.  Sustained increases in fuel prices can competitively favor airlines with younger, more efficient fleets.  Legacy carriers like UAL, LCC and DAL have older fleets than low cost carriers like Southwest and JetBlue (JBLU).

Lastly, consolidation may at first seem like a viable option for some airlines. Look at what United and Continental did and follow their lead, right? In this case, it’s not the best idea. Canada’s airline industry has tried playing the consolidation game before and it did not benefit customers or airlines.  Worse, United Continental appears to have higher costs than when the two airlines operated independently and the attempted integration has been enormously disruptive.  The failure of the United Continental integration over the past two years should give the AMR creditors committee pause in considering a tie-up with US Airways.

INDUSTRIALS: Planes Feeling the Pains - AIRLINES slide3

In our view, consolidation will not matter for US legacy carriers because they are high cost.  In an industry with low barriers to entry, growing low cost competition and price based competition, a high cost position is a losing position.  We would avoid the equity of LCC, DAL and UAL.