(Bloomberg View) -- United Continental announced plans in late January to add routes to domestic hubs, enhancing the airline’s capacity by 6 percent by 2020. United’s shares fell 11 percent the next day, and other airline stocks dropped as investors feared they would follow with capacity additions, leading to excess seats and price wars.
I’m not surprised by United’s actions or the likelihood that other airlines are following. When jet fuel costs, the airlines’ single biggest outlay, collapsed along with crude oil prices in late 2014, airline CEOs vowed they’d use the windfall to reward investors, not increase capacity. Those plans have been effective in recent years, as full planes show. But now, airlines are back to their old ways. The industry is planning to add 5 percent to capacity this year despite the recent leap in jet fuel prices, double the February 2016 level. The Labor Department’s consumer price index report Wednesday showed that airline fares fell for a third straight month in January, dropping 0.59 percent.
United’s plan follows robust growth in air traffic as business and leisure flyers recover from the recession. Air passenger growth globally is in the high single digits, above the historic average of 4 percent to 5 percent. After years of declines, revenue per passenger mile has climbed even with low fares designed to attract passengers.
The economic reality is that airlines are a high fixed-cost/low marginal-cost industry. An airline that’s scheduled to fly from Atlanta to Los Angeles has incurred all the overhead costs of management, airplanes, reservations personnel and systems and airport gates. It is locked in to the costs of pilots, flight attendants, ramp workers and gate agents for that flight. So the cost of flying an extra passenger is trivial -- a snack, soft drink and several gallons of jet fuel.
In addition, the industry is an easy entry business. Sure, planes are expensive, but lenders are eager to finance them. If the airline goes belly-up, the lender can easily fly away the collateral, though it must be sold or leased to another airline. Demand for used aircraft spills over from the growing interest for new planes. Boeing expects to deliver between 810 and 815 commercial aircraft this year, up 7 percent from the 2017 record, and received new orders for 912 last year. Airbus delivered 718 planes in 2017, up from 688 in 2016, and orders for 1,109, which raised its backlog to 7,265 from 6,874 in 2016.
Economics 101 says that, in this environment, the airline makes money in the short run as long as the passenger who fills an empty seat pays more than those tiny marginal costs. So when there’s free fare competition and excess capacity, fares -- at least for the last passengers -- will be driven to almost zero. This structure screams for consolidation of the industry into a few large carriers that would exercise cartel controls on capacity and fares, but it hasn’t developed for a number of reasons.
Mergers are a classical way of removing excess capacity, but antitrust authorities tend to frown upon airline mergers regardless of the financial health of the companies. Frequent flyer programs slow rationalization since they create customer loyalty. Major airlines use sophisticated computerized pricing models that separate price-insensitive business flyers from cost-conscious leisure flyers. Also, legacy carrier management and labor have been unwilling, until recently, to face the reality of deregulation and the resulting competition.
United averted bankruptcy in 1994 by giving 55 percent of its stock to employees in return for $4.9 billion in wage concessions. Still, the machinists’ union subsequently refused to accept further wage cuts, knowing that bankruptcy would follow and result in abrogation of their lush contracts. United’s pilots only agreed to concessions with the understanding that their pay would jump 22 percent between 2004 and 2007, fully restoring the reductions. Wishful thinking! United’s share price surged in the years following the employee stock deal, but the airline still filed for bankruptcy in December 2002.
Major airlines do their best to keep out low-cost upstarts. A report by Connan Snider and Jonathan W. Williams in the December 2015 Review of Economics and Statistics found that 40 percent to 50 percent of the decline in fares in markets they investigated was a result of intensified competition from low-cost carriers. Smaller carriers pay higher landing fees than large airlines and are limited in subleasing unutilized boarding gates. Also, pilot shortages affects smaller airlines more since new pilots prefer careers with established carriers.
Government regulations are barriers to entry, including compensation for denied bookings, a mandatory 30-minute advance notice for flight status changes, and rules on handling tarmac delays. It’s estimated that regulations cost the airline industry more than $1.5 billion annually. The $5 billion that Washington gave air carriers after the Sept. 11, 2011, terrorist attacks and additional loan guarantees also set back the natural economic process of creative destruction.
A very important deterrent to consolidation in the airline industry is the cost-cutting opportunities through bankruptcy. This makes it possible to cancel labor contracts and to dump defined-benefit pension fund obligations on the federal government’s Pension Benefit Guaranty Corp. Bankruptcy also allows airlines to drastically reduce or even eliminate debt, to say nothing of essentially wiping out stockholders. With all these advantages, it’s no wonder airlines have entered bankruptcy 200 times since 1979.
With these many deterrents to consolidation, expect airlines to continue their historic pattern of adding too much capacity and then resorting to fare wars that lead once again to a declines in real passenger revenue miles. Further bankruptcies are probably likely. That may have something to do with U.S. airlines selling at 12.7 times earnings on average versus 26.3 for the S&P 500 Index.
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A. Gary Shilling is president of A. Gary Shilling & Co., a New Jersey consultancy, and author of “The Age of Deleveraging: Investment Strategies for a Decade of Slow Growth and Deflation.”
To contact the author of this story: Gary Shilling at agshilling@bloomberg.net.
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