The Airline Industry Needs More Consolidation

by: Vaughn Cordle, CFA

Legally and financially, the airlines that file bankruptcy have failed. After a bankrupt company emerges, it's a new legal entity that may or may not succeed. So far, Delta (combined with Northwest), United (combined with Continental), and US Airways (combined with America West) are reporting profits. However, they will produce a negative return on the weighted average cost of capital in 2011 because of weak economic growth and higher fuel costs.

This is also the case for recently merged Southwest Airlines and AirTran. The total shortfall for the passenger-only industry in 2011 is around $5 billion. 2012 will likely be a better year for profits, but those profits will still be too low (in my estimation) given the required rate of return on capital.

Some airline brands are kept alive after restructuring because they are valuable franchises with name equity and infrastructures that has the potential to produce an adequate return. In terms of magnitude, it has always been the reductions in labor costs (increased productivity, lower pension/health care costs and obligations) that enabled the large network airlines to emerge successfully from bankruptcy.

Those airlines are still over-leveraged with high costs, but have been profitable after the mergers. They will continue to be profitable if labor costs remain appropriate for the expected revenue produced from assets employed. Fuel costs are the wild card in terms of determining how much value labor can extract from the business as new contracts are negotiated.

Based on our recent industry concentration analysis for an institutional investor, a case can be made that the optimal number of large network airlines is three in the U. S., with a handful of lower-fare, lower-cost airlines providing mostly point-to-point flights. Therefore, it is my belief that the industry still needs at least one more major merger, in addition to a restructuring of the commuter segment.

There are over 20 commuter airlines that need to be consolidated into a smaller number of competitors. Then this segment would be optimally structured for the network airlines that contract out (or wholly own) this type of capacity and feed. This process is already underway as the segment has already consolidated by 25% and several commuters are in financial trouble.

The fragmented commuter segment benefits the large networks because of labor arbitrage that keeps costs and fares competitive in the short-haul markets. And, it's a strategic way to fend off the lower-cost airlines from taking too much market share from key hubs, as well as providing the higher frequency of flights that passengers value.

What might be considered an optimal structure today will likely not be the best structure in the future. The airline industry and its various business units continuously morph into organizations that can better compete in a more competitive and global marketplace. It's a marketplace with decreasing restrictions on capital flows and business formations.

Perhaps at some distant point in the future, the large (and recently merged) network airlines may have to be broken up into smaller units if their efficiencies and costs do not produce the profitability for the business that must attract and maintain the support of its shareholders.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.