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In Part I of this article, I took a look at why the airlines have historically been unprofitable since deregulation. I argued that the root of the airline industry's troubles was that deregulation caused a shift to hub and spoke networks, but that none of the carriers had sufficient scale to operate these networks efficiently. As each airline scrambled to gain market share, the industry lost all pricing power. It was in each carrier's individual interest to undercut the others' prices in order to fill more seats on routes through its own hub(s). But ultimately this type of cutthroat competition prevented the industry from remaining profitable over the course of the business cycle. The result has been a string of bankruptcies among the legacy carriers.

Now, however, conditions in the airline industry have significantly improved (but see this article for a bear case). The most dramatic evidence of this improvement is that the U.S. airline industry will be easily profitable this year, in spite of record high jet fuel prices and a very soft economy. One of the key questions that airline industry bears have to answer is this: if the airlines can earn significant profits in a weak economy/high fuel price environment, how will conditions deteriorate to the extent that these companies would lose substantial amounts of money?

One major reason why the airlines are more profitable today is that the previous bankruptcies allowed them to rework contracts and shed costs. Just as important, however, is industry consolidation. Just in the past four years, Northwest, Continental, Midwest, and AirTran have ceased to exist as independent airlines. Many industry bears claim (rightly) that individual airlines have no pricing power, but overlook the industry's ability to generate collective pricing power when the major airlines restrain capacity. It was overcapacity that undermined the industry's pricing power in the three decades after deregulation, and overcapacity was a symptom of having too many small network carriers. Larger carriers (due to their scale) can more easily reduce capacity while still offering their customers sufficient travel options to keep their business.

This effect is readily visible in looking at the airlines' respective capacity growth this year. United (UAL), the largest airline, has reduced capacity (available seat miles) by 0.2% year over year through November. Delta (DAL), which is slightly smaller than United, increased capacity by 1.2% over that same period. American (AMR), significantly smaller than United and Delta, grew capacity by 1.7% between mainline and regional growth. US Airways (LCC), which is only half the size of American, grew capacity by a slightly smaller 1.4%. For comparison, Southwest (LUV),the largest low-cost carrier, grew capacity 5.2% this year. On the whole, these numbers suggest that (Southwest aside), size does matter when considering future capacity decisions. The effect is even more stark when looking at planned capacity cuts for this fall and 2012. Of the top six U.S. carriers, only JetBlue (JBLU) plans to grow significantly next year. Delta is leading the way with significant cuts, while the other carriers are maintaining roughly flat capacity with the option to cut back if demand deteriorates.

This new found capacity discipline has already improved airline profitability. With fewer major airlines, there is a lower probability that a competitor will attempt to undercut prices. (Essentially, it's easier for the airlines to tacitly collude.) This has allowed the airlines to successfully raise airfares ten times this year (out of about twenty attempts).

Most importantly, these trends seem likely to continue in the immediate future.

American Airlines, which had previously been reticent about cutting capacity, is likely to cut capacity by as much as 10% now that it has entered bankruptcy protection (and has already announced initial cuts). I have previously argued that United and Southwest are the largest likely beneficiaries of AMR's bankruptcy, because they have the most route overlap. Those two carriers will be able to raise fares on routes for which American cuts capacity. Furthermore, it is likely that US Airways will launch a takeover bid at some point; if successful, this additional consolidation would further support capacity restraint and industry profitability. US Airways itself would be the biggest beneficiary here, since it is currently at a disadvantage as the smallest network carrier.

One last near-term catalyst for the airlines is that jet fuel prices are finally moderating. While jet fuel was priced around $3.10 in the first half of November, prices have since dropped to around $2.80. Considering that United and Delta use nearly 4 billion gallons of jet fuel a year, even a drop of this relatively small magnitude can have a substantial impact on profitability.

To conclude, there are many near-term catalysts that warrant considering a long position in the airline industry. But far more significant are the structural changes associated with consolidation. With fewer major carriers, the airline industry will be able to profit in the long term: something it previously failed to do. As investors become comfortable with these long-term prospects, airline stocks will finally begin to shine.

Source: Why The Airlines Are Finally Profitable - Part II