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The airline industry has long been an unprofitable industry, plagued by nearly every external force surrounding it. The industry is characterized by intense competition, threat of substitution, threat of new entry, and strong buyer/supplier power, which lead to dangerously low profit margins. To make things even worse, the airline industry is also adversely affected by volatile fuel prices and economic conditions. This report is the second of many to help investors truly understand how the airline industry works, and the factors influencing it. This report is the continuation of my analysis of the airline industry; focusing on helping investors understand why and how the airline industry operates and which airlines are positioned for the greatest success.

Since 9/11, the airline industry has experienced rapid changes adversely affecting each player, from rapid fluctuations in fuel prices and a terribly weak economy over the decade to industry-wide consolidation and the creation of strategic alliances.

Industry Consolidation

Since 2001, airlines have experienced consolidation through 12 mergers and acquisitions. We've also seen growth in strategic alliances this decade, spurring off from Star Alliance's success since 1997. A strategic alliance isn't consolidation in the sense of smaller companies merging into bigger ones, however, the partnership acts in a same manner. In terms of mergers, probably the most notable comes from the merger of Delta (DAL) airlines into Northwest Airlines, helping them become the largest carrier by passengers in 2008. The current ongoing merger between United and Continental (CAL) is off to a bumpy start; I even heard the flight attendants bickering about the transition during my last flight. Also, American Airlines' recently declared bankruptcy and is speculated to merge with US Airways (LCC).

Presumed Benefits of Consolidation

The primary benefit of consolidation is the industry's reclaiming of pricing power over their consumers. Traditionally, consolidation was done through mergers of smaller companies into larger ones, but we've seen a new trend with alliance programs.

In 2005, American Airlines (AMR), Delta, United (UAL), and Southwest (LUV) airlines controlled roughly half of the airline market share, said analyst Jamie Baker of JPMorgan Chase. He also went on to say:

If US Airways and American successfully merge, close to 90 percent will be concentrated in the hands of just four airlines… Four airlines with 90% market share represent the optimal industry structure and should allow for consistent return generation going forward, in our view.

If the merger between US Airways and American Airlines does successfully go through, I believe airline profitability will increase tremendously. Not only will there be consolidated power through mergers and acquisitions, which undoubtedly increases the airlines' pricing power, but also the conglomeration of the industry through strategic alliances will further increase and consolidate that power into the hands of a few. With minimized competition and increased industry power, the airline industry will actually be able to command profitable fare rates.

The Star Alliance program is, in my opinion, a genius strategy to regaining pricing control. It eliminates the undercutting of those participants within the program, allowing them to mandate higher price points while reducing excess capacity. Instead of the slower approach to merging into consolidation, strategic alliances are quick and efficient ways for airlines to transcend from a highly competitive market to more of an oligopoly-style market. It's the most effective reclaiming of pricing power since the deregulation of the airline industry in 1978.

Alliance programs also help tremendously in reducing costs in promoting customer loyalty. The greatest drawback to traditional rewards programs is that you can only redeem the reward from one airline provider, although many of us use several airlines depending on the cheapest airfare, resulting in less "sticky" customer loyalty because of the often limited choices provided to consumers by just one airline. Strategic alliances, like Star Alliance, help promote and create very strong customer loyalty by providing them with a multitude of airlines to choose from, while still receiving bonuses and awards. Strategic partnerships also help reduce the overall marketing costs in retaining, and growing, market share. In addition, the benefits provided by Star Alliance, which harbors 25 different airlines, is far greater than the benefits provided by merely one airline. Not only do members of Star Alliance redeem bonus miles regardless of which airline they use in the alliance, they also have the luxury of utilizing 950 exclusive Star Alliance lounges worldwide. Members of any program want to feel rewarded and the exclusivity of a Star Alliance lounge reinforces the positive association of being an exclusive member. We've seen this effect of consumers seeking status and exclusivity in the massive boom of fake high-end apparel. People want to feel like they're part of an exclusive group and, when given the opportunity, they jump for it.

Current Impact of Low-Cost Carriers

Southwest has been, by far and large, the most successful domestic airline in the industry. Even in the midst of the steepest losses recorded in the airline industry, Southwest continued its 39th consecutive year of profitability in 2011 in an industry that has seen 180 bankruptcies since 1978 (Morning Star). Their business plan is simple: provide a service at the cheapest possible rate.

Low-cost carriers utilize consumer price elasticity to their benefit by creating a "no frills" airline, translating in savings they pass onto their consumers. Southwest was the first and is still currently the reigning champion of this business model, although competitors like United Airlines tried, but failed with a similar no frills model. Southwest's particular success comes from a combination of multiple factors including: a highly incentivized workforce, efficient point-to-point networking, and utilizing economies of scale.

Most legacy airlines are in a constant battle with their labor force; constantly renegotiating their agreements, slashing their pay, and viewing them as a bulwark to get around. Southwest has maximized the utilization of their workforce through giving them a large stake in the company. Even though 82% of Southwest's labor force is unionized, they work in harmony with management because of their incentivized pay structure (Solano). This gives Southwest a competitive advantage to all its competitors: a workforce with a deep sense of loyalty. As a result, Southwest has a record 15-minute turnover rate and continues to set the standard for the industry.

Southwest has also done away with the traditional hub-and-spoke model, which requires tremendous infrastructure to utilize. Instead, they use a point-to-point networking model, which essentially acts like a bus making its way around the country; picking up and dropping off passengers at each location. Also, Southwest avoids paying the excessive fees charged by larger airports by flying into second-tier airports. To increase efficiency, Southwest uses only one aircraft, the Boeing 737 (and Boeing 717 after merging with AirTran) which has contributed to their 15-minute turnover rate and reduced maintenance costs. Historically, in utilizing only one aircraft, Southwest has optimized its economies of scales, by creating a workforce that's homogeneous in their expertise; instead of having multiple different crews for different planes, Southwest's entire crew is perfectly familiar with one aircraft.

When combining the all the factors that play into Southwest's business model, it's not a surprise that they have the lowest operating expense per Available Seat Mile of 12.96 cents; this is painfully obvious when compared to Delta Airline's 14.76 cent cost, a 13.9% difference which affects bottom-line profitability tremendously, especially in this industry.

The effects of low-cost carriers have been pretty apparent, especially in recent history with the economy slowing and consumers becoming more price-sensitive. Airlines all across the board, even legacy airlines, have been forced to shift toward a "no frills" approach, regardless of their choice. They don't have a choice. Consumers have become extremely price-sensitive during our most recent economic downturn, which has resulted in multibillion-dollar losses for airlines charging price premiums for additional services that people would rather not pay for.

All airlines have realized this and the effects have taken place rapidly. We've seen airfare rates stagnate amid inflation over the decade because of the weak pricing power legacy carriers had from threats of substitution and competitors -- especially low-cost carriers. Also, the fact that low-cost carriers have lower break-even points has allowed them to remain profitable, while the rest of the industry has experienced tremendous losses, despite their efforts to mimic the no frills approach. I find it amazing how in the first quarter of 2000, the breakeven load factor for most airlines, like American, Alaska, Continental, and Delta, was 77.7%, which jumped to 114% in the first quarter of 2003, all while the breakeven load factor for Southwest remained below 70% (RITA). It's a perfect illustration of how low-cost carriers can utilize the high fixed cost model to their advantage; by minimizing total costs, they can attain breakeven points at manageable load factors and remain profitable, despite adverse economic conditions.

Impact of Low-Cost Carriers in a Post-Consolidated Industry

In a post-consolidated airline industry (if America Airline's merger goes through), we'll see 90% of the domestic airline market controlled by (the new) American Airlines, United, Delta, and Southwest. Of these four airlines, Southwest is the most successful low-cost carrier and will reap the most benefits from an industry with higher pricing power. In a post-consolidated industry, I see a shift from the traditional business models of American, United, and Delta to the modern model utilized by Southwest. With Southwest expanding into more airports, especially after its merger with AirTran, giving it access to 37 new markets, legacy airlines will have to compete on a competitive price-point with Southwest; otherwise, their bottom line profitability will suffer as a result of Southwest, and other low-cost carriers, picking up the price sensitive customers. Essentially, if legacy carriers can't create a cost structure that resembles that of low-cost carriers', then they'll experience excess capacity while low-cost carriers reap the benefits of higher passenger loads from consumers they've picked up because of a price-point advantage.

The impact of low-cost carriers in the airline industry prevents legacy carriers from having complete price control of the market; however, we will still see an increase in airfares in the coming years. The airlines that will profit most, especially during the ongoing weak economy, will be those will the lowest breakeven load factors. I don't believe we'll see a shift anytime soon to service based airlines and will see a homogenizing effect of the entire airline industry. Basically, the only differentiating factor may become the airline's name on the plane. We've already seen this shift occurring and will see it transgress more rapidly as the soft economy stagnates with recovery, amid increasing operational costs associated with fuel and aging aircraft costs.

Consensus

Since the deregulation of Airlines in 1978 we've seen such intense airline competition that the industry has experienced 180 bankruptcies since; however, the most rapid and pressing changes have occurred after the 9/11 terrorist attacks. Amid a soft economy, the terrorist attacks helped plunge airline profitability to historic lows. President Bush enacted the Aviation and Transportation Security act, which gave rise to the TSA we have today. With the act came a flow of security regulations that directly attacked the profitability of airlines. In 1992, government tax on one-stop domestic flight airfare was 13%, but has now risen to 20%, attributing to the immensely difficult task of attaining profitable margins. During 2011, "special" aviation taxes sucked $17.74 billion from the airline industry, with $3.66 billion going directly to the Department of Homeland Security.

The current status of the U.S. domestic airline industry is highly complicated. We've seen a very sharp drop in jet fuel prices in the past month, which helps reduce operational costs; however, the sharp drop comes from grim reports of our global and domestic economy. We're operating in a highly globalized economy and, in our current economic state, are vulnerable to global economic downturns. China and India's economy is slowing, while Greece is on the verge of default and Spain is facing a drying banking system. Recently, we've experienced a very disappointing report on employment, with only 68,000 jobs added; a far cry from the expected 150,000, pushing unemployment from 8.1% to 8.2%. These are all factors that affect consumer behavior in the United States and we may experience a pullback in consumer spending on airfare for the short-term, until we see better economic news.

For now, though, low-cost carriers, like Southwest, will benefit the most from the light of recent news -- or, should I say, suffer the least. Consumers considering flying will consider a future economic slowdown and may opt to low-cost carriers for cost saving measures.

Overall, we've seen tremendous change surrounding the airline industry over the past century, most of which occurring in the past few decades. Since 2001, the airline industry has gone through a tremendously difficult rough patch, with continued grim prospects for the future. Issues of excess capacity, intense competition, rising operational costs, and a tepid global and domestic economy have plagued airline profitability over the past decade. Consolidation through mergers and strategic alliances will undoubtedly shift pricing power back to the airlines, allowing them to mandate more profitable airfares, and will also aid in decreasing excess capacity. Essentially, the airline industry is going through a liposuction now, trimming off services and costs, to create more manageable breakeven load factors. We'll see a shift toward a higher efficiency, lower cost, and "no frills" approach for the foreseeable future as airlines continue homogenize their services, likely making their airline's name the only point of differentiation.

Disclaimer: Please read my standard disclaimer for my articles here.

Source: In-Depth Drilldown Of The Airline Industry - Part 2