The Effect Of Financial Distress On Air Fares: A Vicious Circle?

| About: American Airlines (AAL)

As the stock price of AMR Corp. (AMR) hovers above its 52-week low, industry analysts reiterate that a major restructuring is required to restore competitiveness. It is unclear to what extent the air carrier is at risk of failing, an event which would have a negative effect on ticket prices. In general, it is put forward that air fares are discounted to compensate for the possibility of an inconvenient cessation of operations, and loss of accumulated frequent flyer and travel agent points. The lower revenue then exacerbates the airline’s financial condition, and causes an additional discounting of prices. A closer examination reveals that it is also important to consider the airline’s operating costs, size, market share, as well as the market concentration.

Research indicates that there is an inverse relationship between financial distress and airline ticket prices. Other things being equal, a one percentage point increase in the firm’s distress score (the study uses the Altman Z-score for non-manufacturer industrials) brings about a 3.6% decline in prices (see Table 1). A second regression equation is calculated to determine how financial distress interacts with operating costs, firm size, market share, and the market concentration.
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The authors posit that higher costs per available seat mile counter the fall in air fares caused by financial distress. In other words, compared with a low cost firm, the financially distressed high cost airline discounts prices to a lesser degree. As a result of its higher costs, the airline has a lower profit margin, and is less likely to offer substantially discounted fares. As Exhibit 1 indicates, American is considered to be a higher-cost operator.
The authors also argue that larger firms (where total assets defines size) exhibit more aggressive pricing behavior. That is, compared with a small firm, the financially distressed major air carrier lowers prices to a greater degree. The aggressive pricing is attributed to greater stakeholder concessions and economies of scale in reorganization. In the last decade, major air carriers such as United, Northwest, and Delta emerged from bankruptcy protection, whereas niche airlines such as Independence, Maxjet, and ATA discontinued operations. Moreover, the network carriers were accused of using bankruptcy protection to offer distressed fares for a lengthy period of time.
The study indicates that a high market share (in terms of passengers carried on the route) counters the negative effect of financial distress on prices. Compared with a firm with a low market share, the financially distressed high market share airline reduces prices to a lesser degree. Assuming the high market share reflects high customer switching costs, and/or a superior schedule, it is not as necessary to engage in price-based competition. Thus, ticket prices in the Dallas/Ft. Worth and Miami markets would be discounted the least (see Table 2).
It is also found that a high market concentration exacerbates the decline in prices caused by financial distress. Compared with a firm competing in a low concentration market, the high concentration market airline lowers air fares to a greater degree. Financial distress is said to threaten the collusive arrangement among the few sellers, and induce price-based competition.
The investment thesis that a financially distressed American would adversely influence industry profitably is an oversimplification as it ignores the effects of operating costs, firm size, market share, and market concentration. Research suggests that American’s operating costs and high market share (particularly in Dallas/Ft. Worth and Miami) would counter the fall in air fares caused by financial distress, whereas the market concentration and firm size would worsen the reduction of prices. Ultimately, the magnitude of the effects would remain to be seen.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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