Airlines: The Coming Days Will Test The Power Of The Oligopoly

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Includes: AAL, DAL, LUV, UAL
by: Michael Liu

Summary

A feared price war in the airline industry has driven all four major US airlines' stocks down ~10% since just weeks ago.

The airline oligopoly was made to resist such price wars, and competition like the ones that plagued the industry years ago, making it largely uninvestable.

This article will go through the possibility of a price war in the airline industry, the likeliness of one happening, and its probably repercussions.

Airlines have been massacred lately, with all four leading US airlines (American Airlines (NASDAQ:AAL), Delta (NYSE:DAL), United (NASDAQ:UAL), and Southwest (NYSE:LUV)) down about 10% from their respective highs set two weeks ago. This drop came after Southwest Airline's decision to increase fleet capacity 7%, and American Airline's response that they will "compete aggressively" on price to retain customers from low-cost carriers resulting from capacity increases. This was code word for "price war" in the eyes of many investors, who abruptly sold their positions.

These actions seem to have triggered 'deja vu' responses from some investors, who, thinking back to the numerous price wars and subsequent bankruptcies years ago, believed that the same would happen in the current day. However, airline bulls cite the airline oligopoly, where the aforementioned four biggest US airlines own majority market share, as reason to believe that this price war will not fully develop nor move customers and sales significantly to different airlines.

In theory, competition and competitive advantages in oligopolies are driven by service, brand recognition, and other qualitative factors, and are rarely driven by price. It's therefore interesting as to why American Airline's management would even find the need to compete with Southwest and other airlines on price, if they know that their company operates in an oligopoly. It could suggest that they don't believe the current competitive environment to have a significant amount of apathy towards price, and therefore allow for significant market share gain through a successful price war. Of course, this would, in effect, ruin the whole point of industry consolidation and oligopolies.

If a price war does develop in airlines, the repercussions would be catastrophic. The current investment theses for most airlines are cheapness on a P/E basis and fast growth. However, a price war would effectively wipe out the 'E' in P/E, thus automatically valuing all airlines higher. Also, many current and past investors would either sell or short the companies, again drawing similarities between now and the past, unconsolidated competitive environment.

Of course, the near $10 billion wiped out from airline stocks in the past month was also just the result of one comment from American Airline's CEO, Doug Parker, saying they would compete on price. This comment could mean various things and be for various reasons. American Airlines is in a unique situation in the airline industry, as its US Airways merger happened less than two years ago, and they are still realizing cost-lowering synergies from that merger. Also, American Airlines has famously left its fuel purchases unhedged, and, while competitors still have lingering hedges from oil at its peak, American Airlines is enjoying the full effect of $60 oil. It's likely that Parker simply sees a better cost advantage for American Airlines over the other airlines resulting from its current situation, and therefore found reason to provide this comment, because he knew that, if pressured, he could easily execute on his promise.

This could be viewed both negatively and positively. The good news is that this would mean that other airlines would not get involved (unless forced) in the price war, if it happens, as they don't have the means or the motivation to go out fighting American Airlines. It could also just be Parker trying to remind other airlines that American Airlines still has significant cost advantages, for the time being, over them, and so airlines like Southwest should think twice before trying to steal customers on price. Also, because American Airline's company performance is so contingent on oil price, as oppose to hedged competitors such as Southwest, I doubt Parker would be very keen on starting a price war, especially when oil prices are so volatile and a sharp increase could put Southwest and Delta at a significant cost advantage to American Airlines. Furthermore, I doubt any airlines would be very keen on undoing the years they spent building the current oligopoly. The past year has also shown that, even as oil prices dropped and costs for the airlines got reduced, no one thought of dropping air fares until now, showing that the airline oligopoly may have a considerable amount of strength. Lastly, the four major airlines don't have a lot of overlap in terms of the routes that each takes, so its questionable as to whether price will actually move customers from airline to airline. This could also suggest that Southwest and American Airline's competition may be a special case between the two companies on their overlapping routes, instead of a full out price war involving the entire airline industry.

However, if either Southwest's or American Airline's competitive measures gains them considerable traction in the market, Delta and United will likely join in the fight, not necessarily because they would want to, but because they have an obligation to shareholders to try and maximize long-term value, and gaining customers now, even if it lowers short-term earnings, should pay off in the long run. Furthermore, price wars in the airline industry could just be the start of actual competition in the oligopoly; if one can compete effectively on price, then wouldn't other aspects, such as geographical service, be worth pursuing too? This would be the catastrophic event I talked about before, and would likely have a significantly negative impact on the future of the airline industry by erasing earnings, and therefore valuation, from the airlines, and causing mass investor panic, much like days before industry consolidation.

In conclusion, the coming months will be the first test as to the true power of the airline oligopoly. Will the feared price war happen or not? If it does, the success of any airline is largely dependent on oil price. If oil goes even lower, major hedgers like Southwest and Delta will be stuck with higher-priced oil and higher costs, while non-hedger American Airlines will get the full benefits of lower oil prices, combined with its cost-reducing synergies from the US Airways merger. United will likely fall into the middle with its only minor hedges. If oil surges higher, the opposite will likely happen. However, no matter who ends up 'winning' the price war, it's likely that all airline stocks will be down, with the market returning to pre-consolidation fears of the airline industry. Also, it's earnings will become especially depressed, as a result of radical cost-reductions in airfares.

It's also possible that all of this was just over-exaggerated noise in the airline industry that will never actually happen. In this case, airlines will likely have significant upside, not only making back their losses since the beginning of the month, but also over the long-term, as investors realize that the old airline industry is gone, and that the new one is both sustainable and full of high-quality companies.

Either way, investors in airlines should pay special attention to what happens to the airline industry in the next few months, as it will likely decide the long-term future of the four major US airlines.

Disclosure: The author is long AAL.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have a long position in AAL for the main purpose of hedging other oil-related stocks.