Why Jim Cramer Is Dead Wrong About Airlines

Jim Cramer did the unthinkable this week, recommending an airline stock to "Mad Money" viewers. Cramer admits that he has never been a fan of airlines, but he is now bullish on the sector and especially US Airways (UNKNOWN: LCC.DL  ) . He thinks that the company's planned merger with American Airlines (UNKNOWN: AAMRQ.DL  ) will be a rousing success and send the stock higher. However, negotiating a merger with American Airlines was the easy part for US Airways: now CEO Doug Parker and his team need to integrate two major airlines, which will be incredibly difficult. As an investor, it's probably best to stay away until the integration is complete and the company proves its profitability.

Bad timing
As an investor, if you had put some US Airways stock in your grocery cart along with your turkey on the day before Thanksgiving in 2011, you would be sitting on a better than 250% gain today. US Airways has rallied from below $4 then to $14.57 as of Wednesday's close.

LCC Chart

US Airways Stock Chart, data by YCharts

Cramer is thus late to the action, and investors who follow him will be late as well. The current US Airways trading price implies that the post-merger American Airlines will be worth approximately $10.5 billion. While that's less than Delta Air Lines' (NYSE: DAL  ) $13.3 billion valuation, it is higher than United Continental's (NYSE: UAL  ) $9.8 billion market cap. United is a much better comparison case, because it is in the midst of a merger integration, just as US Airways and American will be for the next few years. On that basis, US Airways stock doesn't seem like such a bargain.

Growing competition
Cramer's main justification for liking the airline industry now is that consolidation has greatly reduced competition. Following the American-US Airways merger, 80% of domestic traffic will be handled by just four carriers: American, United, Delta, and Southwest Airlines (NYSE: LUV  ) . However, competition among those four will remain fierce, and the new American could find itself threatened by the others in certain markets. Furthermore, new competition is arising, particularly the rapid growth of ultra-low-cost carrier Spirit Airlines (NASDAQ: SAVE  ) .

Delta is making a push to grow in two key markets where American maintains hubs: New York and Los Angeles. American's joint venture with British Airways currently dominates the JFK-Heathrow route, which is by far the most important international route from the U.S. However, Delta recently bought a 49% stake in Virgin Atlantic, and announced a joint venture that will give the two carriers seven daily nonstop flights from JFK to Heathrow, along with two nonstops from nearby Newark Airport to Heathrow. This will make Delta's offering much more competitive, and complements its "win in New York" strategy. Delta now dominates LaGuardia Airport and is the leading carrier at JFK, while United dominates Newark; the "new" American is clearly behind in New York. American is also under threat in Los Angeles, where it already trails United, and Delta is expanding capacity by more than 10% this summer.

Furthermore, competition from Southwest is poised to ramp up in two markets that American and US Airways currently dominate: Charlotte and Dallas. Southwest has never served Charlotte, but it "acquired" a few flights from Atlanta and Baltimore when it bought AirTran in 2011. Next month, it will begin serving Charlotte with Southwest airplanes for the first time, with four initial destinations. This is a small start, but Southwest has grown rapidly in other markets where it has attacked an entrenched legacy carrier, such as Denver. Meanwhile, the repeal of the Wright Amendment in late 2014 will allow Southwest to grow its operations in Dallas, whereas Southwest was previously barred from flying nonstop from its base at Love Field to the West Coast, the East Coast, and the Midwest.

Lastly, Spirit Airlines is attacking American's hubs in Dallas and Chicago with its "ultra-low-cost" model. While Spirit is a niche carrier with only 45 aircraft at the end of 2012, it is growing rapidly and has ordered more than 100 additional aircraft for delivery over the next decade. Spirit entered Dallas (a market dominated by American) in May 2011 with just two destinations and four flights a day. Less than two years later, it offers 22 nonstops to fifteen destinations, with seven more destinations to be added this spring. With costs approximately 40% below legacy carriers (including American), Spirit can underprice them to rapidly gain market share. Spirit's rapid growth in some of American's core markets is thus a worrisome trend.

Merger integration pain
Cramer's supposition that competition is decreasing seems incorrect. However, at an even more basic level, the process of integrating American and US Airways will involve significant costs, and mistakes are virtually inevitable. Management currently expects $1.2 billion of one-time integration costs, as well as $400 million of increased pay annually, primarily for US Airways workers who have long earned well below the industry average.

These known costs are expected to be offset by nearly $1.5 billion in revenue and cost synergies by 2015. If integration goes well, that target may be achievable. However, the case of United Continental shows how difficult merger integration can be. Leading up to the March, 2012 integration of United and Continental technology systems, the United management team was confident that the "cutover" would be smooth, after having done several dry runs. Instead, the cutover was a disaster, and the resulting fallout was a major reason why United's adjusted profit dropped by more than 50% in 2012.

The moral of the story is that even when management thinks it has planned for every integration contingency, major problems can crop up. Integrating two large and complex organizations is an extremely difficult task. The resulting risk of owning US Airways as it tries to integrate with American Airlines makes it unwise to invest in the company right now.

I have dealt here with just two of the potential stumbling blocks ahead of US Airways and American Airlines. Other possible problems include its weak position in Asia (you can count the combined carriers' routes to Asia on your fingers) and a low ranking in the Airline Quality Rating survey.

Consolidation is helping the airlines, but that benefit is offset in the case of US Airways by the costs and risks of integration, as well as the entry of Southwest and Spirit into several US Airways and American Airlines hubs, where they may put pressure on fares and depress margins. That's why I think you should ignore Cramer, and stay away from US Airways for now. Do you disagree? Leave a comment for me below.

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Read/Post Comments (15) | Recommend This Article (18)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 09, 2013, at 7:51 PM, tgnytg wrote:

    "The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down."

    — Warren Buffett, annual letter to Berkshire Hathaway shareholders, February 2008

  • Report this Comment On March 09, 2013, at 8:43 PM, borneofan wrote:

    I would prefer to compare southwest, allegiant, spirit, jet blue statistics to the mostly bankrupt former monopoly regulated carriers. That might be more informative than throwing egg on Cramer, though he dearly deserves it with his ceaseless calls and predictions.

  • Report this Comment On March 09, 2013, at 11:24 PM, mvwoolner wrote:

    Was it Buffet who said tht the fastest way to become a millionaire was to start as a billionaire and buy an airline?

  • Report this Comment On March 09, 2013, at 11:43 PM, inmocean wrote:

    Buffett should know; he bought a boatload of USAirways senior convertible preferred in 1989 when it was about $50/share, although he was eventually able to unload it with a positive total return.

    I usually fly out of Washington DC, and US Airways is usually, if not always, the highest ticket price airline. I'll be very surprised if they reduce ticket prices; I have no idea why anyone would fly them.

  • Report this Comment On March 10, 2013, at 12:19 PM, TMFGemHunter wrote:

    @inmocean: US Airways has a huge share of the slots at Reagan Airport, which is far more convenient for most people in DC than Dulles or BWI; that lets them jack up the prices.

    @mvwoolner: I think it was actually Richard Branson. He would know, since he actually did it...

    @borneofan: I've written about the smaller carriers elsewhere on the site. The only I really like is Allegiant. The others are all good businesses, but I don't feel as comfortable with their long-run competitive positioning.

    @tqnytq: the Buffett quote doesn't actually say much about the airline industry today, which isn't growing aside from a few smaller carriers, and which has been profitable for several years now.

  • Report this Comment On March 15, 2013, at 3:45 PM, paskows wrote:

    What about American at around $4? I believe it will continue to go up into the third quarter before the merger actually begins. Besides British American has a similar arrangement with Iberia and their hub in Miami dominates Latin America and is strong in the Caribbean.

  • Report this Comment On March 15, 2013, at 7:43 PM, SanDiegoHJP wrote:

    Are some of these old legacy airlines too BIG or too 'brankrupt' to ever go out of business.

    AMR's stock price from on high had a crash landing at close to $0.00. A low of about 20 cents, now increased 15 times to $3 and up. Can it increase another 10-fold to $30?

    That seems a better investment on a risk-reward basis than US Airways!

  • Report this Comment On March 15, 2013, at 7:47 PM, TMFGemHunter wrote:

    American is a very risky investment at this point. Most of the stock in the "new American" is going to shareholders of US Airways, creditors of American Airlines, and American's labor unions. AMR shareholders are only guaranteed 3.5% of the company, which puts the share value at $1.20-$1.30. The stock is trading for more than that because people are hoping that there will be extra stock left over after paying the creditors claims.

    It's possible that American will go up, but there's also a very good chance that it will lose two-thirds of its value in the next few months. It is very hard to fix the odds on what will happen, because it depends on the company's ultimate valuation after it merges with US Airways and comes out of bankruptcy. To make a long story short, I'd advise staying away.

  • Report this Comment On March 15, 2013, at 7:50 PM, TMFGemHunter wrote:

    @SanDiegoHJP: I can guarantee you that AMR stock will not go up 10 fold. The company is already valued at more than $1 billion, despite being legally bankrupt.

  • Report this Comment On March 16, 2013, at 12:56 PM, SINODOG wrote:

    Cramer's dilemma is that he often sees safety (a good thing) in large numbers. Therefore, he can be late (or not at all) to the party, and is attracted to what he perceives as safety, rather than risk a bit on a disrupter. I would never want to place a big bet on big Airlines, but I'd rather hedge with a smaller bet on say a Spirit. If American does as well as expected, Spirit should see considerable growth with manageability . Unfortunately, between big government , big unions and big debt (in order of priority , it becomes impossible to manage a big Airline.

  • Report this Comment On March 18, 2013, at 8:51 PM, 3l1ngeniero wrote:

    Why we even dignify Cramer with an article in TMF is beyond me.

  • Report this Comment On March 18, 2013, at 9:08 PM, thunderboltnova wrote:

    Cramer will go down in history as one of the worse stock investors of all time. It's no wonder he longer runs a hedge fund. He's only on TV because of his crazy personality and not based on his knowledge or experience.

  • Report this Comment On March 19, 2013, at 5:12 PM, ekchan wrote:

    So far USAir is up 13% for me, since Jim Cramer's recommendation....Also, thanks Professor Cramer for my double digit gains in VZ, VOD, eBay, CVS & AMZN.....Jim's input is one data point for the individual investor....Jim is not perfect....but I value his views...and Motley Fools views....I appreciate their valuable data points .....per Coach Cramer, do your homework.....Booyah !!

  • Report this Comment On November 27, 2013, at 12:00 AM, steveand5 wrote:

    TMFGemHunter: I'm curious to know if you now regret your article proclaiming Jim Cramer is "Dead Wrong" about airlines? Somebody was dead wrong but it wasn't Jim Cramer...

    By the way, you need to get out and fly somewhere, anywhere because the game has changed and the days of Warren Buffett investing or not investing in airlines is over. The fundamentals are in place to make money consistently in this segment and if you don't believe me then try and take a flight where there's more than 1 empty seat and you aren't charged for something - baggage, seat changes, food, internet, movies, etc.

  • Report this Comment On April 23, 2014, at 4:36 PM, U142536 wrote:

    Now that the dust has settled with the merger and we are AAL, I sure am glad that I didn't listen to naysayers and pass up this opportunity. My money has quadrupled and still going up!

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