Airline stocks performed very well in the first quarter of 2013, as investors became optimistic that consolidation would improve the industry's pricing power. However, the party ended when several airlines reported that last-minute bookings had suffered in March because of the sequester. Delta Air Lines (NYSE:DAL), US Airways (NYSE:LCC), and American Airlines (NASDAQOTH:AAMRQ) all posted weaker than expected March revenue results.
In the past two weeks, more bad news about the economy (and travel demand) has emerged. The U.S. economy added only 88,000 jobs in March, less than half of what economists expected. The government also reported a disappointing drop in retail sales for March. Airlines with significant exposure to China, like United Continental (NYSE:UAL), have additional worries: an outbreak of bird flu and a slowdown in growth in China.
On the other hand, airlines are on pace to see a big windfall from lower jet fuel prices this year. New York Harbor jet fuel peaked at approximately $3.34 per gallon back in February, but falling oil prices have pulled the jet fuel spot price down as low as $2.74 per gallon on Tuesday morning. If oil prices remain near current levels, the performance of airlines this summer will depend heavily on the industry's pricing discipline. If the airlines can avoid a destructive price war, the industry will in all likelihood achieve record profits. However, if some airlines try to take advantage of lower fuel prices to gain market share through heavy discounting, airline stocks could be in for a rough year.
Fuel savings vs. lower demand
The cost savings from lower fuel prices could be substantial for U.S. airlines. United Airlines used just over 4 billion gallons of fuel last year, while Delta was not far behind with nearly 3.8 billion gallons of jet fuel consumed. After its merger with US Airways, American will use a comparable amount of fuel. Over the course of a full year, a $0.50 drop in the average price of jet fuel will save roughly $2 billion for these major airlines. For comparison, Delta (the most profitable network carrier) earned non-GAAP net income of $1.55 billion last year. Thus, if a large proportion of the savings on fuel cost falls to the bottom line, it will have a significant positive effect on airline profitability.
However, airlines historically have had trouble maintaining pricing discipline when fuel prices fall. New airline bulls like Jim Cramer believe that things are different now: Consolidation through mergers (not to mention bankruptcies) has reduced competition and improved pricing power. I am more skeptical. While Delta seems well-positioned based on its improving cost structure, I think the industry as a whole has already realized most of its upside.
The problem for the major airlines is that the recent drop in oil prices is being driven by weakness in global demand. In the U.S. specifically, higher taxes and lower government spending are curbing economic growth, which will hurt demand for air travel. In March, Delta and US Airways were already seeing fewer bookings by government agencies as they look to cut their budgets. Falling oil prices are also leading to lower gas prices for Americans, which may encourage some people to go on driving vacations rather than flying.
With sluggish demand, airlines could see summer ticket sales fall below expectations. At this point, while they can make minor cuts to their schedules, most of their summer capacity is locked in. This puts the airlines in a "use it or lose it" situation; it's usually best to sell seats at a discount if the alternative is leaving them empty. The major airlines' conundrum could be aggravated if low-cost carriers cut prices to chase market share. Spirit Airlines (NASDAQ:SAVE), which is growing capacity at a 20% clip, is particularly likely to follow this strategy. As a result, I expect much of the benefit of lower jet fuel prices to be passed through to consumers, rather than boosting airline profits into the stratosphere.
Foolish bottom line
This summer will be "crunch time" for the airlines. If the airlines can maintain collective pricing discipline despite lower fuel prices and sluggish demand, profits will soar. However, based on recent demand patterns, I believe airlines may have scheduled a little too much capacity for the summer. Consumers may thus benefit from lower ticket prices as airlines pass through much of their fuel cost savings to stimulate demand.
Motley Fool contributor Adam Levine-Weinberg is short shares of United Continental Holdings and is long Sep 2013 $33 Puts on United Continental Holdings. The Motley Fool owns shares of Spirit Airlines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.