The New Airline Oligopoly Won't Last Long

Many consumer advocates are worried that consolidation in the U.S. airline industry is creating an oligopoly. After AMR and US Airways close their merger next week, there will be just three network airlines left: Delta Air Lines (NYSE: DAL  ) and United Continental (NYSE: UAL  ) are the others.

Delta Air Lines led the most recent wave of airline consolidation

These three carriers, along with Southwest Airlines (NYSE: LUV  ) , will collectively dominate the industry, accounting for roughly 83% of U.S. domestic capacity. Indeed, one of the main reasons why the Department of Justice originally challenged the merger was the concern that another airline merger would undermine competition, leading to higher ticket prices.

However, any decrease in competition will be temporary. The ultimate reason is that the airline industry has relatively low barriers to entry and expansion. Airline profit margins are rising, and this has created a strong incentive for smaller carriers to grow. As smaller carriers continue to outgrow the larger ones, the competitive balance within the airline industry will improve.

Blessing in disguise
It would be natural to assume that the rise in oil prices over the last decade has hurt the major airlines. In the short run, it did, sending many into bankruptcy. However, the high fuel price environment looks like a blessing in disguise today. Not only did it force the legacy carriers to improve their cost structures, it also deterred start-ups from trying to enter the market and caused smaller carriers to grow more slowly.

For example, Virgin America is the only new airline to get off the ground in the last decade. Virgin America grew rapidly in the first five years after its founding in 2007, but it was consistently unprofitable due to the combination of high fuel prices and new route start-up costs.

Virgin America's growth has slowed in 2013, but higher profits could lead to faster expansion going forward (Photo: Virgin America)

A year ago, the company decided to address its profitability problems by canceling orders for 20 Airbus aircraft while deferring another 30 orders. This rapidly reduced its annual capacity growth rate from 28% to the mid-single digits. As a result of its slower growth, Virgin America has prospered along with the rest of the industry this year, posting big Q2 and Q3 profits.

Rebalancing
However, the burgeoning profitability of the airline industry will catalyze growth, particularly among the smaller airlines. Whereas the legacy carriers are devoted to capacity discipline -- through the first nine months of 2013, capacity grew 0.4% at Delta, 0.9% at American, and 3% at US Airways, and declined 2.6% at United -- smaller carriers see big growth opportunities.

Spirit Airlines (NASDAQ: SAVE  ) has been the most aggressive about expanding. Through the first nine months of 2013, capacity was up 21.4% year over year. Still, Spirit only represents around 1.4% of domestic industry capacity today. However, its current order book calls for doubling the size of its fleet between now and the end of 2017.

Spirit Airlines is set to continue growing rapidly over the next decade (Photo: Spirit Airlines)

By 2021, Spirit expects to hold at least 5% of the U.S. market. There is considerable upside to that number if industry conditions remain favorable. Spirit could extend the leases for aircraft currently in its fleet, and the company could also order more Airbus aircraft for delivery near the end of the decade.

While Virgin America is currently in a "growth pause", it will start receiving new aircraft in the second half of 2015. If its rapid profit improvement from this year can be sustained, Virgin America is likely to adopt a high single-digit or low double-digit growth pace thereafter.

JetBlue (NASDAQ: JBLU  ) is another carrier that is poised to gain market share over the next several years. By next year, it will be the fifth-largest U.S. carrier, and it already operates nearly 200 aircraft. Following a recent fleet restructuring, JetBlue is scheduled to take delivery of 129 new planes between 2014 and 2021.

JetBlue also plans to grow steadily over the next decade (Photo: JetBlue Airways)

Some of these new deliveries will replace older planes in JetBlue's fleet, but the majority of this order represents growth. This will add several percentage points to JetBlue's market share in the next decade.

Other smaller carriers, including Alaska AirAllegiant Travel, and Frontier Airlines, also have growth-oriented fleet plans. As a result, the 17% of domestic capacity collectively held by these smaller carriers could easily rise to 25% or more by the end of the decade, with further gains beyond that.

Tricky situation
Investors have fallen back in love with the legacy carriers this year, believing that consolidation will lead to much higher profit margins in the future. This assumes that the "Big Four" will be able to tacitly coordinate by keeping capacity constrained and raising fares.

However, the growth of smaller carriers will make this at most a short-term phenomenon. The more successful the major carriers are at raising ticket prices, the bigger the opportunity for low cost carriers to grow and thereby steal market share from the top airlines. The airline industry has relatively low barriers to entry and expansion; if profit margins expand significantly from today's levels, it will provoke a new round of growth.

Thus, it's possible that the AMR-US Airways merger will lead to lower competition in the next few years, but it won't have much of an impact on the long-term structure of the industry. Growth-oriented airlines like Spirit and JetBlue should keep fares in check and profit margins at a level not too far beyond what airlines are earning today.

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Read/Post Comments (7) | Recommend This Article (3)

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  • Report this Comment On December 03, 2013, at 5:19 AM, Tyeward wrote:

    It´s natural for people to feel that there will be a monopoly on air travel from the big 3 plus 1. I really don´t consider Southwest to be as major as people claim it is though. They just have alot of frequency to less than 100 destinations. JetBlue actually has just as big of a network as Southwest, just not as much frequency. If people are concerned so much to the point that there is fear, it might be a good idea to put pressure on LCC´s to expand their networks. LCC´s generally have lower operating costs, and who knows. In the future one might find logic in building up Pittsburgh again, St. Louis, Cincinnati, Memphis, or even RDU. The bottom line is that expansion and the potential for expansion is out there for LCC´s. They might just need to hear a very strong argument in favor of it being worth their while for that expansion. That´s up to the potential community to plead that case. You do have competition and it´s pretty healthy in the US when you really look at what is available in the airline industry.

  • Report this Comment On December 03, 2013, at 9:31 AM, ferdiefor wrote:

    Adam,

    You are terribly naïve. Low barriers to entry? Are you kidding?

    The airline industry will check itself because it has learned that adding capacity has killed everyone.

    Oligopolies are not easily dispensed with in any economy. It is about the routes and the destinations and the small start up may be able to take charge in smaller regions but the big boys will prevail where big boys play.

  • Report this Comment On December 03, 2013, at 11:03 AM, nytflyt wrote:

    No mention of HA?

    It will be interesting to see how long the self imposed choke on capacity lasts. Have the airlines learned their lesson? If so, it's only taken 30 years since deregulation to do so. What hasn't emerged is a new operating philosophy to replace what may be a temporary moratorium on market share at the expense of yield.

    Also, at what point will collusion be accused and the practice of capacity discipline be abandoned?

    I wish all of us in the business good luck.

  • Report this Comment On December 03, 2013, at 11:04 AM, AcuraT wrote:

    I agree, this writer is disregarding all the known barriers to entry - and there are plenty to avoid.

    1) Cost. It is a huge capitial investment to get those planes to operate a network.

    2) Landing slots. Many airports are now constrained on landing slots. Why American/US Airways have to give up quite a few at a few airports before merging. Some complained it was not enough airports that had this condition.

    3) Capacity. Some nitwit that comes in adds a lot more planes will once again have the industry supply outstripping demand - and force the industry into losses again.

    I don't see how these three concerns go away - and how those vendors he mentions are going to avoid all three of them and "catalyze growth" as he states. More likely, there will be some growth by the smaller competitors, but not the astronomical amounts he is proposing.

  • Report this Comment On December 03, 2013, at 2:48 PM, TMFGemHunter wrote:

    @AcuraT: I don't think either of your first two barriers are nearly as significant as you imply. In terms of slots, there are only 4 airports in the whole country with slot restrictions: the 3 major NY airports and Washington Reagan. In DC, low cost carriers can grow at Dulles or BWI, which are already the bigger airports in the region. So New York is really the only city where slots are a barrier to entry. But JetBlue, which is arguably the most disruptive player from the major airlines' perspective, already has hundreds of slot pairs in the NY area.

    On cost, I agree that it's a huge capital investment to buy airplanes, but that's never been a problem before. Today, United Continental, which is likely to post an adjusted profit margin of just over 2% for the year is already earning its cost of capital. If the industry starts earning 10% pretax margins, all the airlines will be earning ROICs in the 20%-30% range or higher. If you can earn such a high return on your investment, why wouldn't you invest the money?

    On the third point, can't there be a middle position? Your argument seems to be that if airlines expand too quickly, they will lose money, so they won't expand very much at all. What about a more moderate growth rate that keeps margins around where they are today (or maybe a tad higher)?

    That's basically what I'm suggesting. Over the next 10-15 years, the smaller carriers might double in size collectively. But if the large carriers aren't growing much domestically, that's still consistent with a GDP-like growth rate for total industry capacity.

    @nytflyt: The only reason I didn't mention HA is that most of its growth has been international, and I'm really focusing on domestic growth in this article. But when it starts getting A321s in 2017, HA could join the domestic growth movement in a bigger way.

    @Tyeward: I don't think "pleading" or lobbying is going to get airlines to expand. Economic self-interest will do the trick. But the higher industry margins are, the more enticing expansion will be. This is why the industry will not be able to sustain double digit profit margins.

    Adam

  • Report this Comment On December 03, 2013, at 9:21 PM, Mega wrote:

    I predict American - USAir will be bankrupt again within 10 years.

  • Report this Comment On December 04, 2013, at 4:21 AM, Risky88 wrote:

    Reason why people hate the airline industry?

    Whatever happened to service.

    a customer should NEVER have to go to the SUPREME court over customer service!

    Geez!

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