American Airlines Gets a Windfall Today but Competition Tomorrow

American Airlines (NASDAQ: AAL  ) just got a windfall of more than $425 million, according to the U.S. Department of Justice. That's the total proceeds from American selling off valuable slots at crowded airports in New York and Washington.

American Airlines got more money than expected from selling off slots. Photo: American Airlines.

American Airlines CEO Doug Parker stated that the slot sale brought in much more money than expected: The slots had been appraised at just $225 million. However, as a result of these slot sales -- particularly at Reagan National Airport, which is just outside of Washington, D.C. -- American Airlines will face much tougher competition.

Making room at two crowded airports
As part of its merger with US Airways, American Airlines agreed to sell off 17 slot pairs at New York's LaGuardia Airport and 52 slot pairs at Washington's Reagan National Airport. Some of those slots were already leased to Southwest Airlines (NYSE: LUV  ) and JetBlue Airways (NASDAQ: JBLU  ) , who received rights of first refusal to buy them.

The DOJ mandated that American Airlines auction off the rest of the slots to low-cost carriers. Ultimately, Southwest acquired 11 slot pairs at LaGuardia Airport and 28 at Reagan Airport (one of which it is relinquishing). Virgin America bought the other six slot pairs at LaGuardia and four slot pairs at Reagan. Lastly, JetBlue acquired 20 slot pairs at Reagan Airport.

Southwest Airlines was the biggest winner in the recent slot sale.

Potential bidders could get a pretty good approximation of what the slots were worth based on the results of a similar slot auction for the two airports in late 2011. At that time, JetBlue bought eight slot pairs at Reagan Airport for $5 million each and eight slot pairs at LaGuardia Airport for $4 million each. Based on these valuations, the slots American sold would have been worth around $325 million.

However, airline industry profitability has increased significantly since 2011, boosting the value of scarce slots at these two popular airports. Additionally, it is widely recognized in the industry that there aren't likely to be any more large scale slot openings at either airport.

This caused the ultimate purchase price to exceed $425 million. Of that total, American Airlines is receiving $381 million in cash. The remaining value represents slots that it is acquiring from JetBlue at JFK Airport in New York.

Competition is rising
At Reagan Airport, US Airways long benefited from a lack of low-cost carrier competition. Since other legacy carriers used most of their slots to fly to their own hub airports, US Airways simply avoided flying from Reagan Airport to most of those hubs. This ensured that it faced little or no nonstop competition on the routes it did serve, making Reagan Airport one of the most profitable airline hubs in the U.S.

JetBlue is breaking American Airlines monopolies on two routes in June. Photo: JetBlue Airways.

With dozens of new daily nonstops on low-cost carriers arriving later this year, the calculus is about to change radically. JetBlue has announced routes for six of its new slot pairs at Reagan Airport. In June, it will begin flying two daily nonstops each to Hartford and Charleston, S.C. Today, both routes are American Airlines monopolies (through the US Airways subsidiary).

Southwest Airlines, which won the most slots in the auction, has not disclosed its plans for the most part. However, it has announced new nonstop service from Love Field in Dallas to both LaGuardia and Reagan beginning in November. Today, American holds a monopoly on nonstop service from the Dallas area to Reagan Airport and a 76% seat share to LaGuardia Airport.

Virgin America also wants to compete on routes American dominates today. Photo: Virgin America.

Virgin America also recently announced plans to use its newly won slots at Reagan and LaGuardia for nonstop flights to Dallas. If Virgin America gains access to two gates American is relinquishing at Love Field, it will offer four daily round-trips on both routes. This would turn two routes that American currently dominates into fiercely contested battlegrounds.

Foolish conclusion
Today, American Airlines is getting a nice windfall from selling slots at New York's LaGuardia Airport and Washington's Reagan National Airport. However, investors should also recognize why American is getting so much money for these slots: low-cost carriers see underserved routes at these airports that represent big opportunities to gain market share.

The impact to American will be minimal at LaGuardia Airport, as only a few slots are changing hands and American Airlines doesn't dominate that airport. However, American dominates Reagan Airport today, making it an extremely profitable hub.

As JetBlue, Southwest, and Virgin America add flights there, American Airlines will face a vast increase in competition on multiple routes. This will undoubtedly cut into profit margins on those routes. The only question for investors is whether American can make that up through better results in the rest of its network.

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  • Report this Comment On March 13, 2014, at 1:18 PM, UTNonRev wrote:

    Adam - Just a couple of quick comments on this article on airline competition and the industry.

    It was rather disappointing to see the federal government step in and try to legislate winners and losers in the slot and gate divestitures by American and US Airways. First, the methodology was flawed. All airlines should have been afforded the opportunity to bid on the slots and gates. That would have determined the value of these assets. By limiting the bidding to a select few, it artificially lowered the value of these assets (not market value). Therefore, American Airlines, which was promised the opportunity to sell these assets for market value were cheated by our government.

    The fairer method would have produced similar results without the government picking favorites (those they want to succeed) and to ensure a level playing field (where the scales of justice truly balance) would have been to allow all willing participants. This would have determined the true market value for these assets. Then the federal government could have allowed the "Low Cost Carriers" to match the final bid. They could even have offered business financing to help facilitate their purchase. This way American would have been justly compensated and the low cost carriers would not have been given a financial advantage (being able to purchase the assets below true market value).

    This is just an early step in the journey to consolidation in the airline industry. While there is little likelihood of large airlines merging further, there will soon be a significant shakeup in the ranks of the regional carriers. I mentioned to you a few months ago when the American - US Air merger was consummated, that American Eagle would cease to exist by 01/01/2016. Judging by recent events, 2-years may have been very optimistic.

    It has been reported that 11 of the 12 largest regional carriers failed to meet their hiring quotas in 2013. Most of these regional carriers are essentially living hand to mouth. Any disruption in air travel greatly impacts their financial condition. This is even true for JetBlue. While they are in better financial condition, the loss of the 50 most junior pilots at JetBlue would greatly affect their flying schedule and reliability.

    I predict that American Airlines and the other major carriers (including Southwest) will bide their time for the next year or so. American will work through their integration issues and other carriers will take the opportunity to strengthen their balance sheets during this period.

    The government will be caught up with trying to develop and apply a non-market solution to the lack of regional pilots (it can cost up to $250K to obtain an airline transport pilot certificate on your own but starting pay is only about $20K - you do the math). They won't just let market forces dictate pilot pay. During this time regional and small carriers will find it difficult to turn much if any profit.

    Once the major airlines streamline their operations and strengthen their bottom lines, they will be ready to put the competitive screws to any smaller carrier they wish. Remember the example with JetBlue? Assume Delta has finally had its fill of fighting with JetBlue along the east coast? Delta will be hiring hundreds of pilots each year just to replace forced pilot retirements (age 65 pilots).

    What if Delta made a strategic decision to hire only pilots from JetBlue for its next few classes (most classes are 20-25 pilots). Delta further states that it wants to be sure that the selected pilots will actually come over and so, offers to pay them while they are waiting for their training class to start. The caveat here is that they must give immediate notice to their employer (say 2 weeks). Within a couple of days, JetBlue is down 50-100 pilots. This wasn't forecast and it will take a minimum of 6 months to hire and train replacements (if they can find any). In the interim, JetBlue's flight schedule is decimated and its reliability tanks. People start booking away from JetBlue. The combination of flight disruptions and lost bookings will put a serious strain ion their finances. JetBlue might be able to weather this storm, but what if, American and or United do the same thing a few months later? It could leave JetBlue as a shadow of its former self in the space of a few months if it were to survive at all.

    There are those that say this would be a better demise than the death by a thousand cuts that many of the regional airlines will be facing.

    What am I trying to convey here? The current aviation model is broken. Regional carriers rely on their partner major airlines for income. They provide the crews, ground services, and sometimes even the mechanics, but for the most part the aircraft are owned by the major carrier. Regional carriers have little leverage. Several are now operating at a loss. What will happen when the economy reverses and air travel declines? How will they survive?

    Adam, I believe your rosy view of airline competition fails to recognize the likelihood that several airlines are yet to fail and there will be extensive consolidation in the regional and low cost market.

  • Report this Comment On March 14, 2014, at 2:06 PM, TMFGemHunter wrote:

    @UTNonRev: Thanks for the extensive comments!

    The DOJ's complaint in the antitrust case was that American, Delta, and United were tacitly colluding. When one would raise fares or fees, the others would do likewise. If you think the U.S. shouldn't have tried to block the merger in the first place, that's fine. (I would disagree, but some people argue that the gov't should let the market do its thing.)

    But given that the whole reasoning behind the DOJ's case was that the 3 top legacy carriers were coordinating fares allowing one of the other legacy carriers to buy American's slots would have been pointless. In fact, Delta had expressed an interest in serving smaller cities from Reagan Airport that American was dropping from its service. In other words, rather than offering competing service on any routes, Delta was proposing to tacitly coordinate with American to serve different markets. This clearly would not have improved competition.

    In any case, I think the point is moot. American was VERY happy with the sale price it received, which was significantly above the assessed value. I think it's unlikely that Delta or United would have submitted the highest bid in any case. (On the other hand, it would have been quite reasonable for American to take a below market bid from Delta if it was allowed to, knowing that Delta wasn't likely to compete head to head in many markets.)

    As for the pilot shortage, I absolutely agree that one or more regional airlines is likely to fail in the next couple of years. I don't think it will have much of an impact on the overall industry, though.

    What you have to remember is that Delta, American, and United are on the bottom of the pilot food chain as well as the top. Ultimately, they are the ones whose passengers get inconvenienced when regional carriers have to cut back service (and especially if one folded altogether). So while regional airlines are not in an enviable position, they're not going to disappear. One or two might be able to fail, but after that, the legacy carriers would have to prop the others up -- unless they want to stop serving small communities altogether.

    I don't think JetBlue (or Allegiant, Frontier, Spirit, Virgin America, etc.) is in nearly as weak a position as you imply. The wage gap between these LCCs and the mainline carriers is not nearly as big as the wage gap between LCCs and regional airlines.

    Also, all of the pilot groups at the "big 4" are unionized. So any new pilot has to come in at the bottom in terms of pay, job security, etc. with no special privileges. I doubt many JetBlue pilots would leave or that. In any case, JetBlue could find 10 regional airline pilots happy to work for JetBlue for every 1 who left for a legacy carrier.

    Just my two cents!

    Adam

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