The airline industry is known for boom and bust cycles that give profits to well-timed investors and destroy the portfolios of others. In an industry with high capital costs, large workforces, volatile input costs, and a history of brutal competition, is there any hope of the airline industry becoming a sustainable one for long-term investors?
I'll take a look at what's being done and what would need to happen for the airline industry to avoid another round of bankruptcies and restructurings.
The traditional way for airlines to grow has been through battling for market share. At first, taking market share may seem like a good thing, but airlines were losing money by undercutting each others' prices. Even if an airline could take 80% of the market share, if it's losing money on every passenger, it's just taking its shareholders to the poor house even faster.
One issue was that there were too many airlines, so there would always be one player without enough market share ready to undercut the others and destroy overall pricing power. Airlines have been working to address this issue through a series of mergers that have seen Delta Air Lines and Northwest Airlines combine into today's Delta Air Lines (NYSE:DAL), United Airlines and Continental Airlines combine into United Continental Holdings (NYSE:UAL), and US Airways and American Airlines become the new American Airlines Group (NASDAQ:AAL).
Capacity has also harmed pricing power as carriers try to boost revenues or take market share by flooding the system with new seats. As any lesson in supply and demand will show, when a market is flooded with new supply but demand does not grow, prices drop. Since capacity additions have often been used as a tool of market share warfare, new overcapacity is linked to a high number of competitors, which the industry has been successful in reducing.
But the threat of overcapacity does not just disappear because only a few competitors remain. Each competitor could still add capacity to try to boost revenue or take market share. Although having fewer competitors reduces the chances of multiparty capacity wars, airlines still need to keep capacity under control if prices are to remain high enough for consistent profit generation.
If airlines want to increase capacity anyway, investors should hope they do so in international markets where other domestic carriers are not already competing. Canada's flag carrying airline has taken this approach to grow profits while not diluting its pricing power within Canada. The strategy is allowing the airline to grow capacity in the upper-single-digit range while still maintaining profitable pricing in Canada.
Jet fuel is one of the largest costs for airlines and can make up 30% of an airline's operating expense. Needless to say, the cost of this fuel can greatly affect the industry's profitability. Right now, oil prices remain in the $100 per barrel range as new capacity is in its early stages of ramping up, and tensions from Russia continue making headlines.
But, barring a major geopolitical event, North American oil prices appear on the downswing for the long term. Production is increasing within the U.S. as new fracking techniques give the oil industry access to previously unattainable deposits. Despite the environmental concerns, fracking continues to expand and increase oil supplies in a market where the export of crude oil is banned.
Another factor to watch is for increases in production in Mexico, where the government has opened up the oil industry to foreign investment. Analysts at one major bank predict that this could be the equivalent of putting additional oil production the size of Nigeria's on line over the next several years.If Mexican oil production does ramp up to these levels, it would provide a new large source of oil within close proximity to the U.S.
It's unclear how low oil prices could go, with some analysts calling for prices in the range of $75-$80 per barrel, although these estimates are not a consensus among analysts. Investors will have to see how this plays out, but the increase in supply should help keep prices from rising too high, too fast.
What to watch for
With fewer competitors and major airlines having greater cash positions, a long-term sustainable airline industry looks possible, at least on paper. But for it to happen, a few other things -- both controllable and uncontrollable by airlines -- will need to happen. These include:
- Sustaining profits for the next few years to strengthen cash holdings and pay for new aircraft. By increasing cash holdings, airlines are better equipped to handle inevitable future economic downturns.
- Keeping capacity growth low in competing markets, and growing capacity in markets where U.S.-based carriers do not presently compete.
- Recognizing the pricing power of the oligopolistic industry and not undercutting rivals' prices in market share wars.
- Stable -- or falling -- oil prices thanks to production increases.
Airlines have decent control over three of these four factors, and investors should watch to see how well airlines follow them to generate sustainable long-term returns.
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Alexander MacLennan owns shares of Air Canada, American Airlines Group, and Delta Air Lines. Alexander MacLennan has the following options: long January 2015 $22 calls on Delta Air Lines, long January 2015 $25 calls on Delta Air Lines long January 2015 $30 calls on Delta Air Lines, long January 2015 $17 calls on AMERICAN AIRLINES GROUP INC, long January 2015 $32 calls on AMERICAN AIRLINES GROUP INC, long January 2015 $40 calls on AMERICAN AIRLINES GROUP INC, long May 2014 $31 calls on AMERICAN AIRLINES GROUP INC, and long May 2014 $40 calls on AMERICAN AIRLINES GROUP INC. The Motley Fool has no position in any of the stocks mentioned. 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.