America's Top Airlines May Be Fighting the Last War

Many historians have remarked that militaries frequently make the mistake of "fighting the last war". In essence, military leaders try too hard to learn from past mistakes, and end up applying strategies that would have worked in the previous war. However, conditions have changed, so they wind up making new mistakes.

America's top airlines -- American Airlines (NASDAQ: AAL  ) , United Continental (NYSE: UAL  ) , and Delta Air Lines (NYSE: DAL  ) -- may be fighting the last war. These companies recently endured more than a decade of lean times, during which each one went bankrupt at least once. As a result, capacity discipline has become their collective mantra.

Delta has profited greatly in the last few years from industry capacity discipline. Photo: The Motley Fool

However, the legacy carriers' reluctance to expand is creating a vacuum in the U.S. airline industry that smaller airlines like JetBlue Airways (NASDAQ: JBLU  ) and Spirit Airlines (NASDAQ: SAVE  ) will be eager to fill. Over the next decade, this will increase the airline industry's fragmentation. The long-term result will be a more competitive market that is good for consumers but bad for airline profit margins.

Legacy carriers don't want to grow
Demand for air travel in the U.S. has been very strong for the past two to three years. In spite of this solid demand, American, Delta, and United have kept their capacity roughly flat, creating a tight supply situation. This has driven solid unit revenue increases. Last year, all three carriers grew passenger unit revenue by about 3%.

The same trends have continued into 2014. Aside from initiatives to put more seats on each plane -- something that American, Delta, and United are all doing -- legacy carriers are not growing.

Aside from adding seats to its planes, American Airlines isn't growing much. Photo: American Airlines

Once these aircraft modifications are completed, American, Delta, and United will need to grow their fleets if they want to increase capacity. They have shown absolutely no interest in doing so. Delta and United have both explicitly announced plans to keep capacity increases below the rate of GDP growth for the foreseeable future. American Airlines seems to have similar long-term plans.

The downside of capacity discipline
Today, four carriers control more than 80% of the U.S. air travel market, so if they collectively hold capacity growth below the rate of GDP growth, profit margins should rise. Indeed, this has been happening for the past couple of years.

However, that's not necessarily true in the long run. While the "big four" are devoted to capacity discipline, smaller carriers are growing rapidly. For example, Spirit Airlines holds less than 2% of the U.S. air travel market today, but it expects to increase capacity by 18% this year and then by a stunning 29% in 2015!

Spirit Airlines is growing rapidly to tap unmet demand for cheap flights. Photo: Spirit Airlines

In fact, Spirit Airlines plans to grow its fleet from 54 planes at the end of 2013 to 103 by the end of 2017. (Spirit is also shifting toward larger planes, so this fleet growth will more than double its capacity.) By 2021, Spirit expects to grow its market share to at least 5%, and Spirit executives believe the carrier can achieve double-digit market share in the long run.

JetBlue Airways isn't expanding quite so fast, but it already has about 5% market share in the U.S. JetBlue has 72 Airbus planes scheduled for delivery between 2015 and 2019. Assuming it uses all these planes for growth, JetBlue's capacity would rise about 50% in that five-year period.

JetBlue could grow its capacity as much as 50% by 2019 (Photo: JetBlue Airways)

JetBlue could slow its growth by returning some planes to the lessors at the end of their lease terms. However, aircraft lease rates are very favorable right now, and none of JetBlue's planes are more than 15 years old. Even its oldest planes have at least 10 years of useful life left. As a result, there's no reason for JetBlue to slow its growth as long as industry conditions remain favorable.

Fragmentation returns
United Continental CEO Jeff Smisek recently attributed the airline industry's strong financial results to industry consolidation. In 2007, the four largest U.S. airlines held a combined market share of 55%; by contrast, the four largest carriers have over 80% market share today.

The focus on capacity discipline at United Continental, Delta Air Lines, and American Airlines combined with the rapid growth of smaller carriers will increase industry fragmentation. The airlines outside the top 10, which have 15%-20% of the market today -- depending on how you measure -- could easily double their share within the next 10 years.

Slow growth at legacy carriers like United will increase industry fragmentation over time. Photo: The Motley Fool

That won't quite recreate the brutal competitive landscape of 2007. However, there will be a lot more competition for the legacy carriers than there is today.

Foolish conclusion
The focus on capacity discipline at American Airlines, Delta Air Lines, and United Continental has helped airline profits soar recently. However, they may be "fighting the last war". Capacity discipline is boosting margins today, but potentially at the expense of long-term profitability.

By holding their capacity growth below the rate of demand growth, the legacy carriers are ensuring that smaller carriers like JetBlue and Spirit have lots of profitable growth opportunities. The growth of these smaller carriers will gradually increase industry fragmentation over the next decade. History shows that this will result in lower profit margins for the airlines.

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Read/Post Comments (3) | Recommend This Article (5)

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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 June 09, 2014, at 9:06 AM, ferdiefor wrote:

    I am supposed to worry about Spirit going from 2% to 5% between now and 2021?

    How many small airlines have gone into the drink because they expanded too quickly?

    This author makes the mistake of assuming the legacy airlines are potted plants. They are in fact expanding but they are doing it in a thoughtful way.

    Spirit caters to one class of passenger while legacy carriers are catering to a different class of passenger. I don't think the legacy carriers have any interest in a race to the bottom which has been the outcome for the industry for far too long.

  • Report this Comment On June 10, 2014, at 10:35 AM, TMFGemHunter wrote:

    @ferdiefor: the legacy carriers really aren't expanding. They are showing some modest capacity growth right now because they're in the middle of these projects to put more seats on each plane. But if you listen to the management teams, they're all swearing off the idea of expanding their fleets.

    Spirit is just one carrier that is growing. JetBlue has a much more "upmarket" bent, and it is also growing pretty quickly. There are plenty of other small and growing airlines, too.

    Also, while Spirit is catering to a budget-minded passenger, the legacy carriers have to cater towards all kinds of travelers. That includes wealthy people and corporate travelers, but also the backpack and flip-flops crowd. Legacy carriers won't make money if they don't fill the back of the plane at acceptable fares.

    Adam

  • Report this Comment On June 10, 2014, at 12:05 PM, Inspectigator wrote:

    There is no "capacity discipline", there is a shortage of pilots. The major airlines are all hiring as fast as they can hire and train, they have no ability to grow as their pilots are just entering a massive retirement bubble. The smaller airlines are losing pilots to the majors, and kids stopped entering the pilot profession years ago, so the smaller airlines are parking jets, pulling out of their least profitable markets. Larger and larger markets are losing scheduled air service, and nobody knows how far it will go.

    The majors airlines are assuring everyone they will be able to find enough pilots, by hiring from the regionals. The regionals don't have enough pilots to replace the ones retiring from the majors, and if the majors take all their pilots that will shut down more than half the airline service in the U.S. 70% of cities with airline service are exclusively served by regionals, over half of domestic airline capacity is on regional jets. Losing that much of our airline industry will be catastrophic for the economy, but lucrative for the major airlines.

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