A price war is brewing between United Continental (NYSE:UAL) and Virgin America on two lucrative transcontinental routes. Since the merger of United and Continental several years ago, United has been the only carrier flying from Newark Airport (just outside New York City) to San Francisco and Los Angeles. However, earlier this month, low-cost carrier Virgin America began service on both of these routes, breaking United's monopoly.
To stimulate demand and market its flights, Virgin America decided to undercut United's prices when it entered Newark. United responded with a full-blown price war to defend its turf in the Newark-San Francisco and Newark-Los Angeles markets. While United needed to match Virgin America's prices to maintain its competitiveness, the extent of its reaction will have a noticeable negative impact on its profitability. The ability of a relatively small competitor like Virgin America to disrupt a global carrier like United highlights the continuing risks of the airline industry for investors. Moreover, United's response suggests that capacity discipline is not nearly as engrained as airline industry bulls believe.
United's San Francisco, Los Angeles, and Newark hubs are all located in major markets for both business and leisure travelers. The transcontinental routes from Newark to San Francisco and Los Angeles became highly profitable monopoly routes after the United Continental merger. For a long time, United's strong position in all three hubs and the difficulty of securing slots at Newark Airport deterred competitors from entering the market.
However, the American Airlines bankruptcy allowed Virgin America to buy slots and begin service three times a day on both routes. The Newark-San Francisco and Newark-Los Angeles routes appealed to Virgin America for a few reasons. First, the carrier already has a major presence in San Francisco and Los Angeles. Furthermore, Virgin America specializes in long-haul flying and offers more passenger amenities than United. Virgin America has joined JetBlue (NASDAQ:JBLU) in offering free in-flight satellite TV and other entertainment options, which are particularly nice to have if you're going to be on an airplane for six hours. Lastly, Virgin America recently achieved the top ranking in the Airline Quality Rating survey, whereas United was last. When competing directly with United, Virgin America can try to win customer loyalty by providing a clearly superior service.
When Virgin America began service to Newark, United could have just matched the fares and hoped for the best. Additionally, it could have trimmed its own capacity, in the hope of retaining some pricing power. Instead, United slashed fares even more and added flights! United added five daily round trips on each route for the summer season, moving total industry capacity from 11 daily round trips to 19 on the Newark-San Francisco route, and from nine daily round trips to 17 on the Newark-Los Angeles route. According to Virgin Group founder Richard Branson, United stands to lose as much as $150 million from its actions on these two routes alone. (For comparison, United earned an adjusted profit of $589 million in all of 2012.)
United's management has steadfastly claimed that they are not trying to drive Virgin America out through unfair competitive practices. However, their claims that Virgin America's lower prices "stimulated demand" ring hollow. With capacity rising around 70% to Los Angeles and nearly 90% to San Francisco, it seems highly unlikely that there will be enough demand to fill those seats at rational prices.
Indeed, on the company's recent earnings call, United's management highlighted the new competition and additional capacity on these routes as a factor that will hurt Q2 unit revenue. At first, it may seem surprising that two routes could have a noticeable impact on the results of a global carrier like United. However, by this summer, those two routes will account for 3% of United's total capacity, so a 30% drop in unit revenue on those routes would lead to a nearly 1% drop in system revenue, and a corresponding decrease in margins.
Foolish bottom line
To some extent, it makes sense for legacy carriers to defend their market position on major hub-to-hub routes. That said, United seems to be shooting itself in the foot by cutting prices and adding capacity at the same time. Virgin America's higher-quality service would attract some customers regardless of United's response. Rather than minimizing the damage, United's move to boost capacity will probably lead to even lower average fares and more empty seats, eroding profits during the peak season.
In the next few years, we're likely to see Virgin America, JetBlue, and other low-cost carriers continue their growth, which will occasionally lead them into new competition with legacy carriers. If the legacy carriers follow United's example by cutting fares and raising capacity whenever new competitors arise, the recent trend toward industry consolidation will not lead to higher profitability. This is a significant consideration for investors who are interested in buying airline stocks today.
Adam Levine-Weinberg is short shares of United Continental Holdings and is long September 2013 $33 puts on United Continental Holdings. 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 don't 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.