The airline industry has a history of extreme competition and even more extreme losses. Airlines and bankruptcy have become so closely associated that airlines are almost always cited as among the riskiest of investments. But the latest industry merger has completed the large wave of consolidation and created a far more profit-friendly environment.
Less than a decade ago, the number of air carriers was far greater than today, spawning price wars as airlines fought for market share sometimes selling tickets below cost. With this competitive environment, combined with the high costs of running an airline, bankruptcies were frequent and shareholders were wiped out in all of them except the AMR bankruptcy.
But when the largest airlines went bankrupt, they didn't disappear; they reemerged with leaner cost structures making airlines that had not already restructured uncompetitive on a cost basis. So what do you do when your competition can't die but can only restructure and become stronger? You join forces and that's what airlines have been busy doing.
America West and US Airways combined in 2005 to form US Airways, Delta and Northwest teamed up in 2008 to form today's Delta Air Lines (NYSE:DAL), United and Continental joined forces in 2010 creating United Continental Holdings (NYSE:UAL), and on Dec. 9 US Airways officially took control of AMR, the parent company of American Airlines, and launched the world's largest airline, American Airlines Group (NASDAQ:AAL).
In 2005, airlines fought in a loss-generating battle for market share. Today, Delta, United Continental, American, and Southwest Airlines (NYSE:LUV) together control more than 80% of the U.S. air travel market. Southwest is somewhat unique from the other large carriers in its methods of operation, but even if Southwest is excluded, the three legacy airlines control a significant majority of the market.
Fares and fees
Looking at airfares, things don't seem that bad. According to the Bureau of Transportation Statistics, average airfares today are lower than they were in the late 1990s and early 2000s. Of course, this doesn't stop airlines from trying to raise fares. About a week ago, Delta raised fares $4-$10 in hopes rivals would follow. American and United climbed on board, raising their fares similar amounts. However, this fare increase failed to stick after Southwest and JetBlue (NASDAQ:JBLU) refused to join. Of the 12 fare-raising attempts noted at Farecompare.com, only three have been successful this year.
Still, this puts fare increases at a roughly one-in-four success rate, meaning airlines are unlikely to stop trying and some increases will likely be successful. But where airlines are really cleaning up is on fees for everything from flight changes to checked bags. The year 2012 brought a combined $3.5 billion in bag fees collected by the airline industry as fees in excess of airfare continue to make up a greater percentage of total airline revenue.
Frequent flier miles are how average travelers can find their way into first and business class cabins for long-distance flights without spending a fortune. But recent moves at Delta and United are increasing the number of miles required for certain travel with some tickets rising more than 80% in number of miles required.
Like most fees, airlines blame this change on rising costs. Either way, although travelers may hate it, these increases free up more high-priced seats for Delta and United to sell. And with two legacy carriers making this change, we'll have to watch for what American Airlines does to its frequent flier mile program.
Airlines have realized that since customers have extra money to spend, they should develop new ways for them to do so. With everything for sale including inflight entertainment, extra legroom, meals and snacks, and even baggage delivery at some carriers, airlines are adopting a retail model for selling in flight. A report developed by IdeaWorks Company, a consultancy on airline ancillary revenues, and CarTrawler predicts ancillary revenue in the airline industry will reach a combined $42.6 billion, nearly double 2010 levels of $22.6 billion.
Airlines tend to have much greater margins on ancillary revenues so this extra revenue should be a major boost to airline earnings going forward.
Reshaping an industry
Airline stocks have been unpopular investments for a long time, but a wave of consolidation, greater fee control, and an emerging retail model offer a new outlook on a traditionally poor-performing industry. While the airline industry has been dramatically reshaped by the events of the past several years, not everyone is in agreement on which airline stock is the best, or even if airline stocks are the best overall picks.
Alexander MacLennan owns shares of American Airlines Group and Delta Air Lines and 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, and long January 2015 $17 calls on American Airlines Group. 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.