Airline stocks have dramatically outperformed the broader market in the past few years. One of the main reasons for airlines' success has been the recent consolidation of the U.S. airline industry. With 80%-85% of industry capacity controlled by four carriers, airlines have focused on margins over growth, making fare wars an increasingly rare occurrence.
However, in time, the growth of some smaller U.S. carriers could upset this balance. Most notably, Spirit Airlines (NYSE:SAVE) plans to grow rapidly in the next decade. JetBlue Airways (NASDAQ:JBLU) also has significant growth plans.
In the long run, as industry concentration starts to decline again, capacity and pricing discipline could erode. This is a significant long-term risk that airline investors should consider.
Spirit Airlines: Growth takes off
Last year, Spirit Airlines boosted capacity of 17.9%, as its fleet increased to 65 planes. For 2015, Spirit plans an even faster 30.4% capacity growth rate, and it will end the year with 80 planes in its fleet. Just a few years ago, Spirit was a niche player in the airline industry, but this rapid growth is making it a force to be reckoned with.
Despite its high growth rate, Spirit Airlines has reliably led the industry in profit margin in recent quarters. Typically, airlines have had to choose between growth and near-term profitability, but Spirit's rock-bottom costs have allowed it to stimulate demand with low fares while remaining highly profitable.
As a result, there's nothing stopping Spirit from continuing its torrid growth. Indeed, Spirit has identified another 500 markets that it could serve while meeting its margin target. Today, Spirit's official fleet plan entails growing from 65 planes at the end of 2014 to 144 by the end of 2021 while also gradually shifting toward larger planes.
Ultimately, its growth is likely to be much faster. On Spirit's recent earnings call, CFO Ted Christie stated that the carrier remains comfortable with a 15%-20% annual growth rate over the next five to 10 years. Even at the low end of that range, Spirit could have about 200 planes in its fleet by the end of 2021, and more than 300 by 2025.
JetBlue and others are also growing
Spirit is by far the fastest-growing airline in the U.S. right now, but it's not the only small carrier looking to take advantage of the favorable industry environment. Consider JetBlue: While it is the fifth largest U.S. carrier today, JetBlue is much smaller than the four big airlines that dominate the industry.
However, JetBlue is growing at a high single-digit rate. On a percentage basis, that's nowhere near Spirit's growth rate, but JetBlue is starting from a bigger base. From 2015 to 2022, JetBlue is scheduled to take delivery of 101 new Airbus planes (mainly A321s). It is also adding seats to its existing A320s, creating the equivalent of about a dozen planes of new capacity.
These new planes may not be offset by many retirements, as JetBlue's fleet remains quite young. The result is that JetBlue could be nearly twice its current size by the end of 2022.
Several other low-cost carriers are also planning significant growth in the years ahead. For example, Frontier Airlines currently has about 55 planes in its fleet, but it has 80 A320neo family jets scheduled to arrive between 2016 and 2021. Frontier also recently ordered nine A321s for delivery in the next few years. This indicates that Frontier's new owners are serious about growth.
Virgin America is also hoping to expand significantly in the years ahead. In 2016, its growth rate could be as high as 20%, and CEO David Cush stated last November that Virgin America aims to grow 10% to 15% annually beyond 2016.
Even Alaska Air, a more established airline that is roughly similar in size to JetBlue, is planning to grow faster than its larger peers. Alaska recently increased its 2015 capacity growth guidance from 8% to 9.5%. By delaying the retirement of some of its older planes, Alaska may be able to continue its high single-digit growth rate for the next few years.
Don't count on capacity discipline
In a recent note to investors, analysts at Stifel stated that "... capacity discipline appears to be a sustainable, investable theme. With four major domestic carriers and a handful of niche carriers, market share battles seem to be non-existent to certainly less frequent than in the past."
Yet with numerous smaller carriers (led by Spirit Airlines) planning rapid growth in the next few years, "sustainable" might be a bit of a stretch. These carriers, which collectively represent less than 20% of the U.S. airline industry, are likely to more than double in size by 2025. This will gradually reduce the concentration of the airline industry, increasing competition.
Growth by carriers like JetBlue, Alaska Airlines, and Virgin America is likely to be concentrated in a few cities where those airlines have major bases. Their growth will have a big impact on other carriers with major operations in these markets, but airlines with less route overlap may escape unscathed.
By contrast, the growth of Spirit and Frontier may be more disruptive, because it will be spread across the country. Today, ultra-low-cost carriers are small enough that their growth has not affected higher-cost competitors too much. But Spirit's growth will have an increasingly large impact on industry pricing dynamics over the next decade.
The rapid growth of low-cost and ultra-low-cost carriers won't necessarily lead to all-out price wars. There will be much more differentiation between carriers than 10 or 15 years ago, when LCCs were a small part of the industry and ULCCs didn't even exist. But a less-concentrated industry is likely to feature more price competition than there is today.
For the next few years, airlines are likely to earn historically high margins thanks to strong demand and capacity discipline among the biggest carriers. However, long-term investors need to realize that the competitive landscape will be tougher five to10 years from now.