As oil prices have fallen during the past year, pricing pressure in the airline industry has steadily increased. Markets targeted by low-cost carriers like Southwest Airlines (NYSE:LUV) and ultra-low cost carriers like Spirit Airlines (NYSE:SAVE) have seen some of the biggest impacts.
Incumbent carriers have reacted to these threats in various ways. American Airlines (NASDAQ:AAL), the largest airline in the world, has made a bold bet on price matching. Yet it has suffered significant unit revenue declines for the past few quarters. Does this mean its strategy is backfiring?
Pricing pressure heats up
American Airlines was one of the first airlines to report pricing pressure in a handful of domestic markets beginning in late 2014. It attributed the pressure to capacity growth by a number of low-cost carriers.
Most notably, Southwest Airlines has dramatically expanded its capacity at Dallas Love Field since the expiration of the Wright Amendment last fall. This has affected pricing at nearby Dallas-Fort Worth International Airport: American's largest hub.
Meanwhile, ultra-low cost carrier Spirit Airlines was a small niche carrier just a few years ago, but it has been growing extremely quickly. In 2015, Spirit expects to increase its capacity by 30.3%, while adding 15 planes to its fleet. As a result, Spirit Airlines has added capacity in markets across the country.
This explosion of low-cost carrier and ultra-low cost carrier capacity across the country has led to extremely cheap fares on certain routes, especially on off-peak days. This includes roundtrip fares of less than $100 on routes like Chicago-New York, Chicago-Washington D.C., and Dallas-New York.
Fighting back with price matching
American Airlines management first mentioned that it was matching low-cost carriers' prices on the company's Q4 earnings call in January. As the year has progressed, the company has become even more aggressive, though.
In July, American Airlines President Scott Kirby told a Wall Street analyst, "I think we are all-in now in matching everywhere." Kirby asserted that this aggressive posture was working -- markets where the company had started matching competitors' prices were outperforming on a relative basis.
On the other hand, this hasn't appreciably improved American's unit revenue trajectory in the domestic market, where it faces the most competition from discount airlines. Passenger revenue per available seat mile, or PRASM, declined 1% on domestic routes in Q1, and then declined 6.2% in Q2. The company expects a fairly similar performance in Q3, and on the Q2 earnings call, Kirby opined that PRASM could continue declining until the second half of 2016.
There's no good alternative
American Airlines has stated that routes where it's matching prices are outperforming other routes. However, it's possible that unit revenue would be higher still if it had, instead, cut capacity in markets where it's facing the most competitive capacity growth in order to prop up fares.
The problem is, while that strategy might have bolstered unit revenue in the short term, it would have created even bigger problems in the long run. If American Airlines were to retreat in every market where Southwest, Spirit, and their peers are expanding, those carriers would be even more profitable than they are now. Those excess profits would likely be reinvested in future capacity growth.
In essence, American Airlines would be aiding the growth of its competitors. Additionally, those rivals would have strong incentives to expand in other American Airlines markets going forward, knowing that the latter would pull back to avoid a collapse in pricing.
It's not clear whether American's decision to aggressively match competitors' prices will allow it to maximize its earnings in 2015. However, the real payoff will come later on. Hopefully, a bold price-matching strategy today will make competitors think twice before planning big encroachments on American Airlines' territory in the future.
Adam Levine-Weinberg owns shares of Spirit Airlines and is long November 2015 $40 calls on American Airlines Group and long March 2016 $40 calls on Spirit Airlines. The Motley Fool recommends Spirit Airlines. 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.