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Airlines Are Getting Serious About Unit Revenue Growth

By Adam Levine-Weinberg - May 21, 2016 at 2:15PM

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American Airlines, United Continental, and Delta Air Lines are finally acting decisively to get unit revenue growing again.

American Airlines (AAL -4.00%), United Continental (UAL -2.51%), and Delta Air Lines (DAL -2.62%) have been posting disappointing unit revenue results for more than a year now. American and United have seen the biggest declines, but unit revenue has also fallen steadily at Delta.

Executives at all three airlines have predicted more than once that a revenue recovery was right around the corner. However, falling jet fuel prices and rising competition from ultra-low-cost carriers (ULCCs) have kept fares on a downward trajectory. Industry unit revenue is declining just as quickly today as it was a year ago.

Unit revenue trends haven't improved yet at most U.S. airlines. Image source: American Airlines.

However, fuel prices are starting to bounce back. As a result, some airlines' profit margins are starting to come under pressure. This has finally forced American, United, and Delta to get serious about putting unit revenue back on a sustainable positive trajectory.

Fixing irrational pricing

Some of the recent revenue weakness at U.S. airlines can be blamed on a change in the legacy carriers' philosophy about competing with ULCCs. Two or three years ago, the legacy carriers mainly ignored ULCCs, figuring that it wasn't worth competing for the most price-sensitive customers.

In the past year or so, they have executed a 180-degree turn and now typically match ULCC fares. Not surprisingly, that has created pricing pressure.

To serve this market profitably, Delta, American, and United are all in the midst of rolling out no-frills "basic economy" fares. By better differentiating between customers who are willing to pay for quality and those who just want the cheapest price, legacy carriers should be able to mitigate the negative impact of matching ULCC fares.

Capacity discipline is the key

Still, pricing strategy hasn't been the main cause of legacy carriers' weak unit revenue. Capacity growth that outpaced demand deserves most of the blame.

When oil prices were plunging, it was profitable for airlines to add capacity at the margins, even if it led to unit revenue declines. However, it now looks like most airlines will face year-over-year increases in their fuel bills within the next two or three quarters. That makes it imperative to keep capacity in line with demand.

All of the major airlines recognize this and are acting accordingly. United Airlines -- which has kept the tightest lid on capacity in recent years -- reduced its 2016 capacity growth plans by 0.5 percentage points last month. It is cutting back in weaker markets like Houston, Brazil, and the Middle East. Most of its growth is concentrated in San Francisco, where it is adding a slew of long-haul routes that won't face any direct competition.

United is focusing its growth on routes where it won't face competition. Image source: The Motley Fool.

Delta Air Lines is also ratcheting back on capacity growth. In Q4, domestic capacity will rise just 2.5% year over year, compared to 4%-plus growth in the first three quarters of 2016. Meanwhile, international capacity will remain flat-to-down year over year throughout 2016, with capacity down across all regions during Q4.

American Airlines is also slashing its growth. Last month, the carrier announced that it will increase international capacity just 2.5% year over year in 2016, compared to its original plan for 6% growth. American should also benefit from rivals' cutbacks in Brazil, a market that has been a big source of unit revenue pressure for the past year and a half.

United, Delta, and American have also made recent fleet plan changes that should limit capacity growth over the next few years.

Delta is deferring some aircraft deliveries. Image source: The Motley Fool.

In March, United decided to retire its 747 fleet by the end of 2018, a few years ahead of schedule. Just in the past week or so, Delta has deferred the deliveries of four A350s from 2018 to 2019 and 2020, while American Airlines has accelerated retirements for several different aircraft types. All of these moves foreshadow a slowdown in U.S. airlines' international growth.

Results coming soon

Airlines' near-term capacity cuts and longer-term fleet plan changes won't get unit revenue growing immediately. Nevertheless, investors are likely to see measurable progress this summer, as unit revenue declines start to moderate, with further sequential improvements coming in the fall.

Now that airlines are getting serious about reining in capacity growth to match demand, the industry should be able to return to unit revenue growth within the next 12 months. That will make investors a lot more comfortable about airlines' long-term profit potential.

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Stocks Mentioned

Delta Air Lines, Inc. Stock Quote
Delta Air Lines, Inc.
DAL
$38.21 (-2.62%) $-1.03
United Airlines Holdings, Inc. Stock Quote
United Airlines Holdings, Inc.
UAL
$43.10 (-2.51%) $-1.11
American Airlines Group Inc. Stock Quote
American Airlines Group Inc.
AAL
$16.08 (-4.00%) $0.67

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