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US Airlines: Feds vs. AAL DAL UAL LUV

November 9, 2015
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Roger King, CreditSights (Reproduced with Permission) – Telephone #: +1 (203) 904-8365

Executive Summary

  • DoJ investigates the potential of noncompetitive behavior in the US airlines industry artificially raising fares.
  • Data shows independent airline capacity initiatives, in fact over-expanding this summer and suffering declining yields.
  • Capacity growth is limited along the east coast by airport constraints and overall by the geriatric air traffic control system.
  • Current industry consolidation was DoJ-approved.
  • Most likely resolution has incumbents giving up some slots in New York and Washington to low-cost carriers.
  • Buy US airlines bonds and EETC tranches—the industry outlook is very positive.

Relative Value
Now back from August vacation, the Department of Justice can dig into Senator Blumenthal’s postulation of non-competitive behavior in the US airline artificially raising fares. As unofficial amicus curiae, here are some points for the DoJ to ponder: 1) unit revenues on multi-year decline; 2) real yields remain flat; 3) no direct evidence or behavioral patterns of collusion; 4) airport fees, TSA surcharges, and federal fees keep rising; 5) major airports are capacity constrained; 6) advance fare announcements and capacity outlooks are fundamental to reservation systems and financial analysis; 7) DoJ approved the current industry structure; and 8) DoJ does not understand airline industry fundamentals—the core issue. Most likely, incumbents will give up a few slots at controlled airports and this will be a blip. DoJ might slice a sliver off the expanding pie, but the US airline outlook is very bullish. Buy any senior
secured note offered, a scarce commodity (See Report: US Airlines: 2Q15 Review and Outlook).

Point Counterpoint

At an early 2013 equity conference, airline managements claimed lack of direct competition from rationalization well lead to significant financial gains. LCC CEO Doug Parker famously summed it up, “I am surprised everyone hasn’t figured it out yet” (see Airlines: Love Fest at JPM 3/4/13). Turns out they were prescient (although unpredicted $50 crude oil did not hurt): lower leverage; high load factor; huge EBITDAR gains; shareholder rewards; rebounding salaries; rejuvenated fleets; equity outperformance; but declining yield and unit revenue.

Fast forward to an early 2015 equity conference where an analyst directed this fascinating question to Southwest management: “I think people have asked you guys in the past about the growth, and how you think about it. And you guys have said you’re going to do what’s best for your shareholders, and others have said that, too. I think any logical C-level executive would say that when asked about anything about their business, but the reality is that your shareholders are also their shareholders. And about 60% of your top 20 shareholders are also owners of the other guys, and 30% of your top 20 shareholders own all these guys’ stocks. So, what’s best for your shareholders might not be what’s best for you, but actually what’s best for the industry, because with the industry, your multiple is down about 20% this year, year-to-date, despite the fact the result have been spectacular, and I think that’s the commentary about the market, expressing concern about some of the growth as it relates to the industry. So, the question is, how do you factor that in? You’ve got to do what’s best for you, obviously, but how do you factor in the overall perception of how investors are going to view this industry in the context of your own growth?” LUV CEO clearly answered the airline is only run for its shareholders and its capacity growth is a function of available opportunities and up-gauging.

Maybe Senator Blumenthal, on the senate aviation subcommittee, is aware of these statements, or maybe is wondering, like many of his constituents, how airline profits could be so high and cabins so cramped. Airlines raise fees and discount mileage awards, almost in lockstep, but behind the bad public relations are more competition and infrastructure hurdles than retail realizes.

Declining Unit Revenues

The yin, yang, and yung of airline revenues are capacity, load factor, and yield—the typical cycle is stimulate demand → raise load factor → drive yield → increase capacity, then do it all over again. Somewhere in there is hard-to-define price elasticity (See Report: Price Elasticity of Airline Demand 10/3/06). But the bottom line is unit revenue (yield x load factor). On that scorecard, US airlines are losing altitude since the 2010 industry recovery (See Report: US Airlines: Demand Inelasticity, The Wrong Way 7/8/13).

Atlantic, Pacific, and LatAm sectors have factors beyond US airline control (currency, foreign economies, idiosyncratic events, and foreign airline capacity), but domestic is firmly in control of four major airlines and a few pesky little guys. If there is anti-competitive behavior, it is not working.

Domestic Capacity Behavior, Market Signals

Patterns of capacity collusion are not evident in this table. This data does show the industry increasing capacity at increasing rates, though individually at different pace. Domestic Capacity Behavior, Market Signals Patterns of capacity collusion are not evident in this table. This data does show the industry increasing capacity at increasing rates, though individually at different pace.

United Continental constrains growth until management can figure out how to run the airline. American is distracted by merger integration. Delta takes advantage of them by increasing capacity. Southwest is only tangentially competitive to those three, growing in its own unique markets. The four smaller airlines do not compete with each other, aggressively going off in different directions. Industry capacity growth exceeds GDP growth.

That leaves the potential for collusion through subtle market signals. Airlines publish schedules and fares months in advance for the convenience of customers and third-party intermediaries. So one airline announces a fare raise and the others follow or not – meaningless headlines because every ticket is sold in real time by yield management programs, not by list price. Nobody pays list as the airlines constantly try to maximize what the market will bear at the time of sale. It is highly unlikely there is a secret underground cable or satellite transponder linking certain servers in Atlanta, Chicago, Fort Worth, and Dallas.

Equity analysts were worried airlines will stop providing capacity and cost outlooks, because they are free – did not happen as of 2Q15 earnings calls. Several third-party vendors provide reams of individual and industry capacity and list price data derived from published schedules, for a fee. No airline provides yield guidance except what is already booked.

Real Yields Remain Flat

Looking back as far as the Wright Brothers, passenger fares in 1978 dollars are at historical lows (at least the portion airlines collect ex government fees and taxes) and flat for the last fourteen years, while passenger traffic is at all-time highs – basic ECON 101 facilitated by improving aircraft and IT technologies.

New technology 787s and A350s offer -30% lower operating costs with longer range, opening up new markets; airlines bought thousands. If Boeing and Airbus redesigned narrowbodies with this technology, airlines would have ordered tens of thousands. The manufacturers did not want to cannibalize their huge backlogs of high-margin aircraft. Instead only engines were upgraded with new technology (BA kicking and screaming before offering the MAX versions); airlines ordered 4,000 A320neo and 2,800 737MAX. The airlines are victims of delayed technology, not co-conspirators.

FAA Constrains Infrastructure

Airlines cannot conspire to restrict capacity growth in the New York/eastern corridor—airport and traffic control capacity are maxed out. Slots were handed out by the FAA decades ago to then-incumbent airlines as JFK, LaGuardia, Newark, and Reagan filled up. FAA claims it “owns” these assets; airlines claim their slots are grandfathered in by longevity and use. Airlines who want to merge or swap slots “volunteer” to relinquish a few slots for auction to have-nots (but pocketing the money). The status quo works for incumbents and the FAA, so neither group wants to litigate and risk losing control. Every airline, haves and have-nots, wants more NYC slots.

GPS spreads throughout every industry, except the FAA – aair traffic control still has a person with a phone in front of a radar screen, World War 2 style. Switching commercial aviation over to GPS will be at least 40 years behind the technology and cost over $40 billion (half paid by airlines to retrofit current fleets). So every flight into, around, or over New York (and the country in general) needs a greater safety of margin around it than GPS would.

DoJ-Approved Industry Structure

It all began with the DAL/NWA merger, approved rapidly with few comments by DoJ. Then UAUA/CAL gave up a few slots here and there for approval. Then DAL and LCC swapped LGA and DCA slots, giving up a few more slots after over a year of DoJ inaction. Finally AMR/LCC, and DoJ finally realizes they might have let the airlines out of the hanger, but settled for a few more slots (see HY Note: AMR/LCC Successfully Settle DoJ Complaint). Along the way, five Atlantic JVs were approved that control over 80% of transatlantic capacity. If those JVs are conspiring to raise fares, they are doing a lousy job (See Report: Airlines: The Transatlantic Capacity Caper). Now the JV concept expands to Pacific and LatAm sectors.

The US airline industry consolidated into four airlines with about 20% domestic market share each and a few others combined to round out the last 20%, all under the watchful eyes of DoJ. The problem is DoJ never understood the airline industry (See Report: Airlines: Running the DoJ/DOT/FAA Gauntlet 7/6/10), primarily that airlines are networks, not collections of spokes (See Report: US Airways vs. United States of America for a detailed look at DoJ shortcomings). The left hand approves consolidation, the right complains.

Outlook
Airlines do not help their case when one changes fees or frequent-flier rules and the others quickly fall in line, recently with bans of African animal trophies. It upsets customers, generates consumer advocacy activity, and provides politicians fodder to slice a little more pie from the pie enlargers. But the pie grows so much that even billions of dollars of shareholder awards do not deflect balance sheet improvement. All US airlines have rating upgrade potential into 5-B territory. Buy any senior unsecured bonds offered, delevering adds to their scarcity (See Report: US Airlines: 2015 Outlook updated by US Airlines: 2Q15 Review and Outlook for current industry outlook). Also EETC tranches—stable asset values plus improving airline credit metrics.

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