Major Airlines Continue to Flounder in May
Over the past two months, I have reported on weakening unit revenue trends within the airline industry. While the industry bottomed out in April, results in May were still fairly unsatisfactory at most carriers. Airlines are benefiting somewhat from lower fuel prices and planes are more packed than ever before, but pricing power has been extremely weak. As a result, most carriers suffered a second straight monthly decline in unit revenue.
Unit Revenue Change
Delta Air Lines
Unit revenue is a very important indicator of performance for airlines, because it includes the effects of both "load factor" (the percentage of seats filled with paying passengers) and "yield" (the average ticket price). For several years, airline industry unit revenue had shown continuous growth as the U.S. economy rebounded from the Great Recession. However, that trend seems to have been broken this spring. If unit revenue continues to stagnate, airlines will have trouble producing meaningful profit growth.
Where's that capacity discipline?
Much of the bull case for the major airlines has been built on the premise that consolidation has improved capacity discipline and pricing power within the industry. As CNBC's Jim Cramer put it, the U.S. airline industry is essentially an "oligopoly". Assuming that the American-US Airways merger is completed, four airlines will control more than 80% of the domestic market. That fact formed the basis for Cramer's buy recommendation on the sector.
The past few months of revenue results have thrown cold water on the theory that consolidation has significantly improved capacity discipline or pricing power. Most major airlines have been replacing smaller planes in their fleets with larger ones, which is making it difficult to prevent capacity creep. For example, while Southwest's capacity increased 3.4%, it actually few 2.3% fewer trips last month than it did in May, 2012. In other words, the capacity growth was the result of larger planes making longer flights: not operating more flights.
The problem for the industry is that while "upgauging" helps keep costs in check, the beneficial effect is negated if capacity creep leads to lower unit revenues. In fact, that seems to be exactly what is happening today. Carriers are offsetting normal cost inflation through upgauging tactics, but the market is unable to absorb the additional capacity, leading to modest declines in unit revenue.
What remains to be seen is whether the airlines can drive enough cost savings through upgauging to fully offset unit revenue weakness. For the moment, lower fuel prices are providing an additional tailwind and may permit some of the carriers to continue their profit growth. Looking forward, though, airlines may need to implement additional schedule cuts to keep profits moving in the right direction.
The bottom line is the bottom line
Airlines have recently become "hot" in the stock market for the first time in many years. Don't get burned! It's critical to pay attention to company fundamentals, rather than day-to-day stock fluctuations. Delta, which was the only major airline to post unit revenue growth last month, still looks like the strongest of the bunch. The other carriers could be setting investors up for a letdown if they continue to post declines in unit revenue, which could in turn lead to lower earnings.
With the American markets reaching new highs, investors and pundits alike are skeptical about future growth. They shouldn't be. Many global regions are still stuck in neutral, and their resurgence could result in windfall profits for select companies. A recent Motley Fool report, "3 Strong Buys for a Global Economic Recovery" outlines three companies that could take off when the global economy gains steam. Click here to read the full report!
The article Major Airlines Continue to Flounder in May originally appeared on Fool.com.Adam Levine-Weinberg is short shares of United Continental Holdings and has the following options: Long Sep 2013 $33 Puts on United Continental Holdings . The Motley Fool recommends Southwest 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.