The Stengel Angle

I meant to write about completely different topics for this post, but this recent decision by the Department of Justice (DoJ) got me thinking enough to digress for one post.

For those who don’t follow the industry, on August 13, 2013, the United States Department of Justice challenged the proposed $11 billion merger between American Airlines and US Airways on anti-trust grounds, asserting that the merger would lead to higher fares and reduced service, among other things. Many of those who work with the industry, including myself, thought this action came out of left field and we are definitely scratching our heads. Why, for example, after years of unopposed consolidation in the airline industry (United-Continental, Delta-Northwest, Southwest-AirTran, etc.), is the government stepping in now and trying to block the proposed tie-up? I’m deathly afraid that a decision is being made without a true understanding of the airline industry and that the complaint lacks the “big picture” of what has happened over the last decade for the airlines and how the business has changed.

So what is the “big picture” of the industry that I’m referring to? Well, in my eyes and in the eyes of those who follow the airlines, the business models have fundamentally changed in the last decade. Pre-2000, the airlines operated older fleets, operated with a load factor of 70-75%, and focused their strategies primarily based on market share (United Airlines once flew to all 50 states). That last one is the one that’s probably undergone the most significant change. While market share is certainly an important metric, particularly in the home turf hubs, focusing on it too much only leads to price wars where no one makes money. In the last decade, the airlines have shifted their focus away from market share and more towards capacity discipline and on the core business. What has driven this change? High fuel prices. With jet fuel now hovering around $120 per barrel and 30% of cost per available seat-mile, the airlines can’t afford to be present on every market, so every route better have a purpose now. In addition, any part of the business that did not directly contribute to the goal of transporting people from point A to point B was cut or downsized. On top of all that, fleet renewals, consolidation,  and many other moves are having industry executives use phrases like “return on invested capital” and “shareholder dividends” when describing their future plans, words that I’ve never heard an airline executive say seriously.

How does this conflict with the Department of Justice’s point of view? The goal of the DoJ is to make sure there is sufficient competition, and they want to do this by forcing competition to exist so that routes and capacity are preserved, and they hope to accomplish that goal by challenging this merger. In other words, it would be a return to the “market share is everything” school of thought. However, I believe this creates an unsustainable business by flooding more capacity into a market that doesn’t need it. It’s the perfect example of how the U.S. government views airlines more as a public utility that needs to serve as many routes as possible, rather than as a business to be operated successfully, efficiently, and responsibly. This semi-regulation of a supposedly “deregulated” industry is pure market manipulation and only serves to pick winners and losers rather than letting the merits of each company determine the competitive landscape.

Consolidation, new entrants, and LCC growth have led to an increase of domestic capacity in the U.S.

I mentioned some of the fundamental changes to the business models, but there have been other changes to the industry that the DoJ completely neglected in their assessment of the American Airlines-US Airways merger. For example, in their complaint, the DoJ mentioned that, “By ending the Advantage Fares program, the merger would eliminate lower fares for millions of consumers”. If I were the DoJ, I would add a footnote saying, “Assuming current competitive landscape remains constant.” To me, the quote completely ignores the threat of new entrants in the industry, which is always relatively high. Name brands like Virgin America, JetBlue, Spirit Airlines, and Allegiant may sound familiar now, but ten years ago many people were asking who they were. All of those carriers managed to grow substantially as low-cost carriers and succeeded in lowering fares in many markets while competing with the larger legacy carriers. Case in point: despite numerous airline failures and consolidation that has taken place in the airline industry, average airline fares have fallen about 15% since 1995 in real terms.

Speaking of low-cost carriers, the DoJ completely left them out of their analysis! This is particularly concerning, considering that Southwest Airlines is the largest domestic airline by capacity (held an 18% share 2012), and that LCC’s have been the fastest growing carriers in the country since 2003 (see chart). The notion that carriers like Southwest, JetBlue, and Virgin America are not in the same realm as legacy carriers is completely absurd, and I expect the DoJ having a hard time defending the flaw in court.

Lastly, the DoJ has completely ignored how airlines have improved themselves to benefit the consumers, particularly through consolidation. Everyone gives airlines bad raps for the food and the cramped seats, but consider the one overarching goal: getting people from point A to point B on-time. Citing a PricewaterhouseCoopers report, as airline networks became more manageable through consolidation, efficiencies were extracted that improved on-time performance and other operational metrics. The additional financial stability brought by consolidation also drove investments for IT technology that simplified processes and also improved enterprise performance. Additional capital available has also allowed for purchases of newer, more fuel efficient aircraft, as we’re seeing with American Airlines and United Airlines. These newer aircraft also have more passenger-focused features, like clean-sheet interiors, larger overhead bins, more in-flight connectivity, and more.

I’m going to pull one more quote from the DoJ complaint, this time from Attorney General Eric Holder: “By challenging this merger, the Department of Justice is saying that the American people deserve better”. Here’s one point I do agree with the DoJ on. The American people do deserve better airlines, but it won’t come through more government intervention. The merger is in the best interest of the consumer, since most recent consolidation has driven investment, better service, newer planes and technology, more efficiencies, and better reliability. In other words, the airlines are operating like a business. Passengers deserve a healthy airline industry that consistently makes money and can reinvest in itself – not a dysfunctional one that it has been in the past and that the DoJ wants it to continue to be.