Dueling Dallas views of US airline industry

by Aaron Karp
Aug 18, 2017

There were two schools of thought prominent during the recent round of US airlines’ second-quarter earnings calls: 1) Yes, net profits and margins are down year-over-year, but look at the long-term picture: the US airline business is absolutely fundamentally changed and will be strongly profitable, despite some temporary dips here and there, for years to come—so investors should get on board quickly and unhesitatingly. 2) Well, maybe the business is different than it used to be, but maybe not. Airlines—and investors—need to be prepared for some rough patches and airlines need to be prudently managed under the assumption there will be difficult times.

You don’t have to leave Dallas to find perhaps the biggest proponents of each view. American Airlines chairman and CEO Doug Parker is repeatedly pounding view number 1. Southwest Airlines chairman and CEO Gary Kelly is the more cautious voice, expressing view number 2.

Both men, of course, are coming at things from different perspectives.

Parker took over the merged American-US Airways just as American was emerging from Chapter 11, and he believes consolidation, fundamental changes made during Chapter 11 restructuring and a reformed view by airline management regarding capacity discipline insulate the industry from the disastrous sea of red ink US major airlines swam in during the previous decade. Kelly’s Southwest has always been profitable—net profits every year, without exception, for the last 44 straight years—and that is because it never assumed things would always be rosy and planned accordingly. It’d be great if airlines writ large are now perpetually profitable businesses, Kelly believes, but Southwest won’t assume that’s the case and will make sure it stays profitable even if the rest of the industry nose dives again.

Is Parker too optimistic? Is Kelly too cautious?  

The half-year financial results for the nine publicly traded mainline US airlines released this week by Airlines for America (A4A) include some numbers that certainly provide grist for Kelly’s wait-and-see caution.

US airlines’ expenses grew at more than twice the rate of revenue in the 2017 first half, leading to a 23.3% year-over-year decline in pre-tax profitability. Higher expenses included increases in fuel (plus 19.9% YOY), labor (plus 9.1%), maintenance (plus 8.3%), aircraft (plus 6.8%) and airport rents and landing fees (plus 3.1%).

What if those kinds of expense jumps become common? Parker and proponents of the fundamentally changed view believe the cost hikes are not going to be repeated over and over—the spikes are themselves a sign of a maturing, healthy industry that needed some corrections. Labor costs needed to match airlines’ new level of profitability and now they do, so the jumps being experienced now are just short-term course corrections, the proponents of this view say. Fuel was so low it had to rise somewhat. New aircraft may be costly upfront, but they represent huge leaps in fuel efficiency and so operating costs will decline over time.

I don’t think Kelly would necessarily disagree with the above sentiments, but I’ve heard him in the past discuss fuel volatility. (“I don’t think we’ve ever anointed ourselves the czars or seers of what the future is,” he once said when discussing fuel prices.)

How does anybody know fuel prices won’t skyrocket again? They probably won’t, but they could—and nobody really knows.

What if labor now believes its pay raises should be perpetual and the current round of labor cost hikes are not just one-time course corrections? What if there is some global event outside of airlines’ control that leads to a significant drop in air travel demand?

Wall Street is clearly in the cautious camp, something that has frustrated Parker. “It feels to me that [investors] … can’t just believe that the industry has gotten well, almost like this is too good to be true,” he said during American’s call.

Kelly appears to be among those who believe it may be too good to be true. “The philosophical point to argue here is we are still going to manage the company under the assumption that there will be very difficult times again,” Kelly told analysts. “I’ve heard comments [along the lines of] things are different now. Maybe. But we’re going to make sure that Southwest is very well positioned to weather the storm.”

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