James M. Higgins, CFA / Vaughn Cordle, CFA
A merged American Airlines (AA) and US Airways (US) will pull down uneconomic aircraft and capacity, especially in the overly fragmented regional segment that feeds the two airlines. Load factors are too low on many of the regional carrier and mainline city pairs, and this is where the merged airline can produce cost and revenue synergies by way of improving the fleet mix. Aircraft that are too old and fuel-inefficient will be replaced as the merged airlines’ network is rationalized.
One key outcome we expect from a merger is that higher load factors and a more fuel-efficient fleet that is better mixed and matched with the ebb and flow of demand in various markets will generate higher unit revenue and improved earnings without raising fares.
As an example, the newly merged airline will not want to keep using the old and fuel inefficient aircraft on the Chicago (ORD) to Phoenix (PHX) route where both currently compete. The merged airline is likely to keep US's A320/321 and AA's B737-800 aircraft and phase out AA's MD80/83 aircraft, which in recent quarters have represented 39% of the total block hours on this route (see table). The newer Boeings and Airbuses have 33% lower fuel consumption per seat, which implies that fuel costs per seat on this city pair will be about 16% lower once the older aircraft are removed. As fuel expense represents about 37% of AA’s total operating costs, total expenses will drop by about 6% on this route by simply replacing the older aircraft with more fuel-efficient jets.
Of course there are other costs that must be considered. These costs, specifically labor, will be discussed in one of our next research notes that will be part of a series of notes on the merger and its impact on the airline industry.
Fares will follow costs over time, and the airlines need to earn their weighted average cost of capital over a full business cycle. Accordingly, the new American Airlines becomes more profitable and competitive because it can offer competitive fares while improving earnings once the fleet mix and network are rationalized. The merged airline will need to be fare-competitive in order to enhance scope economies (i.e., network synergies) via increased passenger volumes. The higher the volume, the better the operating economics as the company spreads expenses and fixed costs over more passengers. Moreover, tighter capacity management will reduce the number of lower-end “junk” fares and improve overall yields and profitability without raising prevailing fares in any particular market.
That last sentence is a key point: In our view, it would be a mistake to assume that fares will naturally rise anytime soon as a result of the merger. Passenger demand will be weaker this year than it would have been otherwise due to fiscal tightening, which in turn dampens GDP and job growth. For this reason, we don’t expect average fares to move much higher than inflation in the short and intermediate term.
Over the longer run, average fares will be a function of industry capacity growth, likely higher labor costs, fuel costs, and GDP and employment growth. Capacity levels in the US will be more disciplined because of industry consolidation, and the result will be a more optimal management of supply and demand. Moreover, the key outcome of the recent years’ string of mergers will be that rationalization of the overly fragmented industry will lead to sustainable returns that optimize benefits for all stakeholders--consumers, labor and investors.
In summary, a combined American and US Airways will continue the airline industry’s journey toward higher concentration and sustainable returns, while having significant opportunity to improve company-specific earnings via rationalization and upgrading of an inefficient fleet, among other drivers. There will be labor cost dys-synergies as US Airways’ underpaid (by industry standards) employees are brought to parity, but the overall impact of the merger will be, in our opinion, favorable for both American/US Airways stakeholders and the airline industry as a whole.
Please contact us for additional information or for the full AA+US fleet analysis