For travelers, it’s been an airfare party this summer with many domestic flights cheaper than a nice bottle of wine. Chicago to Los Angeles can be had for $49, Dallas to San Francisco is just $40, and Denver to Dallas goes for only $25—barely enough for a quality pinot.
Airlines and their investors despise these fares, the result of a fierce pricing skirmish that has bickering carriers behaving like quarrelsome 3-year-olds: It wasn’t me, he started it!
The fare fight reprises a similar battle that erupted two years ago, one that dented industry revenues for more than 18 months. Only this past spring did carriers begin to feel confident that their pricing power was gradually returning.
Now there’s a new war, and no clear end—or winner—in sight.
The renewed conflict pits the industry’s deep-pocketed behemoths, led by United Continental Holdings Inc. and American Airlines Group Inc., against a trio of ultra low-cost carriers [ULCC] possessing cost advantages the big guys can’t replicate. Financially, the Big Three “are better positioned now than they’ve ever been,” said Seth Kaplan, managing partner for trade journal Airline Weekly. “On the other hand, lowest cost historically has won.”
Fares and shares are dropping while investor anger rises
Two things undergird the fare war of 2017: fuel and money. Jet fuel costs, while rising, remain inexpensive relative to what the industry paid in the past and, equally important, all the major U.S. airlines remain solidly profitable.
Because of these dynamics, neither side has blinked, just as almost every airline has used the fuel reprieve as an opportunity to increase domestic flying.
Fares—and airline stock prices—have shrunk accordingly. United shares have lost 28 percent over the past three months, given the zeal with which the Chicago-based carrier has taken the pricing battle to Spirit, where the share loss has been 41 percent. American and Southwest shares have declined 15 and 13 percent in the same period, respectively, while Delta has lost 10 percent and Allegiant 17 percent.
“At the end of the day, market share battles always get you into trouble,” said George Ferguson, a senior aviation analyst with Bloomberg Intelligence. As the fares drop, shareholder anger grows—and that wrath is likely to spur higher fares faster than any future jet fuel spike, Ferguson said.
United President Scott Kirby is, arguably, the primary U.S. fare setter today, given his role as architect of a “price-matching” strategy when he was American’s president. Kirby said Spirit has led the most recent ticket battles, with a 50 percent cut to walk-up fares on July 28, followed by a further cut in the following weeks.
Last month, Evercore ISI analyst Duane Pfennigwerth published a client note titled “It’s Not Business, It’s Strictly Personal” that was both a rant and plea to United’s board to curb Kirby’s price-matching. “We remain very surprised that the new board at United is giving this one, big personality the freedom to … roll the dice on industry discipline,” and start fare wars, Pfennigwerth wrote. “Investors and board should know that none of this had to happen.”
Low costs are certainly a ULCC advantage. In the second quarter, Spirit Airlines Inc. had a cost per seat-mile, excluding fuel, of 5.83 cents, compared with 10.28 cents at United, which has a cost structure comparable to those of American and Delta Air Lines Inc. Privately-held Frontier Airlines Inc., a ULCC modeled on Spirit, was at 5.43 cents as of Dec. 31, the company has said. By the same measure, Allegiant Travel Co.’s cost was 6.42 cents in the second quarter.
The price battle is one “the full-service guys can’t win,” said Ferguson, who predicts that deteriorating profits on many routes will compel directors at United, which has a broader shareholder base than the ULCCs, to demand a change. “United is going to lose money before Spirit loses money,” he said.
A full-service global carrier must “fill a good portion of your jet with someone who’s willing to pay a close-in fare at a big price.”
American executives have defended their price matching because half of the airline’s revenue comes from the 87 percent of people who fly the carrier only once a year. This situation has prompted some of the biggest U.S. airlines to fight for every passenger in each of its hubs.
In years past, airlines often ignored the most price-sensitive customers, choosing to keep the higher fares. In many markets that have little or no competition, that is still their position.
Yet the big hubs—like Atlanta, Charlotte, Chicago, Dallas, Denver, and Detroit—are markedly different, and with the incursion of low-cost rivals, the Big Three perceive an existential threat that must be attacked, if not eradicated.
The hubs are where legacy carriers dominate, and in doing so exploit the financial power of their connecting traffic by goosing fares from different markets.
Delta, for example, holds roughly 75 percent market share at its four largest hubs, while American is at 91 percent in Charlotte, according to data compiled by Morgan Stanley.
When Spirit or Frontier entered with daily service, according to an analysis of fares in 2014-15 by consulting firm ICF International Inc., fares at eight U.S. legacy hubs dropped an average of 20 percent.
How the Big Three Could Win
The low-cost carriers do have a soft underbelly, though. Spirit and Frontier have labor contracts pending with their pilots and are likely to assume higher costs as part of the new pacts, a process Allegiant completed last summer.
Spirit’s pilots say they earn about 40 percent less than their U.S. peers flying the same Airbus planes and want to narrow that gap with their new contract.
Frontier delayed its plans to go public this summer, likely due to the increased financial pressure expected from the competitive threats. In a securities filing, Denver-based Frontier also specifically warned future investors about sharper competition targeting its part of the low-fare market.
United’s Kirby was particularly blunt in an Aug. 28 interview. Carriers like Spirit, Allegiant, and Frontier “have created a product that no one wants to buy” if the fare is the same on another airline. “I won’t predict what happens, but I think the U.S. ULCC model is not viable when an airline chooses to compete with them,” he said.
Spirit executives counter that such pricing battles won’t end well for the company with higher costs. “Rumors of the death of the ULCC model are clearly overstated,” Spirit Chief Commercial Officer Matt Klein told investors Wednesday at a conference. “People like low fares,” he said, and “low costs are going to deliver those low fares better than anyone else.”
Spirit is profitable both with paltry fares, which drive more people onto its planes, and with higher fares, which cause load factors to drop and ticket yields to rise, executives say.
Because of costs, a base fare of $25 between Denver and Dallas is generally more acute for American and United than for Frontier, Spirit, or Southwest, although none of the carriers sells a majority of their seats on the nonstop flights at that price. (The big carriers also don’t match the lowest fares on every route.)
The counter-argument is that the legacy airlines’ connecting traffic negates the ULCC financial advantage, since American and United may have equally low costs at their hubs. “In our hubs markets, because we can put so many connecting passengers on a plane, our marginal costs for local traffic is really, really low,” Kirby said. “We can absolutely be profitable in all of the markets where we compete in our hubs with anyone. We couldn’t if we sold the whole airplane at $20 a seat.”
Still, the prevalence of low fares is taking a toll financially, with United Chief Financial Officer Andrew Levy describing the situation as “painful” and “difficult” in his comments this week even as he reiterated the airline’s commitment to its competitive strategy.
If low fares and weak stock performance persists, said Ferguson, that approach may change: “The more pain that the shareholders feel, they’ll be clamoring for the board to do something about it.”