Airlines have been releasing their quarterly earnings reports over the last couple of weeks, and the results have been downright excellent. They’re all making money hand-over-fist, but not everyone is pleased. Wall Street, in fact, is not happy that the airlines are actually trying to compete with each other. That’s keeping fares lower, and that means some analysts think the airlines aren’t doing everything they can to maximize profits. I see things differently.
The airline that really sent shockwaves with its earnings call was American. In the second quarter of this year, American made $1.9 billion net of special items. That meant the airline earned a pre-tax margin of more than 17 percent. Holy crap. That’s starting to sound like a normal company.
But that wasn’t the news that spooked investors. During the quarter, American’s PRASM dropped 6.9 percent versus last year. PRASM stands for passenger revenue per available seat mile. To calculate PRASM, you take the number of seats on each airplane and multiply them by the number of miles they fly during the period (that gives you your ASMs). Then you take the passenger revenue (or, uh, PR) and divide it by the ASMs. The resulting PRASM is a metric that tells you how much money your flights are generating. So while American had record profits, it was because its costs dropped like a rock thanks to low oil prices. Revenues dropped as well, but not by nearly as much, so… record profit.
What is it that can cause PRASM to drop? Well, some of it is boring stuff, like currency exchange rates. But the real substance can be boiled down to two things. If fares are steady but fewer seats are filled, then PRASM drops. If the number of seats filled remains steady but fares drop, well, then PRASM goes down too. Those two metrics drive PRASM changes, and this last quarter, dropping fares appear to have been the biggest issue.
Some of this was due to specific macroeconomic issues. In Brazil, for example, the economy has gone to hell. It’s so bad that even after cutting capacity 20 percent, American’s PRASM was still down 24 percent as the airline had to drop fares to fill the seats it did fly. Yikes. But that’s not American’s fault and analysts aren’t suggesting it is. What analysts don’t like is that American is getting aggressively competitive in certain markets.
Dallas/Ft Worth is a perfect example of what’s going on here. It’s an enormously important hub for American and it’s under tremendous price pressure. Remember, last year the Wright Amendment went away and Southwest was suddenly allowed to fly anywhere in the US from Love Field. It has added a crazy amount of capacity and fares have responded as you’d expect… by going down. American isn’t immune to this even though DFW is not Love Field, so it has been staying competitive. At the same time, it has stepped up its game and is tracking Spirit much more closely than it did before. (US Airways has long operated this way, while American was more hands off.)
Why doesn’t Wall Street like this? In a research note from July 24 entitled “The Frustration Continues,” Helane Becker, analyst from Cowen and Company, had this to say.
The main takeaway we had from the AAL call was American stating they have become a price taker rather than a price setter. Given their size and product, we do not believe they should ever be a price taker. American has cited the competitive market in Dallas as a major reason for their PRASM woes, but this should not have been a surprise. There was always going to be an impact from the repeal of the Wright Amendment but we do not believe American should be a price taker. Southwest has repeatedly state that their Dallas load factors exceed 90%. Given Southwest aircraft are nearly full, American should be able to have a better mix of airfare on its aircraft. We believe American needs to concede some local market share to Southwest and just focus on what makes them potentially great.
In other words, American is big and important, so it should be able to focus on the corporate market and charge what it wants since low cost carriers are serving a different market. I just don’t see it that way.
This is why revenue management exists. If there is a competitive fare in the market, American should match it and then revenue manage its flights to determine how much to sell at that low fare. If American can fill its airplanes without taking that low fare, then great. But if it needs to take that low fare, then it should have that tool in its toolbox. Considering how much capacity entered the market last year, it’s no surprise that fares would drop. But American needs revenue management to manage this in the short term. In the long term….
American realizes that today’s low cost carrier is tomorrow’s behemoth. Remember when people said Southwest wasn’t a threat? Incredibly, it wasn’t that long ago. But look at Europe where Ryanair and easyJet, airlines which were supposed to be ignored because they targeted different types of travelers, are now making big inroads into the corporate market. You think a day won’t come where Spirit makes that same play? American is being smart by trying to compete now. The backdrop, of course, being that it is raking in a very respectable margin so it has the ability to invest in long-term fights that it wants to win.
For now, that means consumers are the winners because they get lower fares on multiple airlines. Might this eventually be proven to be the wrong strategy for this particular issue? Sure. But that’s not where I’d put my money.
I talked about this back in May when I said that higher fares meant airlines were just inviting competition. Will the numbers say that they could have charged more and cut capacity more? Sure, you can always cut capacity and increase fares. But that’s a short term strategy. In the long term, there’s a delicate balance. Just ignoring the competition isn’t going to make it go away.
I’d argue that some analysts probably aren’t really considering these long term ramifications appropriately. This isn’t about adding a crazy amount of excess capacity. It’s about properly managing markets that are already important. I like to see an airline that’s paying close attention to the competitive landscape and acting when there’s a threat. Is it maximizing its profit for the quarter? We don’t know for sure, but the profits this quarter are just fine, thank you. More importantly, the airline has to position itself for the long term future of the business.