By: Vinay Bhaskara / Published July 6. 2015
The US Department of Justice (DOJ) announced that it was investigating US airlines for collusion Wednesday afternoon, building a striking parallel to current efforts by major US carriers to restrict access to the U.S. market for Middle Eastern airlines and European low-cost carrier (LCC) Norwegian Air Shuttle. The DOJ has subpoenaed several major U.S. airlines as part of its investigation into “possible unlawful coordination” to limit capacity and boost airfares. News of the DOJ investigation comes roughly two weeks after Connecticut senator Richard Blumenthal wrote a letter to the DOJ asking them to probe possible collusion amongst US airlines.
RELATED: DOJ Subpoenas Airlines over Alleged Collusion The DOJ has broad latitude in proving collusion.
According to the DOJ website:
Most criminal antitrust prosecutions involve price fixing, bid rigging, or market division or allocation schemes. Each of these forms of collusion may be prosecuted criminally if they occurred, at least in part, within the past five years. Proving such a crime does not require us to show that the conspirators entered into a formal written or express agreement. Price fixing, bid rigging, and other collusive agreements can be established either by direct evidence, such as the testimony of a participant, or by circumstantial evidence, such as suspicious bid patterns, travel and expense reports, telephone records, and business diary entries.
The DOJ’s investigation is the most far-reaching probe by the U.S. government into the behavior of U.S. airlines in a long while, perhaps ever. Still, the investigation has a high burden of proof. In order to prove that U.S. airlines actually colluded, the DOJ must not only prove that the actions of the U.S. airlines reduced competition, but also that these illegally communicated with each other in order to achieve this state of reduced competition.
This second requirement would appear to be the biggest weakness in the DOJ’s case. It appears that the DOJ is (at least partly) relying on public statements made by airline executives at various conferences, as well as the more common practice of providing capacity guidance to investors and the media to prove its case. This seems like weak evidence at best. There’s always the possibility that the DOJ has some sort of whistleblower at one of the U.S. majors, but it seems unlikely given how many resources and employees U.S. carriers devote to regulatory compliance that they’d slip up.
Airlines are certainly a convenient political target given the broadly unfavorable consumer views of U.S. carriers (excluding Southwest and JetBlue?), and the veritable smorgasbord of negative stories from a media primed to view everything involving businesses almost exclusively through the lens of the consumer, without considering the other stakeholders involved (more on this later). Given that context, one almost wonders if the DOJ is looking to score cheap political points by extorting a few million dollars per airline to make this issue go away quickly. Airline stocks are certainly being punished enough such that executives have a pretty strong incentive to do exactly that.
The other plausible outcome from this case is a consent decree (basically a diktat from a federal agency saying “stop this practice or else…”) that would require airlines to stop issuing specific numbers for capacity guidance, or even to stop making public statements about capacity altogether. But airlines primarily issue those statements for the benefit of their owners (i.e. shareholders). They’re not required by SEC regulations, but they are pretty standard practice worldwide because they allow an airline’s owners the ability to react in real time to an airline’s plans and force adjustments that they deem necessary, which is a pretty fundamental shareholder’s right. Moreover, even if the DOJ bans capacity guidance, airlines will just shift to providing PRASM guidance, which will send enough of a message regarding capacity that shareholders will be able to pressure airlines into doing what they want anyway. The DOJ also technically has the ability to break up the US majors, but that’s not a realistic outcome.
Contextualizing the Problem
The argument for the anti-competitive market situation largely rests on two data points: capacity discipline by U.S. airlines and sharply rising airfares. To start with the latter, the rise in airfares is a common talking point. For example, in a CNN report on the probe yesterday, a pundit noted that “Fares have skyrocketed…. according to government data, airfares have increased 16.4% since 2010.” But this data is misleading if not outright disingenuous. First and foremost, using 2010 as a base doesn’t make sense given that 2010 was still in the midst of recovery from the global financial crisis in late 2008-2009. A better design would begin in 2008, which has the added benefit of preceding enough of the mergers such that you start with a fundamentally more competitive industry than today. Then you have to talk about the use of base fares, which are affected by a variety of factors, most importantly stage length. You would expect airfares to rise as stage length rises, and given the 6.6% rise in stage length for U.S. airlines from 2008-2015, that immediately wipes away part of the rise. Luckily, airlines have metrics that account for length of flight, namely PRASM and yield.
While PRASM is the more widely reported metric, PRASM is also affected by load factors and the balance between capacity and demand, so a better metric is adjusted yields, which reflect the average price a passenger is paying for a seat-mile on an aircraft. So just how monstrous is the rise in airfares per this metric? Between 2008-2015, they went up 6.6%, a whopping 1.08% per year. Meanwhile, stage-length adjusted cost per available seat mile (CASM) rose 5.4%. 1.2 percentage points more than costs is what fares have risen since 2008. The inclusion of ancillary revenue like checked baggage fees and change fees complicates the picture, but even so, out of pocket travel costs don’t end up coming out much higher than CPI inflation over the period, at 9.9%.
Capacity moves have been driven by Wall Street
On the capacity side, the DOJ can at least point to plenty of evidence of US carriers making statements about capacity discipline and de-hubbing airports like Memphis or Cincinnati that weren’t a fit post-merger. And on an aggregate, level, the US airlines, particularly the legacies, but also Southwest and the rest have embraced capacity discipline, with post-recession capacity growth under the rate of growth of GDP (the economy) whereas in the past, capacity usually grew at 1.5 – 2x the rate of GDP. But is the cause of this really coordinated action derived from illegal communication? Or should we apply Occam’s Razor and look for the simplest answer?
Like most publicly traded companies, U.S. airlines are in many respects beholden to their shareholders (i.e. their owners). And while Wall Street is oft maligned in industry circles for driving too much short term thinking (occasionally in this space), by and large Wall Street analysts and ratings agencies are a pretty good proxy for most shareholders, who tend to lack a sophisticated understanding of the industry and its vagaries. And Wall Street, for very food reasons, has decided that it likes capacity discipline; and that by extension it will reward it, and punish a lack of discipline. One need look no further than the recent response to Southwest’s share price when the Dallas-based carrier announced that its capacity growth for 2015 would come in around 8% instead of 7% as it had previously guided. Southwest’s share price was hammered (along with that of much of the industry) and it was forced to walk back those plans.
While this might seem to be an overreaction, airline investors have a very good reason to value capacity discipline. It is only in the last five to six years, as investors have pushed airlines to engage in capacity discipline, that they have finally got something resembling a reasonable return for the first time in more than a decade. And unlike the late 1990s, these returns are not contingent on an incredibly positive macro environment in the U.S. and the world. And when a firm’s owners want something, it usually happens (look no further than the ousting of Dave Barger in favor of Robin Hayes at JetBlue). Has this changed the behavior of U.S. airlines in aggregate? Yes. Is it collusion? No.
A situation of the DOJ’s own creation
The real dramatic irony is that the present state of competition in the US airline industry is pretty much the fault of the DOJ itself. If fares are rising and capacity is being constrained, the DOJ has no one to blame but itself. Through a mix of antitrust immunity/joint ventures, mergers, and slot swaps, the DOJ has allowed many of the more anti-competitive situations in the U.S. to develop. There are only three major airline groups across the Atlantic? The DOJ signed off on that. Six legacies merged into three? The DOJ signed off on that too. Delta and American now have fortress hubs at New York La Guardia and Washington Reagan respectively? The DOJ okayed that one as well. We are unquestionably living in an air travel oligopoly. But it’s a bit rich for the DOJ to bluster about the resultant situation today when it signed off on every one of the steps that created it.
And the federal government’s various agencies have the ability to rectify this situation pretty quickly. The US3 campaigns against Norwegian and the Middle East Big 3 can be overruled pretty quickly. Why not go further and sign Open Skies agreements with any country that’s willing? And to solve the issue of domestic competition, why not ease rules on foreign ownership and offer unlimited cabotage? The federal government has plenty of tools to increase competition in the US airline market. None of them involve a politically convenient “investigation” based on exaggerated charges.
The most important philosophical question is which stakeholders matter
The current U.S. airline market is not the best it has ever been for consumers. It’s still better than everything before deregulation and most of the 80s and 90s, but except for high yield and business travelers, the early 2000s were probably the golden age for purchasers of air travel in terms of convenience and low fares. And the reduction in competition through consolidation and capacity discipline absolutely plays a role on that. But is the consumer’s interest the only thing to consider?
Airlines have three primary stakeholders: consumers, employees (including executives), and shareholders, as well as several other minor ones (like airports, airframers, suppliers, etc.). But when the media and broader public think about airline issues, they solely focus on the consumer’s needs and perspective. But shareholders can’t be ignored, if only because they own the airline. Ultimately, an airline, like any for-profit business, is beholden to its shareholders, and largely required to comply with their wishes and act for their benefit. There are very good reasons for this. The original rationale for the shareholder system was to allow the pooling of capital to create large companies while spreading risk. There is no way that the massive, complex, and risky airline networks that exist today would be able to function without the money of the shareholders.
But there’s a funny thing about shareholders: they like getting a return on their money. And by 2007/2008, airlines had burned investors one too many times (Southwest notwithstanding). There was no way that airlines could continue to act in the irrational and aggressive manner they adopted between 2000-2008, if they wanted to continue to access the myriad benefits (such as capital) provided by shareholders. So they decided to buckle down and get serious about delivering returns. In the process, fares went up and planes got fuller. But we have a very good reason to want shareholders, not in the least because they provide the capital for new entrants/growth agents (like Spirit Airlines) who are ultimately the most effective form of competition. Especially given the higher barriers to entry created by additional FAA and DOT rules and regulations, investors who can pool large sums of capital are critical for the US airline industry to develop new entrant activity moving forward. Investors have just begun to trust airlines again. Do we really want to take action against the capacity discipline that has allowed that trust to regrow?
Employees haven’t done anywhere near as well as investors have, but they are also better off than they were in the dregs of the 2000s. Pilot groups have probably gotten the best deals (helped by the pilot shortage), but across the board, employees have begun to share in the profitability of their employers through increased wages, profit sharing, or both. And so amongst the three stakeholders, consumers might be slightly worse off, but investors and employees are way better off. Arguably consumers have gotten the best deal from commercial aviation over the past 30 years, enjoying lower than realistic fares while being cross subsidized by employees and investors taking a hammering. The tables have turned, and we’ve hit a more stable equilibrium. But is that something that the broader populace can accept?
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DISCLAIMER – The Author is long/short on several US airlines, including AAL, DAL, SAVE, ALK, JBLU, and ALGT, as well as several global airlines.