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Consolidation Won't Cure These Overvalued Stocks

Despite recent events, we think long-term prospects for the legacy airline industry are dim.

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"And they're off to the races ..."

So goes the beginning of any horse race--but this time, it's the market racing to buy up shares of major airline stocks. These stocks have witnessed a meteoric rise, climbing more than 18% (on average) since  US Airways(LCC) merger proposal for Delta Airlines (DALRQ) in November 2006. Although US Airways has now withdrawn its offer, the market is still contemplating the idea that legacy carriers might eventually merge. The long-awaited arrival of consolidation has everyone speculating--and not just about what's going to happen to frequent flyer accounts. The market is betting that the airline industry might finally right itself this time. Although industry conditions have certainly improved (and consolidation might extend the honeymoon period), we at Morningstar make no illusions that the long-term picture has changed.

Why the Market is Bullish
The market believes that consolidation is the tonic for chronic overcapacity in the airline industry. According to this theory, fewer competing flights would translate into fuller planes and better price stability. Achieving price stability would be a major accomplishment for an industry that has witnessed declining nominal yields (a common measure of unit prices charged to customers) since 2000 and has experienced declining inflation-adjusted yields since its inception.

Certainly, industry conditions during 2006 have provided a shot in the arm for the advocates of consolidation. Overall capacity for the year grew at an anemic rate of 1% as US Airways, Delta, and Northwest Airlines  (NWACQ) eliminated capacity both in and out of the bankruptcy process. Higher oil prices along with the absence of irrational competitors, like the now-defunct Independence Air, led to an 8% increase in prices for the year, a remarkable achievement. As a result, for the first time in five years, legacy carriers are reporting strings of profitable quarters and impressive free cash-flow gains.

Airlines are exercising unusual discipline to control capacity, and because consolidation has the potential to remove additional seats from the system, we think supply could be held in check for some time to come. The nation's largest carrier,  American Airlines (AMR), plans to cut capacity by 1% this year, and  United Airlines (UAUA) proposes only modest seat growth for 2007. Since US Airways made its merger overtures in November, Delta has been quietly removing capacity from some of its busiest hubs. We also acknowledge that prolonged aircraft delivery schedules at  Boeing (BA) and Airbus coupled with burgeoning foreign demand for planes could prevent draw-downs in capacity from being rapidly backfilled during the short term. With air-travel demand chugging along nicely during this current cyclical upturn, occupancy rates are poised for further increases, even after setting record highs in 2006.

Why We're Still Bearish
However, the honeymoon always comes to an end, and we think that consolidation, if achieved, will only provide a short-term pill for the ailments of the industry. We at Morningstar maintain that airline service has become increasingly commodified (check out this article, "Why We're So Bearish On Legacy Airlines"). While demand for premium travel will always exist, we expect prices in this commodity industry to eventually trend toward the costs of the lowest-cost provider on a given route. In fact, the low-cost carriers still enjoy a hefty 35%-50% cost advantage (excluding fuel) over their legacy peers, and while the majors have shed billions in expenses over the years, many will actually experience cost inflation in 2007. As legacy carriers cut capacity either through restraint or merger activity, we expect low-cost carriers to eventually replace these reduced seats. The low-cost bunch can still make money by introducing more service even as they undercut legacy-carrier prices.

Indeed, low-cost carriers and upstart airlines have plans to continue growing even if the legacy carriers merge.  Southwest Airlines (LUV),  JetBlue Airways (JBLU), and  AirTran (AAI), together, have firm orders and purchase rights for nearly 600 aircraft over the next six to eight years, and low-cost carriers make up 65% of total deliveries during the next five years alone. What's more, new low-cost carriers are always on the horizon; for example, Skybus plans to fly 65 new Airbus 319s out of Columbus, Ohio, beginning in spring 2007, and San Francisco-based Virgin America has plans to fly approximately 30 Airbus 320s while expanding to nearly 10 cities in its first year. To make matters worse, authorities who oversee airports around the country have every incentive to spur competition by attracting low-cost airlines to occupy unused gates, thus enriching their tax coffers from the passenger, gate, and concessions fees.

Although conservative capacity expansion and the potential for consolidation might improve the industry's fortunes near-term, we maintain that legacy airlines continue to be value-destroying entities over the long haul and that the structural dynamics of the industry have not changed permanently.

Marisa Thompson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.