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Stock Strategist

High Oil Prices Pack a Double Whammy for These Airlines

Low-cost carriers are particularly vulnerable to escalating oil prices.

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A fanfare of headlines recently proclaimed the news that crude oil topped $100 per barrel, heralding a feeding frenzy on the first trading day of 2008. But oil prices have been climbing steadily over the past six years, and there are few companies for which fuel is more crucial than it is for airlines. Today's oil prices are particularly burdensome for this bunch, with more than 25% of the airline industry's cost structure tethered to this volatile input. Although conventional airlines such as American Airlines (AMR),  Delta Air Lines (DAL),  Continental Airlines (CAL), and  United Airlines (UAUA) will be affected by higher long-term fuel prices, low-cost carriers such as  Southwest Airlines (LUV),  JetBlue (JBLU), and  AirTran (AAI) are no less vulnerable.

Why Low-Cost Carriers Have Thrived
Low-cost carriers grow by sustaining their low fares, attracting customers who might otherwise drive to their destinations or may not be able to afford other means of travel. Low costs--including the cost of oil--are fundamental to the success of the business model. In fact, the rise of the low-cost business model since the mid-1980s, as exemplified by Southwest Airlines, is directly tied to a period when oil prices adjusted for inflation were generally flat.

As long as oil prices remain tame, low-cost airlines can focus on productivity and efficiency gains to decrease unit costs. As these airlines grow and bring their low-cost business to new destinations, they can use these low prices to stimulate demand. For example, when a low-cost carrier enters a market and undercuts incumbents by offering a $200 round-trip airfare compared with the $400 fares offered by competitors, we all get excited, because it means we can actually afford to take twice as many trips for the same price. In addition, leisurely weekend getaways become more affordable, making trips that might not have been feasible at higher prices a reality.

...and Why Today's Outlook Is Grim
However, this phenomenon is a double-edged sword. Low-cost airlines in particular risk destroying demand if they raise prices, say, because they are passing along higher fuel costs. Indeed, higher oil prices pack a double whammy for these airlines.

First, higher fuel costs crimp profit margins, forcing the airlines to raise prices to recover some of the increased expense. Second, airlines are raising prices at exactly the same time that higher oil prices are taking a bite out of consumers' pocketbooks, which makes it more difficult for customers to afford travel even if airfares remain unchanged. The one-two punch of higher oil prices and a slowing economy make for a destructive combination. As low-cost carriers are forced to pass along fuel prices, we expect that demand destruction will inevitably erode some of their customer base and cause management to continue ratcheting down growth plans. After recently factoring in our expectations for slower growth in the future, Southwest, AirTran, and JetBlue are all 1-star stocks at Morningstar--that is, we think current prices are still significantly above the fair values of these firms.

What Is Southwest to Do?
Low-cost carriers will not take the assault on their business models sitting down. Already, Southwest and JetBlue are shifting focus toward luring more lucrative business travelers. For the first time in its history, Southwest is offering priority boarding, extra frequent-flyer miles, and on-board perks to those who purchase higher-priced business fares. The firm is launching a colossal marketing campaign to woo business travelers in its push to generate $1 billion more revenue annually by 2009. In addition, we think that low-cost carriers will place more emphasis on ancillary revenues, a process that was accelerated with the entry of Virgin America, which is offering a smorgasbord of seat-back options, including laptop plug-ins, connectivity, and an on-board system for ordering food and sundries. Not to be left behind, Southwest plans to unveil its own suite of in-flight tools in the near future.

We expect that in a world of higher oil prices, all of the airlines will be vying for premium customers while fighting over a smaller industry pie. Airlines have yet to pass along the full impact of higher fuel prices, but record load factors (based on the percentage of seats occupied on each flight) have so far offset these pricing deficiencies. As carriers raise fares to offset higher fuel prices, driven in large part by the rolling-off of below-market fuel hedges for price leader Southwest, we expect that demand destruction will lead to falling load factors--and eventually fewer domestic flights.

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