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Airline paradox: Punished by Wall Street for a high completion factor

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On March 9, American Airlines reported that it has been operationally excellent so far in 2017, and the stock market punished the carrier for it. Yes, you read that correctly.

The company began the day by reporting some very good news as part of its February traffic report release: its system-wide mainline completion factor is 98.9% year-to-date, up 1.2 points from 97.7% in the same period a year ago. So why did Wall Street frown? Because that means American is operating slightly more capacity than it anticipated (simply because fewer flights are being canceled) and, as a consequence, its expected first-quarter unit revenue performance is slightly dampened.

“The company expects its first quarter 2017 total revenue per available seat mile (TRASM) to be up approximately 1.5% to 3.5% year-over-year vs. its previous guidance of up 2.5% to 4.5%,” American said in a statement. “This decrease is due primarily to the company’s year-to-date system-wide mainline completion factor of 98.9% vs. 97.7% in the same period last year. The higher completion factor is positive for customer service and profitability, but the additional ASMs generally reduce TRASM results. The company continues to expect its first quarter pre-tax margin excluding special items to be between 3% and 5%.”

So American is providing better customer service, its profitability remains strong and there is no change in its first-quarter margin guidance. How did the stock market react? Fixated on unit revenue, more shareholders moved to sell than buy American’s stock March 9 after the carrier released the above news early in the morning. The airline’s stock price fell 3.5% for the day.

US airlines and Wall Street have had a running debate for the last two years over how much unit revenue performance means. Airlines pointed to record bottom-line profits and ongoing capacity discipline, and urged investors to take the long view and not put too much emphasis on year-over-year unit revenue declines. But Wall Street analysts, notably Wolfe Research’s Hunter Keay, pushed back, arguing that unit revenue performance is a proxy for pricing power and therefore a key factor for investors to consider.

In a recent appearance on CNBC, Berkshire Hathaway CEO Warren Buffett perfectly encapsulated airlines’ dilemma when it comes to pricing flight tickets: “It’s a very tough business. The marginal cost of a seat is practically nothing. You have these huge fixed costs, and yet if you take one more person on, there’s virtually no cost to it. So you’re very tempted to sell the last seat too cheap. And if you sell the last seat too cheap, it becomes the first seat in a way.”

Buffett has long been one of the most famous critics of airlines as investment vehicles. But he believes the US airline industry has now turned the corner. “It’s true that the airlines had a bad first century … Everyone has a bad century now and again,” he quipped on CNBC.

Buffett thinks major US airlines have finally learned their lessons thanks to multiple trips through Chapter 11 bankruptcy restructuring and repeated failures. Late last year, he invested well over $1 billion in American, Delta Air Lines, Southwest Airlines and United Airlines.

Undoubtedly, Buffett is impressed by US airlines’ capacity discipline and the fact that American, Delta and United have virtually brought growth to a halt this year. (The Berkshire investment in airlines was made shortly after the Big Three signaled little-to-no growth in 2017.) His biggest complaint about airlines in the past was that they grew much too fast, particularly given how capital intensive the business is. Major US airlines, at least this year, are focusing on improving the product and reversing a two-year slide in ticket prices, not growth.

But Wall Street as a whole will still demand to see a steady and strong unit revenue performance—something that has been absent since late 2014—before it goes all-in on the airline industry. Fair enough; however, it would behoove investors to peak behind any unit revenue slips to determine the reason before reacting too hastily.

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