Always Ask What Your Airline Can Do For You: Delta Air Lines, Inc. (DAL), Southwest Airlines Co. (LUV)

“How do you make a million dollars? You first make a billion dollars and then invest them in airline companies.” (Warren Buffett)

This phrase by the sage is pretty much spot on. Airline stocks in general have performed awfully over the last decade. In fact, shares of most airlines trade today at the same price they traded back in 2000. This business is shrinking and with good reason.

The airline business is a terrible business. It’s extremely capital intensive, prone to recessions and highly sensitive to the price of fuel, the industry’s main raw material.

The urge to merge

Fierce competition, decreasing passenger ticket rates and high maintenance costs have been leading many airline companies straight to the warm embrace of Chapter 11. After (and if…) a company emerges from bankruptcy, it’s usually a leaner and much more efficient rival in the industry because much of its debt load is eliminated.

Many other rivals simply prefer to merge in order to share the high costs. In the past couple of years, the market has witnessed various mega mergers such as Delta Air Lines, Inc. (NYSE:DAL) and Northwest, Southwest Airlines Co. (NYSE:LUV) with AirTran, and United Continental Holdings Inc (NYSE:UAL) with Continental. In the post -merger era, the first couple will control 20.5% of total domestic market share with a market cap of $11 billion. The second couple will control 12% of total domestic market share with a market cap of $8 billion. And the third couple will represent 21% of total domestic share, with a market cap of $8.6 billion.

In terms of profitability, things seem less rosy — gross operating profit margin for the above trio stand at 8.1%, 5.2% and 4.5%, respectively.

Lately, another mega merger was announced — a merger between American Airlines and the much leaner U.S Airways . Whereas the former has just emerged from bankruptcy, the latter is one of the most efficient and cheap airlines out there. U.S Airways trades at a measly P/E of only 4.5x, with gross operating margin and return on assets of 6.4% and 6.2%, respectively. This merger creates the world’s biggest airline company.

What does the future have in store?

On the consumer front, fewer competitors usually spell less competition and higher air fares. But we are much more interested in the investing thesis behind this merger. There are a few key points that frustrated past airline investors might look up to:

1. Little overlap: Often times, two airline companies buy one another only to end up with the same flight routes. That isn’t the case here. US Airways Group, Inc. (NYSE:LCC) and American overlap on only a dozen routes. Together, they control most of the U.S air space and control 24% of total domestic market share. Such a high dominance is sure to translate into more customers bringing more revenue. The companies stated that they expect to bring in additional $900 million of revenue.

1. Labor issues: American had a long history of union disputes within the organization. This has led in the past to several strikes and caused the delay of many flights, as well as many disgruntled passengers. Now, after the merger (and the bankruptcy of American), the unions finally realize they must either compromise or cease to be. This will take a lot of operational pressure off the new integrated airline company.
2. Cost savings: In the rapid capital expenditure world of airlines, cost saving is a must. The companies stated that they expect to save $150 million annually as a result of the merger.

The Fool flies ahead

Personally, I would stick with Buffett’s rule on airline stocks: Just avoid them. But if you’re a devoted airline fan, I believe that American – Airways is for you. With lean management, dominant routes and less debt, the new merger between American and Airways will create the best rival in the industry.

The article Always Ask What Your Airline Can Do For You originally appeared on Fool.com and is written by Shmulik Karpf.

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