Term Sheet

The latest on private equity, M&A, deals and movements — from Wall Street to Silicon Valley

Delta proves that consolidation drives up ticket fares

October 23, 2013: 12:19 PM ET

Merger hopefuls American and US Airways claim that consolidation would lower prices and increase service. Delta's stellar results -- driven by higher ticket prices -- prove otherwise.

By Cyrus Sanati

131022165456-delta-airlines-620xaFORTUNE -- Delta's record earnings could give the government just what it needs to finally crush the merger hopes of American Airlines and US Airways. Delta's pricing power and heft allowed it to reduce service and raise fares in the third quarter, leading to absurdly high profit margins for an airline. While some of Delta's success can be attributed to good management and cost cutting, it was Delta's ability to force passengers to open their wallets that truly allowed the company to achieve such stellar results.

All of this doesn't bode well for merger hopefuls American and US Airways (LCC), which claim that further consolidation in the industry would somehow lower prices and increase service. But as Delta (DAL), and indeed, the rest of the industry demonstrated last quarter, consolidation has acted like a rising tide, which not only lifted industry profits across the board but also managed to drown consumers with fees and fare hikes.

Delta Air Lines beat analyst expectations Tuesday, reporting a profit of $1.37 billion for the quarter ending in September. That equated to a whopping 31% increase from the same time last year, representing an all-time high for Delta. The company also reported that revenue ticked up nearly 5% from a year earlier to nearly $10.5 billion, boosting expected operating margins for the year from the already impressive level of 7% to 9%.

One might think that Delta achieved this boost in revenue by flying more, but the airline actually increased its load factor by just 2% in the quarter. No, Delta's strong results appear to be a direct result of pricing power made possible through industry consolidation. In Delta's case, that includes its merger with rival Northwest Airlines as well as its newly minted partnership with Virgin Atlantic.

MORE: Most Powerful Women: The International Power 50

In creating what has become the world's second-largest carrier, Delta has been able to do what airlines in the past have only just dreamed of doing -- forcing passengers to dig deeper into their pockets. Fierce competition once limited an airline's ability to make fare hikes stick, but not anymore. Delta managed to increase the average fare per mile, or yield, by nearly 5% in the third quarter, an astonishingly high number, especially given the lackluster economy. This is in addition to the ancillary revenue Delta has been able to extract from passengers that were once free, such as checking a bag, enjoying a meal or watching a film while onboard. Add up all that, and it is easy to see that passengers today are paying more.

Corporate and leisure travelers in smaller markets now pay exorbitant prices to fly short routes, as Delta has in some places become the only carrier that can get you to where you need to go without having to stop two or three times. Need to get from St. George, Utah to pretty much anywhere else? Delta has you pinned down completely.

But it isn't just the smaller markets where Delta is squeezing its passengers, it is also sticking it to them in markets where there is supposed to be great competition. Take one of the most heavily traveled routes in the world, the New York to London route, where several airlines offer non-stop service. Delta was able to increase passenger revenue on this one important route 10% in the third quarter. Think that's bad? At the end of the quarter the company received antitrust immunity on that route with its new partner Virgin Atlantic. This will allow the two carriers to legally collude on prices, meaning that passengers will almost undoubtedly face even higher prices on this critical route in the months to come.

The government seems to have finally figured out that it made a mistake in allowing the nation's airlines to merge into the behemoths they have morphed into today. That is why in August it blocked the proposed merger between American Airlines and US Airways, which would have created the world's largest airline. It finally drew the line in the sand and closed the merger party for good.

MORE: Why Delta ordered 11,000 tablets from Microsoft, not Apple

American and US Airways are taking the government to court to get a judge to overturn what they think is an unfair ruling. If fairness was the goal here then the two airlines would have a case, but it isn't. The goal is to make sure there is ample competition between airlines so that the American public can get to where they need to go in an efficient and cost-effective manner. When it was allowing the airline mega-mergers to go through, it wasn't apparent, at least to the government, that such consolidation would one day come back to bite consumers.

The government also has a duty to ensure that communities, both large and small, have access to reliable air service. Air service has disappeared for some communities after profits weren't as high as the newly merged airline would have liked. In Delta's tie-up with Northwest it has managed to decimate air service at many of its former hubs, something the airline said it wouldn't do when it sought approval from regulators back in 2008.

For example, when Delta and Northwest merged, the combined airline was flying some 240 flights in and out of Memphis. In an effort to boost profits, Delta decided that it wasn't worth having a hub in such a small city so it began cutting flights dramatically. Prices for the remaining flights jumped as Delta began squeezing business travelers who had to fly nonstop. By the beginning of this summer Delta operated just 96 daily flights in and out of Memphis. But that was still too much for Delta. After announcing record profits on Tuesday, Delta sent a memo to employees that it would be reducing the number of flights in and out of Memphis to just 40 peak day departures and would be eliminating over 300 local jobs in the process. It just wasn't profitable enough for it to keep flying small jets in and out of the city.

MORE: In-flight Internet connections pick up speed

The government's meddling into the internal affairs of airlines may seem overbearing, but it is important to understand that due to the great distances between population centers and the absence of a high-speed rail network, air travel is not a luxury, it is a necessity in this country and is therefore extremely important to the economy. The government deregulated the industry in the late 1970s to allow for greater competition in the industry, not less. With that came the understanding that air service would be maintained so that communities, like Memphis and St. George, could attract business.

American Airlines argues that without merging, it won't be able to compete with the merged airlines. But because the airlines have cut capacity and are less inclined to counter fare hikes and new fees, the entire industry has seen an improvement in margins, even American. In fact, if you strip out special costs, American would have made a profit of $530 million in the third quarter. While that is considerably less than what Delta made, it would have represented the most profitable quarter in its history. Can you imagine what it would have made if it merged with US Airways and was able to squeeze their passengers in the same way as Delta was able to do over the summer? This is why the government is concerned, and it is why American will have a hard time convincing a judge that its merger would be in the best interest of the flying public.

Join the Conversation
Current Issue
  • Give the gift of Fortune
  • Get the Fortune app
  • Subscribe
Powered by WordPress.com VIP.