WITH the recent acquisition of Air Jamaica by its Trinidadian counterpart, Caribbean Airlines, the regional airline industry has certainly etched its place on the hot circuit over the past few months. But with last Thursday’s announcement that British Airways Plc and Spain’s Iberia SA finally inked a merger deal, coupled with market rumours that two prominent US carriers have revived talks of fusing, the global airline industry has once again become a hot topic for investors. For many, this is a step in the right direction as consolidation within the airline industry is inevitable for long-term survival. This is an industry in which size matters and that has been long burdened by overcapacity and mounting losses.

The airlines’ demise began in 2001, after suffering significant losses in the aftermath of the September 11 terrorist attacks. The industry was dealt a further blow during the global financial crisis which purported the major dilemma of declining traffic and low demand. According to the International Air Transport Association (IATA), over the past ten years the global airline industry lost approximately US$50 billion, 18.8 per cent of that amount in last year alone. For 2010, the IATA forecasts the global industry will remain in the red, but estimates losses will decline to US$2.8 billion.

More specifically, the IATA predicts 2010 net losses in the European, North American, Middle Eastern and African regions, with profit expected only in Asia-Pacific and Latin American nations. In fact, Latin America was the only region to report figures in the black in 2009 and surpassed North America as the world’s biggest aviation market with 647 million passengers last year. The major difference between the pace of recovery in the airline industry between the Asian-Pacific and Latin American region and the rest of the world is mainly attributable to the economic recovery of emerging markets such as China and Brazil. Furthermore, buoyed by strong domestic demand, increased liberalisation and improved fleets, the regions were able to offset the effect of volatile oil prices during the period and mitigate the issue of overcapacity — a situation which did not occur in North America and Europe.

While the IATA predicts the global airline industry (including North America and Europe) will finally return to profitably in 2011, it should be noted that sustainable profits will not be possible without reform. Using the US airline industry as an example, one would recognise that the problem lies within the domestic market which is over-populated with the combination of legacy carriers as well as low-budget carriers flooding the market with sky seats. The result of this leads to severe low-price competition that stifles revenue growth and the bottom line, making it imperative for the industry to reduce the number of carriers and clearly define niche markets in which to specialise.

Currently, legacy carriers in the US refer to the five major airlines which include AMR Corp’s American Airlines, Delta Airlines Inc and Continental Airlines Inc which service both the international and domestic market, while low-budget carriers such as JetBlue Airways Corp, Southwest Airlines CO and five other carriers are characterised as a reduced-cost model, with a simplified route and fare structure. These airlines are usually confined to the domestic market, Mexico and the Caribbean.

However, despite the overwhelming presence of the legacy carriers, it is the low-budget carriers that have recently taken control of the US domestic market. Between 2003 and 2009 the domestic capacity of legacy carriers has declined by 85 billion available seat miles or by 21 per cent on average, while the capacity for low-cost carriers rose by the same figure. Nonetheless, this is a trend which has become increasingly defined in the global airline industry, where one sees the traditional carriers lose their edge to emergence of the “no-frills” airlines. This is the case with Latin America, whose rare performance was supported by the introduction of budget carriers that mainly served domestic demand.

At first glance, this trend may seem negative for legacy carriers, but in fact it clearly highlights the direction in which the industry must be redefined. The only way forward for legacy carriers is simple — international routes. All but one of the legacy carriers were able to increase international traffic last year, indicating that they still have the competitive edge in that niche. However, in order for legacy carriers to profitably maintain their lead in the international market, the overcapacity which is distorting revenue growth must be curtailed. Therefore consolidation or forming alliances amongst legacy carriers is necessary for two reasons.

Firstly, unlike in the domestic airline market, international ticket prices are usually set at a higher premium, thus making it difficult to maintain this price structure with so many carriers in the sky. According to travel website, Hotwire.com, last year international ticket prices as well as traffic fell further than domestic — indicating that there is more room to rebound and a great opportunity for legacy carriers to solidify their market share.

Secondly, while revenue growth may be the preferred choice to boost bottom lines, airlines must seek to reduce their expenses. In 2008, DAL merged with Northwest Airlines Inc, and a year later the combined company saved approximately US$700 million in cost synergies. However, not all cost-saving exercises result from a full merger: this is also possible through alliances. American Airlines recently announced a partnership with JetBlue which aims to increase its international traffic by expanding its domestic destinations to hubs such as New York through the budget carrier.

These kinds of agreements have certainly been lauded by investors. Last week when US Airways Group and, UAL Corp, the parent of United Airlines, were rumoured to have reignited talks of a merger, airline stocks reached new highs. As airline carriers get on board to trim down the oversized industry, coupled with a pickup in global demand, investors should take a second look at airline stocks before they soar to new heights.

Juvenne Yee is a Research Analyst at Stocks & Securities Ltd. You can contact her at jyee@sslinvest.com.