Legacy Airlines Are Proving They Can Catch Up

The rise of budget airlines has been the aviation story of the 21st century. But legacy airlines are proving they can fight back. It is a shame investors don’t quite believe them.

British Airways


ICAGY 8.61%

-owner International Consolidated Airlines Group has been a notable target of such skepticism. On Friday, its shares rose about 6%—amid deep falls in the broader stock market—after the company reported better-than-expected profits for the second quarter.

IAG’s margins are now above those of Europe’s budget powerhouse,

Ryanair
.


RYAAY -0.37%

Part of the improvement came from its Barcelona-based budget carrier Vueling, which is emerging from a period of damaging air-traffic control strikes in France.

More impressive, however, is the performance of IAG’s two full-service carrier brands, BA and Iberia. The profitability of both has withstood a slowdown in the eurozone economy that is impacting domestic carriers—including IAG’s other budget carrier, Dublin-based Aer Lingus. BA’s resilience in part reflects its exposure to the U.S., where the earnings of the two leading legacy carriers,

Delta Air Lines

and United Airlines, are soaring.

But investors remain suspicious: IAG fetches a big stock-market discount compared with both its U.S. peers and European budget airlines such as Ryanair or

easyJet
.

The valuation of U.S. legacy airlines hasn’t shot up either. This is despite the fact that, in recent years, they have shrewdly redesigned their networks to exploit the power of their hubs. They are also cashing in on premium-cabin revenue—thanks to new segmentation strategies—and have found a gold mine in co-branded credit-card deals.

Europe’s geography limits the use of hubs and its regulators cap credit-card fees. But IAG is proving that there is also a path to—more moderate—success outside of the U.S.

The holding-company structure championed by IAG Chief Executive Willie Walsh centralizes control of the overall network and investment strategy while allowing each of the conglomerate’s carriers to carve out its own market. Other airlines are now seeking to copy the model, which is a sensible way to reconcile the industry’s lack of significant economies of scale with its need to coordinate large-scale networks.

To be sure, many legacy carriers still struggle to escape their past. German giant

Lufthansa

’s obsession with defending its turf, for example, means it hangs on to too many unprofitable routes. American Airlines is still overburdened with debt after its 2013 merger with U.S. Airlines.

Moreover, no strategy can save airlines from being cyclical businesses that will likely lose money again if there is a downturn.

Yet it does seem that the industry has reached a point of maturity after the low-cost revolution that started in the 1990s. When it comes to best-in-class companies, investors should stop discriminating so starkly between “legacy” and budget carriers.

Write to Jon Sindreu at jon.sindreu@wsj.com

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