The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.
-- Warren Buffett, annual letter to Berkshire Hathaway shareholders, 2008.
The airline industry has undergone meaningful changes since the beginning of the last decade. The painful restructuring of labor agreements and balance sheets by most of the legacy carriers via Chapter 11, the significant mega-mergers of Delta (NYSE:DAL)/Northwest, UAL (NYSE:UAL)/Continental, US Airways (LCC)/America West, and Southwest (NYSE:LUV)/AirTran, the introduction of ancillary revenue streams to combat rising fuel costs, and the continued efforts to rightsize domestic capacity to slow the long downward trend in real yields are but a few. While unarguably these are steps in the right direction, airlines remain shackled to the poor structural characteristics of their industry. Absent implicit price collusion across every participant within the domestic landscape (a very unlikely event), airline stocks should solely be viewed as speculative bets or hedges on the trajectory of the economy (passenger travel) and the direction of crude oil prices, and not as long-term investments.
Perhaps the most enlightening of analysis of an airline's business model is to test the sensitivity of its profitability and cash flow to changes in the forecasts of a few industry-accepted metrics: revenue per available seat mile (RASM) and cost per available seat mile (CASM). RASM, or unit revenue, is a function of yield (pricing) and capacity utilization (load factor), while CASM, or unit cost, is predominantly driven by jet fuel prices and labor. The difference of the two represents unit profit, or the profit generated by an airline to fly one seat one mile. Due to the tremendous operating leverage inherent to airline business models non-pursuant to capacity purchase agreements (regional airlines operate on cost-plus arrangements), it becomes readily apparent that even minor changes in these key metrics can have large implications on profitability, cash flow and ultimately the fair value of an airline's equity. And while operating leverage may spell opportunity should these metrics move in favorable directions, the wide range of potential outcomes in forecasting these metrics suggests that most airline stocks should be viewed as no more than boom-or-bust, speculative vehicles.
As many airline executives may attest, both unit revenue and unit cost are largely out of their control. For one, air travel service is largely commodified and suffers from substantial and intense fare competition driven by severe price transparency and the unavoidable concept of perishable inventory -- when a flight takes off, empty seats cannot be filled. Such a combination is the weight that keeps real pricing (yield) growth from being sufficient to meaningfully alter the long-term economics of the industry. To do this day, network airlines are still forced to match fares offered by low-cost carriers or suffer even greater revenue declines. Fare increases can only be sustained if they are matched permanently by low-cost peers (like Southwest or JetBlue (NASDAQ:JBLU), for example).
Further, with barriers to entry primarily limited to capital costs (any US carrier deemed fit by the Department of Transportation can operate passenger service in the US), it's safe to assume that we haven't seen the last domestic start-up, even after the most recent failure of upstart Skybus. The mere existence of interested, economically-tied parties (like Boeing, for example) seem to suggest that new entrants will always pose a threat to dump unwanted capacity on otherwise healthy routes. Perhaps unsurprisingly, one can even tap Boeing's expertise in launching an airline: Starting an Airline. The poor performance of systemwide--domestic and international--real yields (pricing) across US airlines is displayed in the chart below, a trend that is very unlikely to change anytime soon:
As an airline's unit revenue is pressured by intense pricing competition, its unit cost is significantly impacted by the price and volatility of jet fuel. According to the Air Transport Association, jet fuel now represents more than a quarter of industry operating costs, surpassing labor expenses as the largest cost item. Although airlines may hedge fuel to some extent, such a strategic move is financial and should not be viewed as an operational boost or any sort of sustainable competitive advantage. And due to the presence of low-cost providers, network carriers have traditionally found it difficult to hike fares or charge additional fees sufficient enough to pass along these rising energy costs. The graph of the rising price of jet fuel offers an interesting contrast to the one above that displays the rapid decline in industry real yields:
With more than 160 airlines failing since deregulation in 1978, the structural characteristics of the airline industry do not lend itself to long-term investing, and even meaningful shifts in the industry landscape over the last decade have done little to change this. Equity or option speculators with firm conviction in the trajectory of the economy (passenger travel) and the direction of crude oil prices may make some money in the near term, but long-term investors will inevitably be left holding the bag, especially if they find themselves holding shares of legacy, network carriers (such as AMR or US Airways, for example). As Warren Buffett would probably agree, savvy investors can find better places to put their money than the airline industry.
Disclosure: I am short AMR.