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Many investors are familiar with Warren Buffett's "feud" with the airlines. Buffett made a substantial investment in USAir (LCC) and quickly came to regret it; he has since refused to invest in commercial carriers (although Berkshire Hathaway does own NetJets, a fractional jet ownership company). Buffett has even gone so far as to say that capitalists should have shot down the Wright Brothers' plane to save themselves the agony of recurring airline bankruptcies! The airline industry has indeed incurred a sizable net loss since the airplane was invented.

On the other hand, all of the major U.S. airlines with the exception of the troubled American Airlines (AMR) [this group includes United (NYSE:UAL), Delta (NYSE:DAL), US Airways, Southwest (NYSE:LUV), JetBlue (NASDAQ:JBLU), and Alaska (NYSE:ALK)] have been profitable for the past two years, in spite of soft economic growth and high oil prices. These six carriers are expected to be profitable again next year. The reality of sustained profitability despite these historical challenges has led investors and analysts to become very polarized with regard to the airlines. Many analysts have argued, particularly since the American bankruptcy last month, that the airline industry has finally right-sized itself, or is close. They thus argue that the airlines will be able to sustain and increase their profitability, and that their generally low valuations are unwarranted. On the other hand, many value investors continue to follow Buffett's lead and avoid the airline sector like the plague.

I think that airlines are good investments today (my favorite picks at the moment are United, Delta, and US Airways, probably in that order). But in order to understand why, it's important to recognize why the airlines were unprofitable up until recently, and why conditions have changed so that investors can be confident that there won't be another round of bankruptcies in five years. So this article will focus on the "old airline industry", while Part II (coming later this week) will focus on the "new airline industry" and why it is different.

The beginning of the airline industry's woes was deregulation, which occurred in 1978. Prior to that time, the government regulated both what routes an airline could fly and the prices it could charge. Carriers were thus not particularly competing on price, and so it was possible even for inefficient airlines to be profitable. This led to a large number of relatively small airlines (by contemporary standards). Deregulation allowed more or less unlimited competition within the U.S., and this undermined the dominant business model. New budget carriers like Southwest and People Express started competing with the legacy carriers on price, thus undercutting profitability.

The legacy carriers responded by moving to the modern hub-and-spoke model, which creates efficiencies for connecting travel, but also creates perverse incentives towards over-competition. With less point-to-point service, the legacy airlines were all providing the same service (a one-stop flight with a connection at a major hub). Moreover, airplane seats are classic perishable goods. Once the plane takes off, you can't sell any empty seats. Since the marginal cost of filling each additional seat is miniscule, each carrier had an incentive to lower prices in order to direct traffic through its own hub. Of course, the eventual result is that other carriers match the price in order to prevent competitors from stealing their traffic. At the end of the day, overall market share remains roughly the same, but prices are lower and insufficient to ensure a profit over the business cycle. In good economic times, airlines could generate enough traffic growth to be profitable, but in bad times, there was no end to the pain. Because the system began with overcapacity (because regulation allowed inefficiency), the industry has seen 30 years of painful adjustment.

It should be obvious that it was impossible for legacy carriers like American, Delta, TWA, Eastern, Braniff, Pan Am, United, Continental, Northwest, USAir, Alaska, and Western (among others) to successfully offer the same service while also competing with startups like America West, Southwest, and People Express. In addition to overcapacity and nearly undifferentiated products, airlines are also faced with massive capital outlays for airplanes. Having purchased or leased an airplane, airlines were understandably reluctant to cut capacity, even when they were unprofitable due to high fuel prices or economic weakness. Every one of the legacy carriers has since gone bankrupt or merged with another, and many have been through the process multiple times.

Even in 2001, by which time industry consolidation had proceeded to some degree, the airlines found themselves unable to cope with the post-September 11 downturn in the aviation industry. There was lower demand for air travel, but no carrier wanted to cut capacity. Doing so risked losing a disproportionate amount of market share if competitors did not follow suit. The problem was that business customers (and to a lesser extent, leisure customers) enjoy the convenience of having frequent flights and being able to get to whatever destination they choose on a single carrier. By cutting routes and frequencies, a carrier could lose business to airlines with more generous schedules. Furthermore, with so many empty seats, it was impossible to raise prices for the seats that were filled.

And thus the U.S. airline industry stood until roughly 2008. The Great Recession inflicted even more pain on the airline industry, but has finally rationalized it to a degree that the major airlines are likely to survive and thrive over the coming years. In Part II, coming later this week, I will explain exactly what has changed and why investing in major airlines is no longer cause for calling "Aeroholics Anonymous."

Source: Why The Airlines Are Finally Profitable