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"How do you become a millionaire? Start as a billionaire, and then buy an airline"

(Richard Branson)

Overview

The airline industry has long been an unprofitable industry, plagued by nearly every external force surrounding it. The industry is characterized by intense competition, threat of substitution, threat of new entry, and strong buyer/supplier power which lead to dangerously low profit margins. To make things even worse, the airline industry is also adversely affected by volatile fuel prices and economic conditions. Because of the immense complexity of the airline industry, this report is the first of many to help investors truly understand how the airline industry work, and the factors influencing it, to make the best investment decision.

Since 9/11, we've seen tremendous changes surrounding the airline industry: security, regulations, and operational costs. Overall, these variables have had tremendous, and far-bearing, negative impacts on the industry. On November 19, 2001, President Bush passed the Aviation and Transportation Security Act, which established a new Transportation Security Administration (TSA). The most notable, and visible, effect of TSA to consumers has been the intense scrutiny placed on securing personnel and baggage; however, with the increased security measures, airlines claim that the effects have cost them billions in lost ticket revenue. Why? Because the consumer's benefit of using an airline is outweighed by the hours they wait through lines, security, and delays; resulting in consumers utilizing substitute modes of transportation. A research report conducted by the University of Cornell, published in 2005, suggests that the new baggage-screening process has reduced the originating passenger volume by 5% in the industry.

In the past decade, the airline industry has been attacked by economic and regulatory changes, causing many to declare bankruptcy, consolidate, or even leave the market. Currently, the airline industry is suffocating from many factors causing mayhem in the market, including:

· - A weak economy and volatile operational costs

· - Excess capacity

· - Low cost carrier competition

In attempts to cope with these factors, we've seen airlines shift towards a "no-frills" approach, allowing airlines to manage their operational costs, transgressing into a lower price-point airfare to compete against low cost carriers like Southwest (NYSE:LUV), JetBlue (NASDAQ:JBLU), and Virgin America. Recently, we've also experienced tremendous consolidation, which has been shifting pricing power back to the airlines.

Note: much of the data utilized in this report comes from Airlines for America (A4A), which pools data from 130 U.S. passenger and cargo airlines.

A Weak Economy and Volatile Operational Costs

There are certain sectors of the economy that get hit the hardest, stay injured the longest, and recover the slowest during a recession; the airline industry is one of them

In the past decade, the airline industry has essentially suffered 2 heart attacks and a stroke (two recessions and 9/11). Just after the tech bubble, we entered an economic recession in 2001 which lasted to 2003, but because it "officially" ended in 2003 didn't mean the woes were gone. In fact, airlines experienced consistent, multi-billion dollar losses all throughout 2001-2005. Finally, in 2006 they experienced some short-lived economic profit which reversed itself in 2008 and just recently rose to profitability again in 2010-2011.

Many issues surround the industry, which make themselves blatantly apparent in airline profitability. From 2001-2009, U.S. airlines experienced painful profit margins ranging from -18% to a peak of 11%; with an average of -4.8% throughout the 9 years, and currently at only 0.4% for 2011, with a bad start in Q1 2012. Much of the negative returns are attributable to sharply rising fuel costs and weak economic conditions.

Fuel Volatility

Historically, labor expense was consistently the airline's largest operational costs, with fuel expense situated as the second largest expense. Last quarter though, for United Continental Airlines, fuel expense composed 36.4% of total operating expenses, up from composing 32.7% of total operating expenses in the same quarter of 2011. Also, fuel costs, as a proportion of total revenues, increased from 32.6% in 2011 to 37.5% in 2012. We did experience a 4.9% increase in revenues, but also experienced a disproportionate 20.9% increase in fuel expenses, largely attributable to increase in fuel prices over the year. The effects of volatile fuel prices are blatantly apparent in its ability to suck out nearly all profitability in airline transportation. We've seen jet fuel prices rise from just $0.74/gal in September 2001 to $2.79/gal this May, representing a 277% increase in an operational cost which used to be historically stable.

In response to the rapidly increasing fuel costs, airlines have begun aggressively hedging against rapid fuel price increases, with Southwest airlines titled as a "hedging champion". Hedging allows airlines to purchase fuel at a guaranteed spot price, giving them price security while limiting the effects of rapid fuel price increases in the short-term future. It gives airlines control to an, otherwise, uncontrollable beast which can ravage their profitability; however, although hedging can save an airline billions, it can also cost them billions if done improperly. Hedging against fuel price increases works well when fuel prices actually increase, however, if fuel prices drop and stay low, it'll cost the airline billions because of the higher spot price they've locked themselves into. At the very least though, despite the risk associated with hedging, it allows airlines to plan ahead and calculate costs accordingly, in advance, allowing them to create profitable price points in ticket sales.

Weak Economic Conditions

Earlier, I stated how the airline industry experienced two heart attacks and a stroke in the past decade, alluding to the two recessions we've faced and the terrorist attacks of 9/11. The 9/11 attacks also occurred during the economic recession following the tech bubble bust, which led to five years of negative profitability for the industry. During 2006-2007, though, the U.S. airline industry experienced a tremendous boom in profitability, which was again reversed in 2008 due to our financial market collapse. One thing to note, though, is how distinctly different the airline industry's profitability works, opposed to nearly every other industry.

Every business has the following model which defines profitability:

Profit = Revenue - Expenses

which expands to:

Profit = (P*Q) - (Fixed costs + variable costs)

where P represents profit and Q represents quantity

For almost every business, their largest operational costs come from their variable costs: the inputs required to create an output. Construction companies need labor, Soda companies need ingredients and aluminum cans, and pen manufacturers need ink and plastic. All these companies have fixed expenses, like rent, machinery, and utilities, but the overwhelmingly large expense is attributable to variable input costs. For them, this is beneficial during economic slowdowns because, just by cutting back on production, they can cut back on most of their expenses, minimizing their losses.

Airlines are not like most businesses though. To their unfortunate dismay, an overwhelmingly large proportion of their costs is fixed. Regardless of whether or not the fill an airplane with passengers, airlines will still pay for the aircraft leases, fuel expense, labor costs, and leasing space from airports. It can be argued that airlines don't have to fly unprofitable flights, but there are multiple dynamics which force them to eat the short-term costs to avoid long-lasting, permanent consequences. These dynamics arise from the immense competition between airlines fighting for retaining market share, in an industry where customer loyalty is dismal, at best.

Michael E. Porter's analysis of the airline industry creates a nearly flawless depiction of the 'war' airline companies are fighting on all fronts: limited customer loyalty, extreme competition, strong supplier power, plentiful substitutions, and weak pricing power. In attempts to create customer loyalty, airlines have created frequent flyer programs which reward their consumers with bonuses for being loyal to them. This works well in growing market share if you're the only airline providing this system; however, the frequent flyer program has become an industry standard, utilized by all competitors. This creates a very interesting situation though. It essentially creates a rigid market share between the airline providers, making it less beneficial for customers to jump from one airline to another. It limits the threat of losing market share, which can quickly destroy bottom-line profitability; however, it comes at a very, very steep hidden cost.

The frequent flyer programs help retain market share while the airline is providing frequent and flexible flight times for their customers; however, if flight times are infrequent and inconvenient, customers will be much more willing to use a competitor's services for their flying needs. The effects of this can, and will, become devastating to an airline not providing convenient flight times for their already loyal customers. The hidden cost comes in that airlines are forced to provide frequent and convenient flight schedules, even at unprofitable times in order to retain their market share. They're forced to provide convenience, which, in the short-run, comes at the cost of billions to themselves to prevent long-term effects. During the past decade we've seen intense competition in the airline industry from new competitors, which has led to price undercutting and excess capacity, transgressing to devastating bottom-line profitability.

Going back to the airline industry's profit model, we see that most of their costs are fixed costs, with very negligible variable costs. Airlines are forced to fly frequently and can't change that fact, making the blunt of their operational expenses, like fuel and labor, fixed regardless of how much they can fill their aircrafts; though we've seen an increase in passenger load factor over the decade, leading to increased operational costs. This poses an issue, especially when operational costs are increasing, because the break-even point for profitability becomes more difficult to achieve. To make things worse, a soft economy drives down revenue from both business-side and leisure-side revenue, but when combined with rapidly rising fuel costs, becomes a devastating storm for airline's profitability; directly affecting the top line, and savaging the bottom-line. In 2008, with jet fuel reaching $3.89/gal in June, amid a very weak domestic and global economy resulting from the economic recession, the airline industry experienced a net loss of 23.75 billion (Airlines for America). Although the revenue from the previous year declined only by 2%, the sharp increase in expenses, led to a difference of $31.44 billion in bottom-line profitability during 2007-2008. It's an unfortunate case for airlines during weak economies because they suffer so tremendously; however, if they can hedge their fuel costs and manage their expenses during an economic expansion, they can become very profitable. That's the dynamic of a high-fixed cost structure: during an economic downturn, your losses pile quickly, but during an economic uplift, you reap the benefits of increasing top-line revenues, which has an adversely large effect on bottom-line profitability.

Excess Capacity

As consumers, we've all experienced the positive effects of excess capacity, to the detriment of the airlines. Excess capacity derives from underutilized airplanes, leading to intense price competition. Because the marginal variable cost associated to servicing another customer per flight is so low, airlines undercut each other tremendously, leading to fare rates barely even keeping up with inflation. The business model of "supply to everyone, from everywhere" has led airlines to overcrowding airports far beyond their capacity and eventually leading to a decline of bottom-line profitability. I just booked a flight from Newark Liberty International Airport, which is much smaller than giant hubs like LAX, but when I went on Priceline to reserve a seat, I had a choice between 5 different airlines from 41 departing flights, on that day alone; also, remember that Priceline doesn't manage all the airlines in a given airport, undoubtedly meaning there are more departing flights to just one location.

Although we've experienced consolidation recently, the competition is still intense, especially against low cost carriers like Southwest. Because of the intense competition and multiple flights through the same route daily, most aircrafts are underutilized by about 21%, albeit an impressive increase from 70% passenger load factor in 2001 to 78.9% this February. In a time of rising operational costs, we'd expect airlines to pass the costs onto their consumers; however, because of intense competition and strong market forces, this is not the case. Adjusting for inflation, domestic airfares have fallen by 16.4% from 2000-2011. So, although associated operational costs have skyrocketed far beyond the rate of inflation, airfare has declined below the rate of inflation, resulting in a tremendous disadvantage for airlines. With all these forces working against airlines, we've seen multiple airline bankruptcies over the decade, leading to increased consolidation; interestingly too, we've also seen new strategies to cope with these devastating conditions.

Especially in the past decade, we've seen a strong shift in strategies implemented by airlines to maximize bottom-line profitability. The airline industry has increased its passenger load factor utilization of 70% in 2001 to about 78.9% in February, but still leading to a total loss of $1.73 billion in the first quarter of 2012; much in part to America Airlines and rising fuel costs. In part to aggressive steps to minimize excess capacity, we've witnessed the rapid decline of domestic available seat miles operated per $1,000 of real U.S. GDP to about 53 in 2011 (Airlines for America).

In an industry of extremely high fixed costs, airlines are forced to optimize their available seats per airplane to increase bottom-line profitability. Ideally, airlines would experience consistent 100% passenger load factor, but fierce competition has contributed to February's 78.9% utilization rate. Another strategy that has benefited airlines tremendously in increasing load factor is through creating strategic alliances like the Star Alliance program bringing 25 airlines together. This program shifts pricing power away from consumers and back to the airlines involved in the program, also allowing them to reduce their excess capacity. Essentially, we've seen a constant shift towards consolidation, whether it be through mergers or through strategic partnerships, which have been giving pricing power back to the airlines.

This is the first part of my report analyzing the airline industry; most notably, Southwest, Delta (NYSE:DAL), JetBlue, Continental (CAL), and US Airways (LCC). Part 2 of this report should follow this one soon.

Source: In-Depth Drilldown Of The Airline Industry - Part 1