The airline industry (FAA) is one of the most hated in the entire investment universe. Warren Buffett's famous quote is "the net wealth creation in airlines since Orville Wright has been next to zero." Indeed, airlines have been a terrible historical long-term investment. But there are a lot of "terrible historical long-term investments" that have been excellent for certain periods of time, including commodities. Moreover, there are reasons to believe that the airline industry, in general, might be entering a more profitable era.
So why might this be a reasonable time to invest in US-based carriers?
(1) The death of the commodity boom. The current commodity boom is being driven by China's fixed asset bubble. Whether that boom is killed off via a sudden collapse or a slow shift to a more consumption oriented economy, the end result will be less demand for commodities in China. And less demand from China alleviates pressure on oil prices.
(2) The North American oil/gas boom. The other side of the oil price equation comes in the form of increased supply. As more oil and gas is harvested in North America, it's likely that we will be more likely to see a ceiling on oil prices. It seems reasonable to believe that $80 - $120 / barrel prices will persist for the next decade given the supply / demand dynamics. There could be brief spurts above $120, for instance, with Middle Eastern conflict; but the shift right now is towards North American production of oil, which will change the long-term dynamics of the oil prices.
(3) Supply and demand. Supply of domestic flights has been in decline over the past six years, falling about 10% in that period. Meanwhile, demand has increased by about 9%, and has been on the rise for the past two years. Even more dramatically, the load factor has increased every year since 2001, rising from 69.15% in 2001 to 82.92% in 2011. These supply and demand dynamics suggest that the airlines are gaining more pricing power.
(4) Consolidation. Consolidation has been a driving force in the airline industry for the past several years. We've seen major integrations, with Southwest (LUV) acquiring AirTran, Delta Airlines (DAL) merging with Northwest, and United (UAL) merging with Continental. The result has been less intense competition and a shift away from scorched Earth pricing strategies to a more oligopolitistic model. This is bad for consumers, but may ultimately be good for shareholders.
With that said, let's explore the long-term dynamics of this industry.
Can Airlines Be Long-Term Winners?
Is air transportation essentially a commodity? Or can it be more? The jury is still out on this question. Since deregulation in 1978, we've seen a very difficult adjustment process for airlines that were designed to compete in a completely different environment. What's more; since 1990, we've seen at least nineteen major airline bankruptcies; an astounding number when you consider the market. At the same time, we've also seen the emergence of the low-cost business model, originally ushered in by Southwest Airlines .
Of course, thirty-one years may seem like a long time for a market to be in flux, but consider the nature of the airline industry. Airlines' two principal assets are their planes and their labor force. Airplanes are very long-term assets with average lifespans ranging from 20 years to 40 years. Even if deregulation began 31 years ago, most of the major legacy carriers still have airplanes in their fleet that predate 1978.
If the legacy carriers create issues for understanding long-term performance of the industry, we can at least look at the most successful post-deregulation era airlines to understand performance better. And what airline provides us with a better post-deregulation business model than Southwest!
Unfortunately, there's no simple way to measure performance, either. We could look at return on assets, stock returns, free cash flows, earnings, and numerous other measures, but all are flawed for various reasons. The best measure that is available, in my view, is book value per share. Southwest has generally not had much in the way of goodwill or intangible assets on their balance sheet; nor do they suffer the problem of most of the major legacy carriers of carrying an astronomical debt load! So book value ends up being a reasonable (if slightly flawed) measure of growth; and looking at it on a per share basis allows us to ignore changes in share counts.
Below is a chart showing growth in book value per share (BVPS) for Southwest from 2001 to 2011:
As you can see, Southwest had its ups and downs according to this measure, but overall, BVPS grew 61.5% from $5.17 to $8.52. If we use this as a gauge for real return, the firm had an IRR of about 5.13% for this time frame. If you only examine the first seven years (before the Great Recession), the firm had an IRR of 10.6%.
There are two takeaways here: one positive and one negative. The positive is that even during a horrendous environment for airlines, Southwest still managed to turn a decent profit over the long-term. The negative, however, is that if we assume that Southwest is a best-of-class carrier, this implies that even the "best-of-class" did not manage to earn its own cost of capital, which I imagine is probably higher than 10.6%, and most certainly higher than 5.13%!
So the question is, can airlines be a good investment given what we've seen over the past decade?
Airlines as an Attractive Investment?
So we know that airlines have historically been long-term losers, but we also know that it's been proven that airlines can be long-term profitable, via Southwest's performance. The next question is why the airlines have been long-term losers. I'd offer a few explanations:
(1) Regulation-era remnants. The legacy carriers were built to compete in a completely different business environment than the one that has evolved since 1978. Due to their long-term assets and the general slowness in which large organizations adapt to major changes, it has taken a long time for the legacy carriers to adapt.
(2) Too Much Competition. Industries tend to have natural competitive equilibriums. Some industries are naturally suited for hundreds or even thousands of small competitors; none with a dominant market share. Other industries have economies of scale that can be best exploited by a small number of firms. Air travel has needed consolidation badly and it's taken awhile for it all to play out.
(3) Oversupply. Already mentioned this issue earlier, but oversupply in any market can make every company look foolish. Oversupply may have been the result of "too much competition", as well.
(4) Unions. Of all major industries in the US, airlines are probably the one known to have the most influential unions. Since labor unions are essentially monopolies on labor, it's completely plausible that they have been able to demand "above-market" wages for decades, which has greatly contributed to the airlines historically dismal performance. This might have also made consolidation more necessary (to increase the bargaining power of the airlines vs. the labor monopoly.)
(5) Defined benefit pension plans. Albert Einstein has been purported to have said, "the most powerful force in the universe is compound interest." Whether he actually said it or not is irrelevant, because there's a lot of truth to the quotation regardless of who penned it. Most of the legacy carriers have to deal with defined benefit pension plans that pay out retired employees based on actuarial assumptions. And most of these plans have proven to be extremely optimistic and highly problematic for employers and the organizations that utilized them (including state governments). And it all goes back to that quote. These plans guarantee a certain return that might never be met by the market --- and as returns compound over time, the problems grow larger and larger, until they are completely unmanageable.
Fortunately, many of these issues have been resolved or there has been major progress towards resolving them. The legacy carriers have, particularly over the past decade, started to adapt to the low-cost model that has replaced the prior regulation-era one. We've seen more and more consolidation in the industry recently. Partly as a result of this, we've seen declining supply in the market for several years, as well.
While the legacy carriers still continue to have defined benefit pension plans, the newer breed of airlines, including Southwest, JetBlue (JBLU), and Spirit (SAVE); have all opted for the vastly more sustainable defined contribution plans.
That leaves the unions as the last major hurdle to a sustainable industry. While the unions continue to hold a considerable amount of power, at least the emergence of the low-cost airlines has pushed the norms towards more sustainable wages. The consolidation in the industry has also weakened their grip on power.
With that, let's look at the issue of supply and demand a bit more closely.
Supply and Demand Picture
Using data from the Bureau of Transportation Statistics, we can piece together supply and demand in the industry. First off, let's look at passenger and flight data.
Note that this chart has two y-axes, the left y-axis is number of passengers, and the right y-axis is number of flights. I set them up so that we can see that the general trend is that the number of passengers is increasing in relation to the number of flights. In fact, flights have been in decline since around 2005, while the number of passengers has been relatively flat or slightly increasing over that same time period.
Next, let's take a look at passenger revenue-miles versus available seat-miles.
If you examine the numbers, you can see that the trend is that passenger revenue-miles ["PRM"] are increasing more rapidly than available seat-miles ["ASM"]. To see this more visually, we should take a look at excess capacity, which we'll define as ASM minus PRM.
We can see that excess capacity has been in near constant decline since the early 00's. It's also interesting to look at this exact same chart, but in terms of excess capacity as a percentage of ASM. (Btw, this is the inverse of "load factor".)
Here we can see that excess capacity has declined from about 30% in the early 00's, all the way down to around 17% in the current timeframe. This seems to suggest that the airline industry is slowly, but surely, progressing towards a more sustainable supply-demand balance, which could be hinting that we will see less cutthroat pricing over the next few years.
Another factor here is the American Airlines bankruptcy. We can see in the excess capacity chart above that there's been a dramatic decline in excess supply over the past 11 years. American Airlines will likely end up cutting some routes, creating even less excess capacity in the industry. The picture that is getting painted here is that we may actually start to see an environment where the airlines can earn reasonable profit margins in the next few years.
The Next Steps
While there is a common belief that airlines are simply long-term losers unworthy of investment, the evidence before us seems to suggest that the massive losses in the industry are actually a result of a combination of factors, including legacy carriers' pension obligations, and a massive amount of oversupply in the industry, that has slowly been reversing. Consolidation should create a more optimal pricing environment for the surviving carriers and could surprisingly yield reasonable returns for even long-term investors. The end of the commodity super-cycle combined with more oil coming from the US and Canada could also create an added impetus to the industry by relieving pressure on oil prices.
The next question to ask is whether the pricing of the airlines is attractive enough to warrant investment. That I will answer in upcoming articles. We will examine seven major US carriers: Delta, United Continental, US Airways (LCC), Southwest, JetBlue, Spirit, and Alaska Airlines (ALK).
Disclosure: I am long LUV.