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Why Airline Stocks Are So Often Bad Investments

by: Saj Karsan September 04, 2008 | about stocks: AMR / CAL / DAL / LCC / LUV / UAUA    

Saj Karsan

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Warren Buffett is quoted as saying that the airline business in the US “has made no money.” Thanks to a forgettable investment Buffett had made in US Air (LCC), he even went so far as to suggest a capitalist should have shot down the Wright brothers during their historic "first in flight" moment.

Is there something particular about the airline industry that causes these companies to have been such bad investments? Why is it that every recession takes a few airlines down with it? The answer lies in supply and demand characteristics specific to this industry.

Let's start on the demand side. When incomes fall (e.g. during recessions), airlines get hit particularly hard. This is measured by income demand elasticity, which determines the impact changes in incomes have on demand for particular products or industries. According to a study by Houthakker and Taylor, here are some U.S. income elasticities of demand:



Basically the chart is telling us that for every one percent drop in income, we see a drop in demand for each of these items corresponding to its chart entry. For example, at the bottom of the list, we see that for every 1% drop in income, food demand drops by just .14%. On the other hand, at the top of the list, we see that airlines are disproproportionately affected, with demand dropping by 6% despite only a 1% fall in income!

But the converse is also true, meaning that for each 1% rise in income, airline demand increases 6%! So shouldn't this cancel out the drop that occurs every now and then? To see what happens when times are good, let's look at the supply side.

When demand increases (and we see it increases disproportionately with incomes), airlines add to their capacity. This results in fixed costs for airlines, either in the form of lease payments or debt taken out to buy expensive increases in capacity. However, as all airlines do this, the one that increases too much or too fast ends up with overcapacity. Since customers generally choose their airline based on price (though there are exceptions), an airline with too much capacity will simply cut its price to fill its seats. Competitors are forced to follow suit, or carry overcapacity themselves, resulting in an erosion to profits despite strong economic times!

This effect prevents airlines from benefiting from their high income demand elasticity. To make matters worse, when the economy turns down, the airlines are left with large fixed cost obligations (aircraft lease or debt payments) that are tough to pay off, and especially tough considering the disproportionate drop in demand as compared to incomes, resulting in the annihilation of the weakest airlines.

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This article has 19 comments:

  •  
    Sep 04 06:06 PM
    A bulk of their cost is fuel cost (25-40)% and in hard times when fuel cost goes up, and demand goes down, it increases their operating cost and at the same time reduces revenue.
    Reply
  •  
    Sep 04 06:22 PM
    There is also psychology problem: airlines are mostly created and run by enthusiasts. And there are way too many enthusiasts in aviation. Industry lacks real business discipline as a result. There are some exceptions, like Southwest, but they might be enthusiasts with good business sense.
    Reply
  •  
    Sep 04 06:45 PM
    AIRLINES ARE NOW GREAT INVESTMENTS.....tight capacity, lower fuel cost, and additional charges will generate lots of free cash flow.
    Reply
  •  
    Sep 04 08:59 PM
    One component is the spoilers, the virgin Atlantic types, who pick up high demand routes like London and large cross country ones, making a dent in the carrier who have to serve Fresno and Wichita.
    Reply
  •  
    Sep 04 09:50 PM
    Dude, have you been watching the price of oil? It's near $100 and will crumble to $80 or below....do you think that the airlines will be at current price levels when oil crashes to these levels?

    Your article is myopic because it only includes your long term investment option, we intermediate investors seeing the airlines do a turnaround and it's synching with the oil crash.

    I'm in on airlines for this turnaround and will short it once it's finished.
    Reply
  •  
    Sep 04 10:29 PM
    In response to Burkey,

    Are you serious? Can you tell how long a supposed turnaround for airlines will last? What if oil prices remain volatile and fluctuate between $70 and $100? What if they don't stay below your $80 mark for long enough for the airlines to recover? What if the airlines have trouble being profitable with $80 oil (which is exactly what was happening in 2005)?
    Reply
  •  
    Sep 05 12:26 AM
    I am surprised no one mentioned the difference between LUV (and a couple of other successful lower-cost carriers) and the legacy airlines. Part of the problem is that at the legacy airlines both the management and the unionized employees treat their company as a cash cow rarely thinking about the future.

    One example,:UAUA will likely file for bankruptcy again in the next couple of years. They've been there twice already after 9/11 and with the current management they are likely to go that route again. Unfortunately, airlines in bankruptcies seem to keep flying as if nothing happened (who gave Frontier their money and why?) which puts more pressure on the surviving carriers. Even LUV might feel more pressure soon. They are famous for never laying off a single employee which could be a problem if travel demand falls off a cliff.

    Of course, if oil drops below say, $70 airline stocks might be the trade of the year but I wouldn't bet on that.
    Reply
  •  
    Sep 05 02:35 AM
    Saj, its simple, planes are very expensive to buy and operate.
    With such high capital costs you basically spend the whole time paying off planes before you have to replace them again. That is Warren Buffets point about airlines.
    Thats why he prefers businesses that have low or no capital expenditure. Look at businesses like Moodys, insurance or asset managers, their main costs are salaries and accomodation. No huge capitals expenditures or fuel costs.
    Reply
  •  
    Sep 05 02:53 AM
    The RASM Surge; Estimates Improved
    Despite anticipated demand softness, industry RASM is expected to surge
    starting in September, lifting estimates along the way. While airline shares tend
    to seasonally find traction starting in November or December, we suggest
    positions instead be established before the release of September demand data.
    • All Eyes on RASM – With fuel prices at manageable levels, demand trends
    are expected to retake center stage. Starting in September, we expect system
    mainline RASM to exceed 10%, remaining there until well into 2009.
    • We Are Boosting Our RASM Estimates – On an ATA basis, our Q3
    system mainline 5% rises to 7%, Q4 10% to 11%, and 2009 8% to 9.5%.
    • Our Forecasts Are Actually Conservative – Should August~December
    sequential trends mirror those of 2007, Q4 RASM would exceed 15%. But
    we’re modeling just 11%, reflective of anticipated demand softness. Put
    differently, supply is exiting the industry at a far greater rate than
    demand has ever softened, ex-9/11.
    • Our 2009 Forecast Is Similarly Diffident, Yet Shares Look Cheap – On
    an ATA basis, 2008 RASM is expected +7% on a 2% decline in capacity. For
    2009, we anticipate 9.5% RASM on a 6% decline in capacity. Yet despite
    this implied demand erosion, shares in many names are trading at or below
    5x EV/EBITDAR.
    Reply
  •  
    Sep 05 03:34 AM
    hedge funds trade airlines all day, everyday. Ask anyone on the sell side who has to cover these names....there is a buy case here with oil getting torched and volatility this damn good
    Reply
  •  
    Sep 05 05:57 AM
    What is the basic cost to fly the big A380 if only half of the plane is full plus high fuel price that affect Airline companies hard to make good earning?

    No flight magazines, no free drink service, no extra free baggages, even no fancy color painting on the airplane body that can safe some weight?

    Hopefully new Boeing 787 design may help to solve the problem that encourage Airline to make profit.
    Reply
  •  
    Sep 05 11:06 AM
    if you want to become a millionaire start out as a billionaire & invest in airline stock.so said an airline exec.
    Reply
  •  
    Sep 05 11:13 AM
    Everyone has skirted around the issue of marginal cost, without explicitly calling it out. So, I will do it. As mentioned before, airlines have large fixed costs. However, there marginal cost to fly another passenger is extremely low. Therefore, when there is an unsold seat, it is in the airlines best interest to sell that seat at almost any price, no matter how low, because the cost to fly that person will occur anyway in the form of fixed costs. The additional revenue of that extra passenger is offset by almost no marginal revenue.

    Industries that operate with this phenomena of large fixed costs and low marginal costs tend to be natural monopolies, such as utility companies. We all know what happens when there is a monopoly. The company can raise prices at will as there is very little competition (competition in this case being alternative forms of transportation).

    So, we have airline enthusiasts running companies that are destined to not make sustainable profits as long as there is competition.
    Reply
  •  
    Sep 05 11:45 AM
    I spent some time at Southwest. That whole airline can be classified as aviation enthusiasts. The management at many of the Legacy carriers are in it for themselves.

    FYI - Southwest is one of the most unionized air carriers out there. It's pilots, flight attendants, and maintenance workers are all union.

    So stop blaming the unions (although they are part of the problem at OTHER carriers).

    It is all about how the company is run, and how it treats its passengers - just like ANY other business. Unfortunately, you can't run what is essentially a customer-service focused business with non-existent customer service.
    Reply
  •  
    Sep 05 01:16 PM
    Wow, 14 posters all missed the point of the article about how extreme income demand elasticity combined with a cutthroat pricing and expansion business model means that airlines can't make good money in recessions OR expansions. The detailed observations above miss the forest for the trees. Consistent profitability is impossible where these 2 conditions exist, no matter what the details.

    I will only add that if it wasn't for taxpayer funded airports, airport security, air traffic control, and the FAA, none of these companies could even exist. Their revenue seems to come from stock investors, but most of the fixed costs are paid by the government. It's the ultimate socialized industry that ironically benefits the wealthy more than anyone. I'll mention that the next time someone at an airport tells me that single-payer healthcare would be the road to communism! Sorry, but the entire transportation sector is already there.
    Reply
  •  
    Sep 05 03:05 PM
    chris b-you are right & its been there since the start.the start being air mail.
    Reply
  •  
    Sep 05 09:37 PM
    L&G-

    The comment by Chris B above (last paragraph), is incorrect.

    Passenger and freight airlines pay $billions in taxes and fees for the support system required to operate this Nations air transportation system.

    Approximately 30% of each passenger fare goes -directly- to pay government taxes and fees (these costs are frequently broken out on your airline ticket).

    In addition to the taxes and fees noted on most airline tickets, air carriers all pay significant amounts for airport landing fees, terminal rents, fuel taxes etc.etc.

    You can do your own research to verify what I've stated by searching "transportation excise taxes", "Aviation Trust Fund" or check the ATA and FAA websites for specific information and data.

    Regards,

    Robert Herbst
    AirlineFinancials.com
    Reply
  •  
    Sep 06 01:11 PM
    Airlines are, in effect, "owned" by their pilots. Shareholders possess a warrant on the ability of the airlines to remain solvent. The warrant has value over short periods of time because owners can usually find a greater fool to buy it. Over the long haul it normally expires worthless.

    Pilots, collectively, are financial idiots. They refuse to recognize their ownership interest, prefering to style themselves as exploited victims of their managements. The "successful" union leaders are always the most macho and the least suited for the nuanced bargaining required to keep the airlines solvent during the periodic collapses in airline profit margins.

    Note that the highest paid passenger airline pilots (Southwest) are the least aggressive. The rest of the passenger airlines were driven into bankruptcy in the order of the belligerency of their unions. American is the exception that proves the rule. It barely survived because its pilots grudgingly conceded pay and work rule give backs (their membership is still whining about this even though AA pilots are manifestly better off than those at the airlines that did recently go all the way to bankruptcy). Delta, Northwest, and United failed because their pilots wouldn't figure out how to make the necessary short term concessions to allow their airline to survive (United was actually formally "employee owned" at the point of insolvency).

    Analytically this is more a study of the irrational madness of crowds than of economics.
    Reply
  •  
    Sep 06 03:18 PM
    To Burned Investor-

    I wonder if you (or others) would share your opinion of what you believe is a reasonable annual salary for a ~25+ year seniority airline captain in command of and responsible for a large wide body aircraft (~225 passengers).

    I'll make the following notes:

    * It takes several years of experience in the military or/and civilian flying jobs to gain the experience to even get hired by a major airline.

    * Right or wrong, airlines use a seniority based system for all pilot job advancements. (i.e. If you leave one airline for another either by choice or due to the failure of an airline, you start over at the beginning of your airline career.)

    * While it's true excluding SWA, UPS and FedEx, the AA & CAL pilots compensation package are somewhat better than airlines that have reorganized through the bankruptcy process. It is also true the AA pilots wages adjusted for simple CPI (inflation) are about what they were 15 years ago.

    Due to concessions, current hourly rates for UAL, NWA, DAL and USAir pilots are 40-50% less than what they were scheduled to be from their 2000 contracts.

    * Airline pilots are required to take FAA flight physicals every 6 months. FAA mandated recurrent training and check-rides every 6-9 months. Unannounced check-rides from the FAA and company check pilots without notice. Failing any of these could end your career. In fact, due to medical issues a large number of pilots never make it to retirement age as a pilot.

    * While you will never hear about it; Each and every day there will be some pilots that have used their training and experience to turn what could have easily been a disaster into a non-event for the news media.

    * The majority of airline accidents prove to be the fault of pilots. Obviously pilots assume considerable responsibility for the hundreds of lives sitting behind them and the $tens of millions in property each and every time they close their cockpit door.

    None of the above is meant to minimize the important work all airline employees are responsible for each and every time an airliner makes a routine flight from point A to B.

    Regards,

    Robert Herbst
    AirlineFinancials.com
    Reply
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