Berkshire Ruminations

Wednesday, January 17, 2007

Airlines taking flight? Not exactly.

Yahoo! Finance posted a surprisingly bullish USA Today story this morning on the heels of American Airline's (AMR) announcement that it had turned a profit for the first time in quite some time. It even cited an industry analyst who expects industry profits to total $5 billion this year! Now before we dump our BRK shares to buy AMR stock, lets calm down, take a deep breath and think about this situation.

Face it. Airlines are losers and will never make a decent investment of any kind. Even the stock of the strongest airline, Southwest (LUV), is now a mediocre investment at best. Although it has been a great investment over its lifetime, it has substantially underperformed the market over the last five years and, with the other airlines now trying to mimic LUV's low-cost model, it seems certain that its competitive advantage will begin to deteriorate. More on that later.

A quick overview of any airline's balance sheet immediately reveals the biggest problems they face. First of all, each airline employs an enormous amount of capital relative to its income. This makes for lousy returns and destroys value. Take American for example. This company has about $23 billion dollars invested in it, after allowing for the negative retained earnings account that has resulted from years of losses. Now, American is barely profitable, but for now let's make the very generous assumption that it is able to scrape together EBIT equal to the net income of most profitable airline, Southwest's $500 million. This would make its ROIC a paltry 2.2%. Meanwhile, the company is certainly paying no less than 7% on its $14 billion in long-term borrowing, making their annual cost of debt at least a billion dollars, far more than the assumed $500 million in income. This means that even ignoring the cost of equity, and even assuming the company is far more profitable than it really is, it would still be destroying value at a rate of more than $500 million per year.

But forget about all that cost of capital talk, before this most recent period the company wasn't even turning a profit. The reason for this is much simpler. The costs exceed the revenue. I will even go so far as to say that this is unavoidable for airlines. You see, as much as the companies would like to differentiate themselves, the typical airline passenger makes his purchase decision based exclusively on price. This makes an airline ticket merely a commodity and eliminates nearly all the pricing flexibility the airline has. Thus, the revenue of the company is out of the company's control. Meanwhile, the company's costs are just as uncontrollable and generally fixed, as they consist overwhelmingly of either a) depreciation of those expensive airplanes which must be maintained and eventually replaced or b) fuel costs. What we are left with is a company that can't control its revenues or its costs. No wonder these businesses never make any money.

Now, to make matters even worse, consider the fact that these airlines habitually file bankruptcy. The airline industry is one of the few in which firms are generally able to enter and emerge from Chapter 11 time after time. There was a great WSJ article a while back (called “Red Eyes: For Airlines a Shakeout Runs Into Heavy Turbulence,” Sep 19 2005, A1) that suggested the following: Airlines will continue to lose money and operate inefficiently as long as the bankruptcy process allows them to survive despite their inefficient operations. That is, the Darwinian nature of a capitalist system ought to weed out the weakest firms and allow only the fittest (the most efficient) to survive. But the U.S. bankruptcy system prevents this from happening by allowing firms to habitually rely on it for survival. An interesting assertion, but the article gave no supporting evidence so I can’t really assess its validity.

Regardless, an investor who purchases an airline stock must be prepared to deal with a high risk of bankruptcy, in which case he could lose 100%. Add this risk to a commodity business with huge fixed costs and a gigantic capital base and I just don’t see where the value will come from.

There is a reason there is no airline ETF...

FD: I have no position in any company mentioned in this post.


  • we have an airline show and big interview coming. If you buy these stocks you but them out of bankruptcy

    By Blogger Howard Lindzon, at 21 January, 2007 20:56  

  • Definitely. Why not buy them at their freshest right after bankruptcy? But I still don't see a strong case for buying them at all. Look forward to the airline Wallstrip. The GMCR show was great!

    By Blogger Andy Kern, at 22 January, 2007 08:24  

  • Andy, you may enjoy the article I penned on following Buffett's holdings via Form 13Fs here:

    By Blogger Mebane Faber, at 02 February, 2007 10:04  

  • Interesting read--I had never thought of airlines as not being able to control their price and revenues.

    By Anonymous Anonymous, at 04 February, 2007 23:21  

Post a Comment

<< Home