Investing in US airline carriers can be a risky move. Warren
Buffett learned this the hard way, twice.
The airline industry is brutally ruthless. It makes a hockey game
look like a kid's garden party.
Commercial airlines have historically struggled to
deliver sustainable profitability. I think the stats
would bear that out, especially pre pandemic.
But investors tend to stick with the sector despite the
volatility.
You make a lot of money, a lot of people are millionaires. Can
you lose a lot of money in there? Absolutely. So it's a
high stakes game.
Over the long term these businesses can be profitable
over short periods, you can run into challenges.
I mean, they're putting you in a metal tube, taking you up to 30
40,000 feet, and transporting you at hundreds and hundreds of
miles an hour to get from point A to point B. And if you think
about the substitutes for that service, like there really
aren't any. So it's kind of surprising to me that an
industry that delivers that kind of a service, and does it with
like an absolutely impeccable operational and safety record is
able to come under such pressure.
Airlines had a 10 year streak of profitability. And that was very
quickly ended by the Covid 19 pandemic. And that was a crisis
Airlines said had a larger impact than even the 9/11
attacks.
Airline stocks have been on a wild ride since December 2019.
Begging the question should investors steer clear of the
sector? And if air travel is such an integral part of society
and the economy? Why do passenger airlines struggle to
stay profitable?
Airlines face many potential external risks that could impact
a carrier's bottom line, we can break them down into two
categories, price shocks and demand shocks. Price shocks are
when an airline's operational costs suddenly shoot up due to
extenuating factors.
You know the biggest and most obvious ones of these are oil
prices that translate directly into jet fuel. Jet fuel is for
most airlines their biggest expense, and it's one that's not
always very easy to pass on to the customer. So as you start to
see oil prices rise, that again comes right over the airlines
profit loss statement.
The steep rise in oil prices in 2008 during the Great Recession
created a price shock. Airfares trended downward despite fuel
costs going up causing cash inflow problems for airlines
carriers began unbundling airfares from other services
like baggage checks, food and drink purchases, and flexible
reservation changes in order to recoup the losses.
Part of the problem is tickets are sold in advance at a
specific price in advance. And then the input cost that drive
profitability can vary sometimes on a day to day basis.
Another example of a price shock is a sudden increase in labor
costs such as what the industry experienced during the pandemic.
Airlines have told me that they have had to increase sometimes
multiple times the starting wages for new hire employees. So
depending on the price of jet fuel, it or labor can be the
number one cost for an airline.
Demand shocks are when a big event has reduced the number of
people flying. There have been a number of demand shocks in the
past 20 years such as 9/11, the SARS outbreak, the Great
Recession, swine flu and of course Covid. These events vary
in severity but the industry took a hit from all of them.
Airlines are already operating on very thin margins, but when
an event like that comes in the airlines really suffer.
In 2001 airline profits declined a little more than $12 billion
compared to 2000. The Great Recession led to a profit swing
of more than $40 billion, and the pandemic led to year over
year losses of nearly $153 billion in 2020. Soon after
9/11, Congress approved a $15 billion bailout to help prop up
the airlines as well as limit the carrier's liabilities in the
wake of the attacks.
At the time, the 9/11 bailout was the largest airline bailout
that we had ever seen.
The government stepped in again in 2020, as pandemic
restrictions led to a huge decrease in travel demand.
Congress passed the Cares Act in late March 2020. The bill
allocated about $50 billion in grants and loans for passenger
airlines.
The government basically propped up the airlines until a point
where hopefully we now have enough demand that the business
can be sustainable again.
One of the key parts of the legislation is the payroll
support program or PSP. The policy was created to prevent
airlines from laying off or furloughing workers.
On the surface that might seem a bit strange because if they're
flying less capacity, certainly they should be using less people
and they should just lay off employees. It's not that simple.
Because the industry is so safety conscious. If a highly
trained employee such as a pilot goes on leave, that person must
go through weeks of retraining to make sure they're ready for
commercial service again, which comes with added costs and
complications.
So in terms of the payroll support programs that protection
of pilots, mechanics, flight attendants and other grounds
staff was was a big deal, because the rehiring costs could
be painful for an industry that it lost billions.
But there was pushback to the 2020 bailout.
We have privatized the gains, and we socialize the losses. We
seem to do it every single time.
Airlines had faced criticism, some Democrats said, you spent a
lot of your cash on stock buybacks and dividends instead
of a rainy day fund and raising worker wages.
The legislation included some restrictions to deal with these
concerns.
There were limits on CEO compensation, salaries, bonuses,
and things like that. And then airlines were prohibited from
laying off any workers for a set period of time for each of those
three bailout packages.
I think the government realized that with the massive
evaporation of demand, that if they didn't somehow support the
airlines, that there was a credible risk of failure by
perhaps several airlines. And with that comes a lot more
unemployment.
If airlines fail, who loses? If the national transportation
system fails, who's the loser? Everybody in the country,
including other countries that depend on us.
There's a whole spectrum of ways airlines go to market. But the
two buckets that are broadly accepted are full service
carriers and low cost carriers.
Full Service carriers are more business oriented. They operate
out of hubs, which are central airports that many different
commercial routes fly through in order to make connections
easier. Think Delta, American Airlines and United these legacy
carriers also tend to have more infrastructure within their
business and operate several different types of aircrafts as
well as provide services such as lounges and business class.
One shoe doesn't fit all. What about business class and versus
first class versus coach. It's a marketplace and you shouldn't
tell the customers what to buy, you got to give them the menu
and tell them tell us what you want and we'll give it to you.
These models, however, are more expensive to run.
That adds quite a bit of fixed cost, but it also generally adds
complexity, which makes it a little bit harder to be agile.
And puts them a little bit more exposed to both acute events and
bigger ships in the market.
Low cost carriers on the other hand, run a more streamlined
operation. Think Southwest, Spirit, and Allegiant Air. These
carriers run an operation with lower overhead they typically
have a simpler business model, use only one type of plane and
unbundle amenities from ticket prices.
They've proven as a sector to be quite a bit more resilient to
shocks in the past and the poster child for low cost
carriers historically has been Southwest, and up until the
pandemic they delivered 47 years of straight profitability.
The business models vary between these budget carriers. Spirit
paved the way for the unbundling practice, while Southwest has a
motto of bags fly for free, but Southwest keeps its cost low in
other ways, such as only providing one class of service
which means no business class. Regardless of the business
model, all passenger airlines are very acid intensive. Every
carrier must invest in things like aircrafts, facilities on
the ground, training centers, labor, and making sure they meet
government regulated safety standards.
For the vast majority of airlines. They're responding to
what the market's telling them and there is a lot of demand for
cheap airfares. So if you're trying to meet that passenger
demand, you need to think about ways that you adjust your cost
base to do that profitably.
The airline industry is highly regulated from a safety
standpoint, but the government used to also regulate the
business side of passenger airlines. Until the late 1970s,
the government set and regulated airfares, which meant the
airlines had to compete based on what services they offered
rather than offering the lowest cost flights. The Airline
Deregulation Act of 1978 allowed airlines to set their own fares
and routes without needing government approval.
After that period, we entered an era which we are still in where
airlines are more competing on price. And because it's such a
low margin business, airlines tried to pack as many people in
a plane as possible, which has been the reason why leg room has
shrunk on airplanes year after year.
The airline industry has struggled to be sustainably
profitable for ever, but in particular in the US since the
deregulation. It has had really high highs and really low lows.
Deregulation in '78 forced airlines to shift from basically
utility type businesses to free market businesses and it was a
brutal bloodletting.
The deregulation sent the industry into decades of
upheaval and adjustments as the business practices shifted. The
demand of the marketplace lead to a lot of airlines going out
of business or restructuring their operations. There have
been more than 200 bankruptcy filings since the industry was
deregulated. According to Airlines for America But most of
these bankruptcies were for chapter 11 proceedings, which
allows a business to use the law to restructure the
organization's assets and finances rather than to
liquidate it.
When an airline goes bankrupt, it doesn't necessarily mean that
you're not going to see that airline again. Airlines that we
all fly on today, Delta, American, United, all of those
airlines over the last 20 years have declared bankruptcy and
gone through a restructuring process.
United was the first of the major airlines to file for
Chapter 11 in December 2002. That kicked off a wave of
Chapter 11 filings. US Airways filed in September 2004 and
Delta and Northwest both filed on September 14, 2005.
Obviously, that's not a perfect solution, because you're asking
your partners to sort of take some of the consequence of the
restructuring. But it's been a way for airlines to sort of get
back on their feet, protect those jobs, protect those
assets, and rebuild in a way that is ultimately better for
their shareholders, their employees and their customers.
They were coming out of bankruptcy looking for ways to
get a bigger share of the market. They embarked on this
big game of musical chairs where it wasn't clear exactly which
airline was going to end up with which airline.
Delta purchase Northwest in 2008, putting pressure on the
other airlines. After years of negotiations continental and
united merged in 2010.
Continental as large as it was, was still the fourth or fifth
largest airline in the US depending on how you measured
it. And they needed scale.
And you saw Delta buy Northwest, let's say US Air merged with the
United that'd be the end of it. So it was a kind of do something
or be forever in fifth place, or fourth place, which is not a
really sustainable goal.
Through consolidation we have seen airlines compete by not
competing. In the Olympics doesn't matter how good you are,
if you're number four or below, you're not getting one of those
medals, and Wall Street want not just profitability, but they
want to see a path towards sustained profitability.
By 2015 the consolidation led to what are now considered the Big
Four airlines, Southwest, Delta, United and American Airlines. As
of July 2021, those four airlines control about 65% of
the US market. This strategy of consolidating paid off for
airlines, at least for a while.
Coming out of the recession, consolidation in the US, has
certainly contributed to the profitability of the airline
industry, especially in the five or six years before Covid. When
there were record levels of profit, the airlines paid down
their balance sheets, for the most part, they reduced debt,
they improved stockholder equity, but also they went about
massive, massive changes in how they do business.
Analysts are widely expecting the industry to rebound in the
next few years, but there are some caveats. The big question
for analysts is when will people start flying again after the
pandemic?
The business traveler who can be sometimes five times more
profitable than a leisure traveler has been historically,
the core customer for airlines. But the business traveler is not
yet back in large numbers. And they won't be back until
sometime domestically until probably 2023 2024 and the rest
of the world 2024 2025. And some portion of business travel that
existed before the pandemic is not coming back, we estimate
right now it's probably 20% may not return even by 2025. So
that's going to put more pressure on airlines to cater to
leisure travelers.
Demand is definitely very important. What kind of price
point type recovery is also very important. Assuming oil prices
stay at these levels, Freising will probably stay elevated.
That might not be a great message for the consumer. But
it's a better message for the shareholder.
There are pretty significant debt loads that have come along
with a pandemic. Right now rates are pretty low, but they're
probably heading up and they're facing issues in their supply
chain like many other companies, and that includes, by the way,
things like pilots. The airlines are in a better place than many
people would have thought of, you know, early in the pandemic,
which is not to say they're out of the woods but they've done a
pretty good job of responding and addressing what would
normally have been existential threats and finding a way to to
weather through the worst of the storm.