Why The Airline Business Is Broken

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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 kids 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 its a high stakes game.

Over the long term these businesses can be profitable over short periods, you can run into challenges.

I mean, theyre 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 arent any. So its 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 carriers bottom line, we can break them down into two categories, price shocks and demand shocks. Price shocks are when an airlines 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 its one thats 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 carriers 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 theyre flying less capacity, certainly they should be using less people and they should just lay off employees. Its 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 theyre 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 didnt 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, whos the loser? Everybody in the country, including other countries that depend on us.

Theres 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 doesnt fit all. What about business class and versus first class versus coach. Its a marketplace and you shouldnt tell the customers what to buy, you got to give them the menu and tell them tell us what you want and well 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.

Theyve 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. Theyre responding to what the markets telling them and there is a lot of demand for cheap airfares. So if youre 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 its 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 organizations assets and finances rather than to liquidate it.

When an airline goes bankrupt, it doesnt necessarily mean that youre 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, thats not a perfect solution, because youre asking your partners to sort of take some of the consequence of the restructuring. But its 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 wasnt 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, lets say US Air merged with the United thatd 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 doesnt matter how good you are, if youre number four or below, youre 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 wont 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 its probably 20% may not return even by 2025. So thats 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 its 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 theyre probably heading up and theyre 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 theyre out of the woods but theyve 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.

CNBC: Why The Airline Business Is Broken - Business Services