A Primer on the Airline Industry, and Why I Would Never Invest in It

As some of you already know, I have a degree in Aerospace Engineering. The choice for pursuing involved a multitude of factors, one of them being since I was a child, I was always fascinated by flying. I would sit at airports wide-eyed seeing the various aircraft scurrying around both in the air and on the ground (I’m not going to lie, I still do this today).

With this fascination, however, sprung a natural interest in the companies that owned and operated those huge aluminum beasts. Since then, I’ve followed the airline industry closely and have tried to understand in depth their operations, challenges, and ultimately, why they’re so bad at making money! Eventually I came to a basic understanding, don’t ever invest in an airline (or at least a US based one).

The Basics

I’m not going to patronize you and go into details on what airlines do – I’m going to assume everyone already knows that. One thing I do think that some people don’t realize is the sheer number of sub-operations that are required to operate an airline. The include:

1. Aircraft – Buying/Leasing/Selling, Inspecting, Maintaining, Overhauling, Field Repairs, etc.
2. Ground Operations – Managing the various offices (on airport and off), terminals and associated facilities (yes, sometimes the airlines actually own those terminals)
3. Information Technology – One of the coolest aspects of airlines. Ever wonder how your luggage gets where it needs to go when it’s among luggage from people going all over the world? It’s all IT baby (and despite people griping about it, airline baggage handling is actually a very accurate process. It’s one of the few business processes the gets even remotely close to a 6 Sigma operation).
4. Logistics – There’s a whole lot of back-end logistics that goes on for airlines. Everything from tracking a plane from origin to destination, to rerouting 100’s of flights due to a storm and accommodating the affected passengers . It’s pretty complex stuff.

There’s a bunch that I’m skipping, but you get the idea

But Herein Lies the Problem

Take a look at the list above again. Notice that pretty much all of those aspects of airlines listed are fixed costs. In other words, even if the airline wasn’t able to sell a single ticket, they would still need to pay those costs. This is known as an industry with a high capital cost structure. It just takes so much money just to run the operation, regardless of how much people actually use the product. This also relates to another concept known as an ‘exploding asset’. And exploding asset is the seat on the airplane. The airline has to pay all the costs for the plane, labor, operations, etc., to get that seat available and give it value. However, as soon as that airplane door closes, if that seat is empty, it no longer has any value. It’s an asset that (figuratively of course) explodes. Airlines have every reason to minimize empty seats – and this is the primary reason why you see flights getting overbooked – to minimize the chances of having those valuable assets ‘explode’.

There’s also a Catch-22

Even with the high fixed costs airlines would probably be able to make some money. But here’s another challenge they face. The biggest single cost for the airlines is fuel, and the cost for that fuel is directly proportional to the price of oil. In the energy markets, the price of oil generally rises when the economy is good. So when the economy is good, the costs for the airlines rise dramatically (sometimes as much as 3 times). However, the airlines can’t charge nearly enough to recover those cost increases.

In the same vain, when the economy is bad, the price for oil generally drops (in the current downturn, oil fell from a high of about $150 a barrel, all the way to $30 and is currently hovering around $70). But now the problem becomes revenue. Fewer people are flying and prices are going down. The airlines can’t catch a break either way.

Competition

Another challenge the airlines face, and this primarily applies to US based airlines is competition. Prior to the 1980’s airlines were regulated. However, since deregulation, they have started to compete more directly with each other. Unfortunately there were (and still are) way too many airlines and the industry has gone through decades of consolidation and liquidation to eliminate this competition (the most recent being the Delta/NWA merger and the ATA and Aloha Airlines bankruptcies). The high level of competition plays into the pricing power issue mentioned earlier, because even when the economy is good, airlines have trouble raising prices because they’re so heavily competitive with each other.

The Bottom Line

With the issues mentioned above, along with many others, the US Airline industry will constantly have trouble being consistently profitable – there are just too many reasons for them not to. Because of this, the industry as a whole has not made a single penny in profit in total over the last 25 or so years. As an investor, I can’t bring myself to buy into a company that faces so many consistent challenges. When pretty much all the major players have filed for bankruptcy in the last 10 years (e.g. United, US Air, Delta, Northwest), it makes it hard to stomach buying their stocks (although I think trading the stocks is still a viable option. Just don’t hold them for too long).

But All Hopes Not Lost!

Although things are bad now, I don’t think it’s the end of the world for the airline industry. Here are a few major business structure changes that I think in time will help the industry become profitable. If you see some or most of these changes happen (they probably need at least 10 years to even begin happening), you should start looking at the stocks again:

1. Continue Consolidating – We need to get rid of more of the weaker players. Some airlines that I really think need to disappear are US Air (horrendous customer service and a perpetual bankruptcy filer), and Frontier (just not big enough to compete)

2. Cut Fuel Expenses – The industry needs to work with the aircraft manufacturers to make a concerted effort to cut fuel costs. The investment needs to be made in technology so this huge burden is lessened. Boeing’s new 787 plane is a step in that direction, but is only a first step.

3. Put Emphasis Back On Customer Service – With the drastic cuts to customer service levels put in place by pretty much all the major airlines, I think there’s opportunity for airlines to use better service as a real competitive advantage. Reduce or eliminate the nickel and diming and treat your passengers with more respect and I think you’ll have a recognizable advantage that people will be willing to pay more for – thereby giving you some previous pricing power.

Questions/Comments/Feedback?
Please don’t hesitate to let me know of any questions or comments you have about this post or any other. If you want me to write about something else investing related, do let me know!

The Standard Disclaimer:

The stuff I just wrote above is my opinion and my opinion only. Please do not take it as fact. Perform all necessary research and analysis prior to acting on anything I've said above. This includes consulting with a financial advisor.