Owning an airline may be glamorous, but for most of us, flying really isn’t – economy travel sucks around the world.
Long queues, cramped seats, chronic delays, and bad food make air travel usually the most uncomfortable (also the safest and most efficient) way to get from point A to point B.
It is easy to assume that given how focused they are on squeezing every last penny, even at the expense of their harrowed customers, the airline business would be spectacularly profitable.
We all know that it really isn’t.
“The worst sort of business is one that grows rapidly, requires significant capital to engender growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers.
Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favour by shooting Orville down.” – Warren Buffett, in the 2007 Berkshire Hathaway shareholder letter Buffett actually made money on the US Air bet he made in 1989.But that, as he put it, was down to some good fortune – “In one of the recurrent, but always misguided, bursts of optimism for airlines, we were actually able to sell our shares in 1998 for a hefty gain. In the decade following our sale, the company went bankrupt. Twice.”
So, what makes the airline business so tough:
1) High fixed and semi-fixed costs: It starts with buying or leasing a very expensive piece of machinery. One of the most popular airplanes in the world, Airbus 320, costs around $100 million.
In addition, usually, one has to anticipate demand and place orders well in advance, and then, irrespective of those estimates being correct, pay up for the planes.
Airline operations are also very labor-intensive and generally have high payroll costs and other costs (like airport slots, ground equipment etc.) that are semi-fixed in nature.
You can’t really fire staff at a moment’s notice when demand slows down and rehire them immediately when it picks up again.
Finally, if this wasn’t enough, fuel is a major expense item – often as much as 30% of the total cost base. Especially in these times – which makes elusive profits often a derivative of oil prices.
2) Elastic demand: Air travel is extremely sensitive to economic activity. This means that as demand slows down, demand for airlines falls disproportionately, often 2-4x. But because of high fixed and semi-fixed costs, losses pile up.
One would think this would be compensated for, when demand is on the way up. Not really. Because, often, airlines add capacity in anticipation of demand (as we noted above – planes take time to acquire).
This often results in a race to the bottom on prices because filling the incremental empty seat has a very low marginal cost.
3) External shocks: As we have all seen recently, this industry is particularly vulnerable to external shocks. Whether it is a near-complete shutdown because of Covid-19 or it is higher fuel expenses and blocked air spaces due to the Russia-Ukraine War.
Despite his quote above, Buffett did dip his feet back into airline stocks. He poured billions into all four major US carriers – United, American, Southwest, and Delta Air Lines. What changed?
Well at least as far as the US was concerned, the industry went through major consolidation – basically, nearly 2/3rd of the market is controlled by these 4 major airlines. This meant that they contained competition and unnecessary capacity expansion.
Combined with near perfect economic conditions, it led to a very lucrative period. North America is by far the most profitable region in the world.
In 2019, it accounted for 66% of global profits ($17.4 billion out of $26.4 billion), and the four major airlines had recorded 10 straight years of profit by 2019. It has also been the quickest to recover since 2020.
However, the problem remains that, fundamentally, even in 2019, at the end of probably its best decade in near-ideal economic conditions (growing demand with low inflation), the return on capital for the global industry was still only 5.8%.
The industry now faces headwinds with sky-high inflation (in both fuel and labour costs) and shaky demand, especially from its most lucrative segment – business travel.
Business travel is estimated to be 5x more profitable than leisure and is the slowest to recover after shocks. Virtual meetings are a formidable threat – business travel may never fully recover to pre-pandemic levels.
This is probably why Buffett decided to fully exit the positions in those 4 airline stocks – mind you, this was near their bottom during the throes of the pandemic. He wasn’t as lucky this time, and Berkshire Hathaway had to bear massive losses.
“But seriously, the airline business has been extraordinary. It has eaten up capital over the past century like almost no other business because people seem to keep coming back to it and putting fresh money in. You’ve got huge fixed costs, you’ve got strong labour unions, and you’ve got commodity pricing. That is not a great recipe for success. I have an 800 (free call) number now that I call if I get the urge to buy an airline stock. I call at two in the morning and I say: ‘My name is Warren and I’m an aeroholic.’ And then they talk me down.”
The lure of the airline business is strong for obvious non-business reasons, and I am sure there is even a business case for an extremely well-run operation in conducive economic conditions.
After all, Tata has doubled and tripled down with as many as three airline operations – Vistara, Air Asia, and now Air India. The late and great Rakesh Jhunjhunwala launched a new airline – Akasa Air.
But billionaires and business giants will do well to heed the warning from one of their own, albeit with burnt fingers and a pledged Carribean home.
“If you want to be a millionaire, start with a billion dollars and launch a new airline.” – Richard Branson
(The author is Co-founder, Upside AI)
(Disclaimer: Recommendations, suggestions, views and opinions given by experts are their own. These do not represent the views of Economic Times)
