They may be romantic,  but are they a good investment?

By Steven Albrecht

I have been a pilot since I was 17 years old. I passed my first flight exam on my birthday as soon as I was old enough to hold an unrestricted pilots license. Over the years I have owned several aircraft of which my Seneca turbo charged twin was my favorite. I have also traveled a great deal in my career and accumulated many miles on commercial airliners. Regretfully, I had over one million miles in the PanAm Clipper program when that airline decided to park their planes.

I have observed changes in the airline industry over the years as it moved from a service and safety oriented approach to one that I call adversarial. Flying used to be fun; some called it romantic. When did it change? At about the same time the airline started making the passenger an undocumented employee.

Starting an airline requires a large capital investment. It is one of the highest capital expenditures of any industry. Airplanes, such as the Boeing 767 costs $120 million to acquire and you need several of them to build a route. You have to buy the routes; you just can decide one day to start flying to Orlando because everyone in New England wants to go to Disney World when winter sets in. Routes must be approved and assigned and not all airports are available. Seven of the 25 busiest airports in the U.S. are capacity constrained. Los Angeles is the busiest, handling 3.9% of all traffic while generating 4.2% of all revenue. Other capacity restricted airports are: Chicago O’Hare, Atlanta, New York LaGuardia, New York Kennedy, Newark, and Washington Regan. Capacity constraints are one of the most roadblocks to expanding airline services.

Airports are not free. They charge for facilities and it is on a long term contractu d all of the services across the country from Boston to Los Angeles for $350 round-trip. However, passengers still want the service for less. It is that simple.

What is the view from the executive office? Airlines know that fluctuations in airline travel is driven by GDP, economic activity. If GDP is increasing, airline travel generally increases within 12 to 18 months. Global GDP is growing at approximately 3% but, it is not uniform across the world. Europe is struggling while America is moving slowly upward at a steady pace. India and China are growing at a rate that is almost twice what other parts of the world are experiencing. Japan has resolved itself to low, growth rates just above zero while the Arab countries grow at a faster pace than average.

What does individual country GDP have to do with foreign country airline travel? A great deal. Airline travel is truly global and airlines can compete on a global scale. How do global enterprises compete on a world basis when they have individual governments and regulations? Open Sky agreements have been the mantra of the U.S. government for several decades. This started when the charge was hurled against foreign governments by American carriers that airline favoritism should not be allowed and that all airlines should compete in open skies in open markets. This was a great idea while the U.S. airline industry was dominate and expanding rapidly into international markets.

When deregulation opened the domestic markets every airline was allowed to fly internationally if they could get the schedules, crews and facilities. PanAm and TWA had exclusive privilege to the international market. No other American carrier was allowed to fly outside of America. America’s domestic routes were equally protected from foreign invasion. Foreign carriers could only fly to specific airports such as New York Idlewild (now Kennedy), Miami and Los Angeles. BOAC, Lufthansa, Air France and Japan Air Lines were restricted to just a few airports. Deregulation changed the restrictions and carriers, domestic and foreign, wanted open skies. Over the years the airline industry truly became over saturated with flights to everywhere – hypercompetitive.

US Major Airlines Since 1950

Today large airlines like American and Delta fly both domestic and international routes. They can move passengers from nearly any part of the world to another part in hours. Some routes are more popular than others but, the costs are spread across the entire network. This means the most popular routes with the highest competition see lower fares and the less popular routes with lower levels of competition see higher fares. If this model gets disrupted, some of the lucrative routes can no longer subsidize the less popular routes. Airlines have been so protective of this route/fare structure that there is an unwritten agreement that carriers flying with connections will charge the same fare as non-stop carriers so as not to disrupt the route/fare structure. If everyone does not play by the “rules” the game changes, and this has been a problem since deregulation.

The current airline market is now labeled uncompetitive oligopoly when it used to be tagged as hypercompetitive. What happened? Mergers is the simple answer. We now have four major airlines: Delta, United, Southwest and American. Before the mergers, new arrivals to the industry were frequent. However, when they arrived they frequently decide not to play by the rules and started targeting the major carrier’s high margin routes on a selective basis. Such a route might be New York to Orlando, or Chicago to Boston. Since the new competitor had lower costs, one route, fewer planes, fewer spares, less complex network, less complex reservation system, they could drop the price significantly to attract passengers. The established airline needed to match the fare, or watch passengers switch brands. Airline passengers are not brand loyal. If the established carrier does not match the lower fare the new carrier will eventually gain strength and compete on a larger basis. Southwest taught the world this works when it started from Love Field in Dallas. American never responded to the early threat and suffered dearly from lost traffic. It is in the major carrier’s interest to match fares when a price war starts.

PANAMSince the pre-price war fare was not excessive, lost revenue had to be made up somewhere else. A major carrier would increase fares on less popular routes to make up the difference. That is why it can cost more to fly from Louisville, KY to Topeka, KS than from San Diego to Atlanta or from Philadelphia to London. The airlines were stuck in an uncomfortable position. If they did not lower fares on the popular routes it would invite competition, and if you charged too much on the less popular routes, people don’t fly.

Each airline was uniquely challenged at different times and in different locations. Delta was challenged in Atlanta, American in Dallas, United in Houston and Chicago. Older names such as Northwest were challenged in Detroit and Minneapolis and eventually lost the war. Eastern lost the war in Boston and Miami. U.S. Air just lost the war in Philadelphia and Continental lost the war in Newark. All of these great names are now part of the Delta, American, United, Southwest quadrangle. There are other airlines but, they are small by comparison. The next place carrier is JetBlue with just 4% of all traffic; the same as Alaska Air. It is definitely a segmented market of majors and everyone else. Now you can see why increased competition from a powerful foreign carrier can disrupt the schedule and profitability. This is why the airlines are currently keeping 90% of the savings from lower fuel costs rather than lowering fares. A financial war chest may be needed in the not too distant future.

What is an airline to do to solve this problem because passengers are very price sensitive and will move immediately to the lowest fare. Airlines know this because they can watch ticket purchases across the reservations network. Have you ever wondered why you can go online and see a price of $450 for a flight from Washington D.C. to Miami at 2:00pm and then check again at 4:00 pm and see a price of $600? It is because the airlines can watch the number of seats available and how many days remain before the flight departs. If a larger number of seats are available than expected three days before departure the price will be lower. However, if there are fewer seats available than expected, the price goes up. Since anyone can scan Orbitz or Expedia at any time for free, do you think the airlines have the same information? The market is extremely efficient and the passengers are highly price sensitive.

boxAirlines always had frequent flyer programs. If you flew frequently you were identified in the airline’s database. Many airlines had private clubs such as Delta’s Crown Room or TWA’s Ambassador Club. The airlines thought they could increase brand loyalty by making the private programs membership clubs. The program gives rewards of free upgrades and flights to destinations as a means of saying thank you. But wait, that is a discounted or non-revenue paying passenger catching a free ride. Airlines should not be in the business of giving away seats. The new membership programs developed more problems because people with high miles want to fly to fun places like Hawaii or Paris not Des Moines, IA in January, sorry Des Moines. The flights to Hawaii and Paris are high margin flights and the airline would be giving them away for free.

The other way frequent passengers use frequent miles is for upgrades for Business or First Class. Again that is a high margin seat. Instead of $450 to fly from Chicago to Phoenix, the First Class passenger is paying $1,200. The airline just gave away $850. For those that have flown for a long time you might remember when airlines modified the frequent flyer programs to be an annual reward program. If you did not use your free miles within 12 months you gave them up. This was because people were accumulating large balances of free frequent miles and accountants identified this as a huge liability that was a possible crushing future obligation. One airline actually had enough people with frequent flyer miles that if everyone booked a flight with frequent flyer miles the airline would need to fly for a year for free. In the end, the programs did bring about loyalty, but at a huge cost. This is why many of the programs have fewer free flights, fewer destinations and fewer benefits. This has not gone unnoticed by the passengers and some experts say generated an adversarial relationship between the pax (passenger in airline parlance) and the airline.

There is another way to improve the margin on seat miles, get the passenger to do some of the work. This is a more recent tactic. For those of us that have been flying for several decades, could you imagine hearing the announcement I recently heard on a flight to Tampa, in January, here it goes, “For those of you that brought top coats onboard with you today, please place them on your laps to allow more room for luggage as we have a full flight this afternoon”. Yes, it is a true statement. Or, could you imagine being asked to clean up the area around you and throw it away in the trash receptacles in the gateway as you depart the plane. I am not a messy passenger, but when did I accept clean-up duty for my fellow passengers?

Worldwide airline shares

A lot has changed over the years…

What about baggage? The airlines were successful in getting you to carry your own luggage onboard, and if you don’t, they now charge you for the privilege of traveling with your belongings. We make our own reservations, check ourselves in at electronic kiosks, pay for luggage, pay for a drink, food, and clean the aircraft. What’s next? Will they be giving us all ice scrappers to de-ice the airplane before take-off?

Some airlines are finding it difficult to compete in the rough-and-tumble marketplace. Mergers are announced and we are asked to believe that two failing airlines can be successful if they merge. It might work if one was amazingly successful, but how does merging two bankrupt failing airlines make a good airline?

Flight crews have been asked to give up about everything that was important. I think the only reason most of them are up front anymore is because there is nothing more beautiful than seeing the sun after climbing through an overcast sky where everything on the ground was gray, dark and wet. Unfortunately, that does not pay a mortgage, send kids to college or pay for heat. Ground crews, mechanics, and dispatchers have all given up income and benefits to keep the airline in the air. You do reach an end to what can be sacrificed.

You may be convinced that you do not want to start an airline but, what about the stockholder? The shareholder is not unfamiliar with bankruptcy. Stocks that were high flyers become a nice framed wall hanging. There are some beautiful certificates with engraved airliners on the face. One of the most beautiful is PanAm, then there is TWA, USAir, and Eastern. What about the mergers where stock is swapped and then the new airline goes bankrupt? This happened with Piedmont, Ozark, National, and Northeast to name a few. International partnerships are arranged as “marketing partners” as if the link will now expand the route system into profitability. Neither airline was profitable to begin with and somehow magically they will now make money?

Taking a look at the four major carriers in the U.S. tells an interesting story. All of the prices are in Fair Value range (yellow box) with three in the upper regions of fair value and the other three about mid-way. What is interesting is the similar pattern each has with the other airlines in the industry. The path each has taken to their current price level is identical. It is so close that you might suspect they are the same chart, except for American Airlines which recently merged and started a new track record. Even with the merger event American almost immediately climbed to the current price in a similar fashion.

There is another security that has followed the same path as the airlines and that is the S&P500 Index. In the last chart I have placed all five airlines on a single chart along with the index. I have adjusted for difference in individual stock price levels on the chart, American in the $50’s and JetBlue in the $20’s so that you can see the pattern visually.

If an investor was tempted to buy a single airline stock they would be better off buying all of the airlines as an industry group to avoid the risk of a single carrier going bankrupt, total loss. However, the best idea would be to take the same funds and invest in the index (IVV) thereby placing the risk across 500 stocks and not a single industry or security. The performance is the same, and the risk is much less. It may not be as exciting as a fully powered jumbo-jet at take-off or as romantic as the vision of flying off to Madrid or Paris now that you own part of the airline, but your investment will be more secure.