Thursday, September 4, 2008

Why Airlines Are Bad Investments

Warren Buffett is quoted as saying that the airline business in the US “has made no money.” Thanks to a forgettable investment Buffett had made in US Air, he even went so far as to suggest a capitalist should have shot down the Wright brothers during their historic "first in flight" moment.

Is there something particular about the airline industry that causes these companies to have been such bad investments? Why is it that every recession takes a few airlines down with it? The answer lies in supply and demand characteristics specific to this industry.

Let's start on the demand side. When incomes fall (e.g. during recessions), airlines get hit particularly hard. This is measured by income demand elasticity, which determines the impact changes in incomes have on demand for particular products or industries. According to a study by Houthakker and Taylor, here are some U.S. income elasticities of demand:

Basically the chart is telling us that for every one percent drop in income, we see a drop in demand for each of these items corresponding to it's chart entry. For example, at the bottom of the list, we see that for every 1% drop in income, food demand drops by just .14%. On the other hand, at the top of the list, we see that airlines are disproproportionately affected, with demand dropping by 6% despite only a 1% fall in income!

But the converse is also true, meaning that for each 1% rise in income, airline demand increases 6%! So shouldn't this cancel out the drop that occurs every now and then? To see what happens when times are good, let's look at the supply side.

When demand increases (and we see it increases disproportionately with incomes), airlines add to their capacity. This results in fixed costs for airlines, either in the form of lease payments or debt taken out to buy expensive increases in capacity. However, as all airlines do this, the one that increases too much or too fast ends up with overcapacity. Since customers generally choose their airline based on price (though there are exceptions), an airline with too much capacity will simply cut its price to fill its seats. Competitors are forced to follow suit, or carry overcapacity themselves, resulting in an erosion to profits despite strong economic times!

This effect prevents airlines from benefiting from their high income demand elasticity. To make matters worse, when the economy turns down, the airlines are left with large fixed cost obligations (aircraft lease or debt payments) that are tough to pay off, and especially tough considering the disproportionate drop in demand as compared to incomes, resulting in the annihilation of the weakest airlines.


Anonymous said...

Interesting article. Now there's some things I didn't know!

Airlines earn apalling returns on capital. Take British Airways (I'm a Brit). Over the last 10 years, its median return on equity was 7.55%. It has made losses before tax in 3 of the last 10 years. It has debts falling due outside of one year of £4.8b, against an equity base of £1.9b. It also has negative working capital of £1b, making its indebtedness look even worse. Its z-score is 0.74 - confirming its financial vulnerability. Despite global economic crisis, ash clouds grounding aircraft, and strikes, it is still trading above book value. So I still don't think it is cheap.

So yes, I'd agree with you, airlines are bad investments.

-- Mark

james moylan said...

I have a web site where I research stocks under five dollars. I have many years of experience with these type of stocks. I would like to comment about airline stocks.I don't know if I would agree with the statement why airlines are bad investments. although airlines have been bad investments since they were deregulated back in the 1970's airlines have become extraordinarly efficient over the last ten years in spite of the high cost of jet fuel and all the new airport regulations that have taken effect since nine eleven. also the number of airlines and the capacity have been greatly reduced over the last ten years. I think the airlines may have entered a period of sustained profitability. although I would not recommend buying individual airline stocks their is an exchange traded fund that invest in airline stocks it trades under the symbol {FAA}