Vishal Khandelwal

We analyse the Airline industry and bring forth the reasons why despite some bright spots, it has been a gruesome
play as far as investors are concerned.

Ever since the invention of the airplane, the industry has been one of the world’s most eye-catching. The appeal of global air travel has always drawn capital to the industry. So finding money has never been the problem – making consistent profits has always been the challenge.

The industry is much better known for losing money than for making it. When trying to understand what’s wrong with airlines, it’s important to remember that the industry is:

Airlines, globally, has never been a profitable business. In fact, when someone once asked Sir Richard Branson, the much-acclaimed chief of Virgin Airlines, how to become a millionaire, he replied, “That’s easy. First you become a billionaire and then you buy an airline.”

Here is what Warren Buffett wrote in his annual letter to Berkshire Hathaway shareholders in 2007:

The worst sort of business is one that grows rapidly, requires significant capital to engender the 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.

The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it.

• Highly fixed capital intensive – Needs consistent inflow of money for expansion (an average airplane costs around US$ 200 million).
• Heavily dependent on economic cycles – Every bad phase is the worst phase.
• Hamstrung by volatile fuel costs – Can’t do without it.
• Selling what is essentially a commodity (airline seats) – No one has reasons to ask for a higher
price than competitors.
• A real bankruptcy risk – What we are seeing so often these days (Kingfisher, Spicejet, etc.).

This all adds up to create a pretty unattractive picture. Essentially, over the course of multiple economic cycles, these companies can’t earn more than their costs to operate. And as an investor, over many years, it is tough to make money holding onto airline stocks.

You can’t sleep peacefully at night if you are an investor in such stocks. Just a look at the financial performance of airline companies on the next page will tell you why these are such gruesome businesses.

Rs 100 invested in March 2005 is now worth…

As you can see from the three tables above – Jet Airways, Spicejet, and Indigo – you can notice that Indigo, which is not a listed company, has been an exception in the Indian airline industry, constantly churning out profits year after year. While not many details are available on the company’s operations, constant profits have been attributed to a combination of operational performance and financial engineering (sale-and-leaseback transactions). Even then, the company has not been completely immune to the ills of the airline industry (currency volatility, cut-throat competition and high jet fuel costs), and has seen a volatile earnings growth trajectory in the past three years. Profits, for instance, declined almost 60% YoY in FY14.

Airline: Porter’s Five Forces Analysis

1. Bargaining Power of Buyers

• Low switching costs for buyers.
• Few airline operators and thus the choices available to buyers are low.
• Overall, low bargaining power of buyers.

2. Bargaining Power of Suppliers

• Major suppliers are the airplane manufacturers, with the two biggest being Boeing and Airbus.
• Airline companies cannot easily switch suppliers, because having the same supplier supplying similar
kinds of planes with standardized components helps the former keep operational costs lower. Most airline
companies have long term contracts with their
suppliers.
• It is difficult to enter into plane manufacturing because of the capital and expertise needed. If a supplier, say, Boeing, in harmony with its peer Airbus changes the credit terms by even a small amount, it could mean a significant loss for airline firms.
• For airline manufacturers (suppliers), airline companies are the only source of income, and thus having a cordial relationship is extremely important.
• Overall, medium to low bargaining power of suppliers.

3. Threat of New Entrants

• Airlines industry is highly regulated, and any new player – even with deep pockets – cannot enter at will.

• Switching costs for customers, however, is low and thus a new player can gain market share by keeping costs and thus prices lower than competitors (though this is extremely difficult to do).
• Overall, low threat of new entrants.

4. Threat of Substitutes

• No real substitutes given the time saving benefit airline travel provides. But, for short distances, train and bus travel are substitutes.
• For long distances, often airlines are cheaper or at par with other modes.
• Airlines surpass all other forms of transportation when it comes to cost, convenience, and sometimes service.
• Overall, low threat from substitutes.

5. Rivalry among Existing Players

• Rivalry is intense in the airline industry, despite limited number of players.
• Fixed costs are extremely high in this industry, and thus airlines compete hard for customers to at least meet these costs.
• High fixed costs also makes exit from the industry extremely difficult
• While some players in India like Indigo have maintained market leadership, the overall market remains almost equally distributed largely because switching costs are low.
• Overall competitive rivalry is high and thus creates a threat.

As we see from the above analysis, the strongest forces in the airline industry is the rivalry or competition among existing firms and some power that suppliers have. The rivalry of existing players is high and this restricts new players. Plus, capital requirements are huge and constant.

In his 2007 letter to shareholders, Warren Buffett wrote that a durable competitive advantage in the airline industry “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 favor by shooting Orville down,” he joked. “The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit.”