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American Airlines Bankruptcy: Fear and the Airline Business

October 05, 2011 | About:
American Airlines' parent’s stock (AMR) has plunged rapidly, dropping more than 33% in a day on concerns that it might be headed for bankruptcy protection. A corporation once worth $13.6 billion in the beginning of 2007, now hovered around $660 million, a big net deep negative for investors who hold the airline stock for the long term.

American Airlines is the only major airline that has not filed for bankruptcy protection in the last decade. However, dated back in 2005, the bankruptcy was right near them when Delta Airlines and Northwest Airlines filed for bankruptcy in September of that year. Airlines and bankruptcy are best friends. They often go along with each other.

And according to the two of the most successful people, Warren Buffett and Richard Branson, owning airlines was the key to the financial disaster. Warren Buffett discussed this some years ago, that from the time of Wright brothers, the total return to airline investors is a negative net amount. In the letter to shareholders in 1996, he wrote: “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 favor by shooting Orville down.” Richard Branson, the owner of Virgin Airlines, has advised people how to become a millionaire: Just start as a billionaire and buy an airline.

The best times for airlines were when they were still regulated, decades ago. When the government dictated the fares and route competition, all airlines at that time grew fast and everybody was happy. However, when deregulation came around 30 years ago, tough competition between one another pushed all airlines down to the sink. Peter Drucker has pointed out three main structural weaknesses that industries have. They are either labor intensive, capital intensive or vulnerable to the cost and supply of key commodities. The airline industry has all of those weaknesses combined.

For any business, the simple equation is the profit derived from revenue after deducting all of its costs. For airlines, it is the business of filling seats. So it has a huge fixed cost standing in front of profitability, no matter how much the revenue. The majority of people would prefer to go on the airline with the cheapest cost, and they have many alternatives. Thus, airlines have to fight vigorously to win passengers by reducing airfares. That makes a lot of pressure on the top line. The margin gets squeeze by the pressure of reducing airfares without much ability to reduce costs. This is hardly the formula to business success.

History has proven, along with the testimonial of several successful people, an airline normally is not a business to own for the long term. It can be speculative play of a cyclical industry, as we look at American Airlines in 2003-2007, when its stock price had rose from $1.5 in 2003 to $40.5 in 2007, but the business itself does not seem sustainable.

About the author:

Anh Hoang
Money manager into global equities, especially with US and Vietnam markets. CFA level 3 candidate. Lecturer for Stalla - CFA course in Vietnam

Visit Anh Hoang's Website


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