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Ong Kai Kiat
Ong Kai Kiat
Articles (11) 

It's Time for a Fresh Look at the Airline Industry

Airlines continue to outperform despite negative media reports

July 12, 2017 | About:

Do you remember the viral video where Dr. David Dao was forcefully removed from an overbooked United flight on April 10? This incident led furious passengers to call for a boycott of United Airlines and raised congressional concerns. By April 14, Time magazine noted there was $770 million worth of damage to the company when its stock price plunged from $71 to $69. Checking on United Continental Holdings Inc. (NYSE:UAL) three months down the road, it was surprising the parent company of the airline had soared 14.5% to $79.

Source: TradingView

With the benefit of hindsight, it is clear that although this shocking incident garnered worldwide attention and condemnation, it was a storm in a teacup. Despite pledges to review their policies on overbooking, United was once again in the news for such behavior on July 6. Instead of dragging a 69-year-old man from his seat, however, this time the company forced a toddler to give up his seat to another passenger. So why does this repeated occurrence not have more of an impact on United's stock price?

10 years of mergers resulted in little choice since 2010

If you want to boycott United Airlines, what can you do if you want to take a flight from Dulles to San Francisco? According to The Washington Post, you will have to pay $115 extra for Virgin Airlines (NASDAQ:VA). Are you willing to do that? Behind the controversy, it is clear United is the dominant airline for certain locations, including Houston and New Jersey. In fact, the Department of Justice had to act to prevent United from increasing its slots at Newark airport from 73% to 75%, creating an effective monopoly.

How did this sad state of affairs come to reality? Decades of profit-bleeding operations and bankruptcies in the once hyper-competitive airline industry has led to major consolidation since 2005.

Source: NPR (Chart from August 2013)

In October 2015, the five major airlines became four when U.S. Airways was formally absorbed into American Airlines (NASDAQ:AAL). In April 2017, CNN summed up the total impact of such mergers: 82% of all domestic flights are flown on these four remaining major airlines. For half of the popular flights, you can only choose one airline if you want to fly non-stop. The number of daily flights have also been reduced as airlines choose to fly bigger planes in order to save money.

Surging demand for airline travel

One powerful factor backing the growth of airlines is the growth in demand for airline transport globally. Rising consumer confidence has resulted in rising travel demand over the past five years as the economy has made steady progress since the global financial crisis.

Technological advances have made it more convenient for travelers to buy airline tickets and hotel rooms with online platforms like Agoda and Booking.com. Popular blogs by TripAdvisor and travel programs have encouraged an entire generation to travel and experience the world. The easy access of information on the internet facilitated this shift in demand globally and frequent flyer miles are becoming more popular among consumers.

Source: International Air Transport Association (IATA)

The surge in demand had a positive impact on airlines' revenue. For instance, Southwest Airlines (NYSE:LUV), which is one of Warren Buffett (Trades, Portfolio) 's holdings, reported six years of soaring revenue.

Source: GuruFocus

Southwest's revenue has soared by more than three times since its dip in 2010. This is partly due to the company's excellent customer service and happy employees who are willing to go the extra mile for customers.

Southwest recently spent $800 million on its digital platform, of which $300 million went into its technology operation and $500 million went into a new reservation system. This is happening in an age where people can buy practically anything including smart drugs online. Therefore, a digital presence is necessary to capture customer loyalty.

Low fuel prices

Fuel typically accounts for around one-third of the costs of airlines, and it is a major tailwind given oil prices have remained depressed for the past three years. Ever since oil prices plunged in mid-2014, there have been numerous predictions oil will return to $100 per barrel. Today, it is sitting at $45 per barrel and analysts expect the price to remain at this range in the near future.

For instance, Moody analysts predicted oil prices will remain in the $40 to $60 range until 2018. Oil price.com noted oil companies are now resigned to low prices and do not expect them to return to $100 per barrel. In fact, they are happy if prices stay around the $50 to $60 range.

Rising profitability

The combination of rising revenue and falling costs is a piece of good news for the airline industry. This results in increasing margins, which have increased over the past two years. Rising profitability will also help airlines to obtain business financing for future expansion.

Source: PwC

At this point, the question is whether such performance can be maintained for the foreseeable future. There are other cost drivers, including airport fees, labor costs and security costs, and headwinds like travel bans that airlines have to endure for sustained profitability.

The Buffett endorsement

With all these changes, it is clear less competition means airlines have more pricing power. And there is really nothing passengers can do about it. A one-hour flight between Chicago and Louisville is served by Delta (NYSE:DAL), American and United. A round trip costs between $195 to $240. While consumers can choose to drive, the 297-mile trip will take approximately 5 hours and cost around $55 in fuel.

If you are a doctor who is preparing for an urgent operation or an executive who is giving an important presentation, time is something you cannot afford. You can choose to cut costs by searching for affordable office spaces or removing unnecessary expenses, but traveling costs are not easily slashed.

Source: Berkshire Hathaway

Warren Buffett (Trades, Portfolio) jumped into the airline space with substantial holdings in three major airlines. His investments suggest these airlines have a substantial moat guarding against competition and the macroeconomic trends are favorable.

Since 1978, there have been over 100 bankruptcies filings among airlines in the U.S. Therefore, it is understandable that these stocks are typically avoided by investors. Regardless, it appears 2015 was a key turning point for the industry as consolidation resulted in only four major players amid greater demand for travel. It is time to put the past in the past and for investors to reconsider the airline industry.

Disclosure: No holdings in the stocks mentioned.

About the author:

Ong Kai Kiat
I am a freelance writer from Singapore who specialize in writing about finance and technology.

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