This past January marked the 100th anniversary of the first scheduled commercial flight, which originated in St. Petersburg, Fla., and spanned Tampa Bay. For investors, the past century has been a very bumpy ride. Warren Buffett in particular has been a veritable trove of quotes criticizing airlines and those who had the poor judgment to put money into them. "If a capitalist had been present at Kitty Hawk back in the early 1900s, he should have shot Orville Wright," the Sage of Omaha once joked.
The problem was that the large commercial airlines' business model was faulty. They made their money from the business class traveler and from those who bought their tickets at the last moment, paying full price. Economy passengers at best provided low margins and were often loss-making for the airlines. They are highly price sensitive, and attempts to raise prices always led to a decline in passenger payload. While oil prices are three times higher than they were around 1980 in nominal dollars, economy class tickets often cost about the same.
Unworkable Model
Price wars were a common feature of airline travel, a situation that was exacerbated by the fact that discount carriers could be started by leasing a few aircraft and picking a few busy routes. Established airlines in most cases could see discounters off—with the exceptions of JetBlue and Southwest—but not without undermining their own margins. On potentially lucrative international routes, private U.S. airlines competed with national flag carriers, which, even if they weren't subsidized directly, managed to skew competition in their favor in other ways.
Meanwhile, pilots and flight attendants were unionized, with rigid work rules and generous salaries, benefits and pensions. Finally, schedules meant that airlines had to run planes daily, regardless of how many passengers they had. Some routes were consistently profitable, but in order to maintain profitability, carriers had to run feeder flights on routes that weren't.
Finally, a number of events of the past 15 years pushed many airlines into bankruptcy and the entire industry appeared to be on the brink of extinction. In particular, relentlessly rising fuel prices jacked up costs and the terrorist attacks of Sept. 11, 2001 led to expenditures related to providing security and screening passengers and their luggage.
By 2012, many analysts expected further deterioration of most airlines' financial position. The Guggenheim Airline ETF was wound down in May 2013, after many airline shares hit rock bottom.
Change in Fortunes
And then, suddenly, a turnaround. Shares of Delta Airlines (DAL) have gone up 2.5 times since the start of 2013. Stock analysts who follow the airline have unanimous buy or overweight recommendations on the stock—something that is rare these days on Wall Street, where valuations have become rich.
Delta has been an outperformer, but other U.S. airlines have posted similar results. The shares of merged American Airlines and US Airways (AAL) started trading in early December and their price is already up by two-thirds. The broad Dow Jones U.S. Airlines Total Stock Market Index (DWCAIR) has performed spectacularly over the past 15 months, tripling in value.
Of course, there have been cyclical factors pushing up both traffic and fares, as the U.S. economic recovery gathers steam. But there are strong fundamentals as well, which extend beyond the cost-cutting efforts and the reduction in labor costs that are common across the U.S. corporate sector. The airline industry has gone through substantial consolidation, with mergers reducing the number of competing players and creating economies of scale for survivors.
Meanwhile, several important factors have made it very difficult to set up a low-cost carrier from scratch.
Social trends are playing into airlines' favor. Only recently, analysts have been predicting that videoconferencing would make business travel unnecessary, undermining an important source of revenues and profits. This has not happened. On the contrary, technology allowed business operations to become more spread out geographically, necessitating more site travel by managers. This has been also reflected in the spread of hotel chains throughout the country.
Plus, the upper middle class in the U.S. has been doing extremely well. Its members' travel habits are prompting the airlines to expand their first and business class sections and improve services. They have also been able to charge higher fares to their upmarket passengers.
However, what turned the airlines' business model around is the new logistics. Gone are the days when you could spread out onto an empty seat next to you or take a nap lying down in the middle seats of a wide-body aircraft. Flights are now typically full because airlines can deploy capacity more efficiently, adjusting the size of equipment to accommodate the passenger load, whereas selling tickets through the Internet not only removes the middleman but also provides added flexibility in capacity management.
With economy class travelers still extremely cost-conscious, raising run-of-the-mill fares has been difficult. Filling planes efficiently, therefore, has been key to boosting Passenger Revenue per Available Seat Mile (PRASM), a comprehensive statistic of airline efficiency.
International Boom
While in North America air travel is expected to be relatively flat, growing by around 2% a year, the International Air Transport Association (IATA) sees extremely strong expansion worldwide. Airlines ferried some 3.1 billion passengers last year, and by 2017 IATA expects this number to rise by nearly one-third. Looking over the longer term, experts expect airline traffic to more than double by 2032.
True, the bulk of the increase will take place in China and other emerging economies, and will be concentrated in Asia, Middle East, Latin America and Africa. Compared to the U.S. market, those regions are currently underserved both by the air travel infrastructure and scheduled flights.
The greatest winner among U.S. companies, according to analysts, will be Boeing (BA). The company expects airlines to purchase more than 35,000 new planes by 2032, with 60% of this number representing a net increase in the size of the existing global fleet. The market for commercial aircraft remains dominated by Boeing and Airbus, which means that the two companies will divvy up the bulk of the $4.8 trillion in sales the new planes represent.
But airlines, including U.S. airlines, also stand to benefit greatly from the coming growth in airline travel. Replacement of older planes will account for nearly 15,000 aircraft to be sold over the next decade and a half. Those planes will be on a different level technologically, offering more flexible exploitation and far greater fuel economy.
Moreover, growth in air traffic in emerging economies will come mainly thanks to the emergence of the new upper middle and wealthy classes. They will be doing more international travel and travel more to the U.S., mostly in business class. Most global airlines have been linked by alliances and joint ventures, with national carriers acting as feeders for one another.
The new generation of aircraft, meanwhile, will offer more comfort—as represented by the new Boeing 787, the Dreamliner. After ferrying passengers in uncomfortable, claustrophobic tubes for 50 years, airlines will now be able to provide the kind of luxury that has not seen since the days of the Boeing 314, the Yankee Clipper flying boat—or even the luxurious 36-hour crossings of the Atlantic on board dirigibles.
Even after a huge run-up in the prices of airline shares, investors remain apprehensive. Delta in particular, despite paying a modest dividend, trades at a P/E ratio of less than 3. While risks of a cyclical downturn or disruptive event still hold airline shares back, the underlying dynamics of the industry have improved dramatically. After a rough first century, commercial aviation may yet start to reward its long-suffering investors.
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