Warren Buffett for years was an outspoken critic of airlines, going as far as to say that they were a “death trap” for investors. In 2016, he changed his tune with a position in Southwest Airlines. What happened? Epoch Analyst Nigel Frankson joins the show to discuss what has changed within the industry's competitive landscape. (February 21, 2020)
Warren Buffett for years was an outspoken critic of airlines, going as far as to say that they were a “death trap” for investors. In 2016, he changed his tune with a position in Southwest Airlines. What happened? Epoch Analyst Nigel Frankson joins the show to discuss what has changed within the industry's competitive landscape. (February 21, 2020)
Hello, and welcome to Actively Speaking. I'm your host, Steve b Weiberg. Join us each episode as we discuss current issues concerning capital markets and portfolio management from the perspective of an active manager. Hi, welcome back to another episode of Actively Speaking. Um, today we're gonna be talking about airlines, and my guest is Nigel Franken, who is an analyst here at Epic and part of the Capital Reinvestment team. Welcome Nigel.
Speaker 2:Thank you. Thanks for having me.
Speaker 1:Um, so the airline industry is kind of notorious as one that for a long, long time, uh, was, was not particularly profitable. And, and there's a famous interview that Warren Buffet did, uh, almost 20 years ago. This was in 2002. He was, he was with the Guard, I'm sorry, the Telegraph, uh, in London. And he said if a capitalist had been present at Kitty Hawk back in the early 19 hundreds, he should have shot OVO Wright. He would've saved his progeny money. But seriously, the airline business has been extraordinary. It has eaten up capital over the past century, like almost no other business, because people seem to keep coming back to it and putting fresh money in. You've got huge fixed costs, you've got strong labor unions, and you've got commodity pricing. That's not a great recipe for success. I have an 800 number now that have, that I call if I get the urge to buy an airline stock. I call two in the morning and I say, my name is Warren and I'm an aholic. And then they talk me down. Close quote. Uh, more recently though, Warren Buffet has, uh, made headlines a couple years ago because he took a stake in Southwest Airlines. So Nigel, what changed between 2002 and, uh, recent years, such that Warren Buffet, who was pretty darn skeptical of, of investing in airlines, uh, 20 years ago, is now an airline investor.
Speaker 2:It's important to look at the, uh, airline industry in two distinct periods. There is the pre-financial crisis and the post-financial crisis. Why while nine 11 essentially brought the industry down to its knees, the great financial crisis was really the tipping point that really changed the, the psychology, uh, throughout the management teams, and changed how these, uh, companies were run and in my opinion, permanently. So prior to the financial crisis, you had a more fragmented industry. The top four carriers accounted for about 63% of the, uh, of all traffic in the domestic market. You had an empire building psychology. The goal was going after market share by any means necessary. There were not returns or cash flow, uh, uh, focused. Uh, what changed with the great financial crisis were bankruptcies, uh, poor financial performances, plummeting stock prices, and something clearly had to change. Since the great financial crisis, we've, we've had several, uh, mergers that took place in the space as a result. When you look at the industry today, the top four carriers account for about 85% of domestic traffic versus 63% or so prior to the great financial crisis. Um, so noteworthy, uh, m and a transactions are Northwest Airlines with Delta. I think that was the, I mean, there were, there were mergers prior to that, but I think the Northwest delta, uh, combination in 2010, I believe it was, was really the trigger for this industry to really consolidate and for the, uh, the network carriers in particular to, um, get their act together. This evolution of the industry is really focused on the network carriers. That's your Delta Airlines, your United Airlines, and your American Airlines. These airlines have been around forever, and they're the ones that have changed the most dramatically, uh, over the last several decades. I would view Delta Airlines as the class of the network airlines. They were essentially the first to have a meaningful merger. They're the first to rationalize their fleet. They were the first two, uh, acquire discipline as far as capacity is concerned, uh, managing their balance sheet, uh, simple things such as bringing ancillaries and charging you for bags or changing your seat. They were the first amongst the network carriers to employ these various tactics that improved returns and improved margins.
Speaker 1:Okay. Okay. So, I mean, uh, well, first of all, so clearly consolidation, you're saying, has played a big role. Yes. In the, uh, sort of move towards profitability. Uh, I always like to point out that at one point in our history, we had, uh, airlines covering practically every point on the compass. We've had, uh, we used to have a, Northeast Airlines became part of Delta a long time ago. There was Eastern, there was Southeast, there was Southern, which also eventually ended up in, uh, actually in Delta. But the torch was path. Um, they actually became part of Republic, which then became part of Northwest, which then became part of Delta. Uh, we still have Southwest Airlines. We had a, Western Airlines became part of Delta. We had a Northwest Airlines, uh, that's part of Delta.
Speaker 2:So you're, you're referring to the, um, post 1978. So in 1978, the industry deregulated as a function of that, you saw a lot of competition and literally something like 24, uh, airlines were started between 1978 and 1985. Uh, mo most of the ones you're mentioning as well, I would say by the early two thousands, if not sooner, the, the, those 24 airlines ultimately compressed back down to two. Yeah. That, that proliferation of air of airlines really started in 1978 and then petered out probably by the nineties.
Speaker 1:Right. Um, so yeah, so consolidations played a, a role. You mentioned, um, you know, Delta, you know, charging for bags, stuff like that. It seems like that was also a significant change in the industry. There were things that used to be free, like food, uh, checking your bags, uh, that they were able to make fees stick for that. Uh, there was, I think, annoyance at first. You know, people were kind of annoyed that now they had to pay the check and bag, or they had to pay to buy food on the plane. Of course, nobody objects. Uh, when you get on an Amtrak train and they charge you for food, nobody expects to get free food. But simply because there was a time when they used to give you food for free and it changed, uh, there was resistance, but the point is it has stuck. And what role do those fees, like, uh, food baggage and also importantly the change fees, if you wanna make a change to a reservation, it can cost like$150. Uh, what role do those fees play in the profitability of these airlines today?
Speaker 2:Uh, they're quite significant, but I think it's important to, um, to highlight certain things about the industry before we get into the, the fee structures, because they're leveraged very differently depending on the airline and depending on the type of airline, there are, I would say, four different business models within the industry. Uh, it's easiest to highlight the differences between them by looking at the extremes. First, on one side, you have the network carriers, uh, network carriers leverage a hub and spoke network geared towards maximizing the destination, uh, number of destinations and frequency to those destinations. They have segmented cabins, they have heterogeneous fleets, if you will, different sized aircrafts that have different ranges to service different markets depending on where they are and how far they are and so forth. Uh, these airlines are mature business models. They're GDP growers, and, um, again, those are the American airlines of the world, United, the Deltas, et cetera. Historically, you buy one ticket and you pretty much get everything. You can check in as many bags as you want, you get an inflight meal. It's the standard airline experience that we, that most of us grew up with. On the other end of the spectrum, you have the ultra low cost carriers. They fly a homogenous fleet. So maybe the, uh, Boeing 7 37, for example, which is the Southwest airline, uh, aircraft type. Uh, they fly those exclusively. Uh, they have virtually no cabin segmentation. So there's no business class, no first class. Uh, it's a point to point network. It's geared towards leisure passengers, and they do some unbundling of pricing. In fact, the spirit airlines of the world will nickel and dime you for everything you can conceivably think of. Uh, these carriers tend to be smaller. They tend to be plus GDP growers. And then you have business models that are in between the ultra low cost carrier and the network carriers. And these in between business models leverage components of e of, of either side, depending on where along the spectrum they care to lies. So for example, Alaska Airlines, you could consider a low-cost network carrier. They probably look more like Delta than a Spirit Airlines. And then you have someone like a JetBlue, which is more of a low-cost carrier without the network, and they probably look more like spirit than like Delta. So these intermediate business models fall between somewhere in that spectrum. Uh, the low, the ultra low cost carrier business model kind of started in 2002, 2007, 2008, and really picked up being steam post-financial crisis. And it's this business model that started to, that was again, plus GDP growers taking market share and kind of forced the hand of the rest of the industry to more aggressively unbundle the, the price of the ticket that allows you to reach more travelers. It allows people to pay for exactly what they want. If you want to fly from New York to Disney World, for example, but for whatever reason, you don't want to carry any bags, you don't have to pay for any bags, it becomes a cheaper flight for you. It becomes more likely that you'll fly. Uh, so that ultra low cost carrier and the success that it's had over the last 10 years is what's, um, fostered this culture of price unbundling. So in as a competitive response to the ultra lowcost carriers and the Spirit Airlines of the world, the network carriers like the Deltas and Americans had to, in order to defend market share, had to start unbundling the ticket price. To some extent, they're nowhere near as unbundled as the ultra low-cost carriers, but they have given a little, uh, with, um, the comeuppance, for example, of the basic economy section of the airplane with charging for bags, with charging for change fees. That's why you're seeing that with the network carriers. As far as the profitability of these ancillary services, it can be shown that if the global airline industry produced about, and these are rough numbers, 20 billion in net income for 2019, 80 billion of that was ancillary fees. It's literally, well, more than, wait,
Speaker 1:Wait, you said 20 billion in profit? Yes, but 80 billion.
Speaker 2:Yes. So if you excluded all the change fees, all the baggage fees, all the ancillary add-ons and so forth, and most of these, uh, add-ons are pure profit features that you're charging for as a airline service provider, the industry would be negative by billions of
Speaker 1:Dollars. Oh, wow. Wow. I see<laugh>. Wow. That's where all the profits coming from. Yes. More than a hundred percent of the profits coming from
Speaker 2:Those fees. Yes. Now, that depends that that's different airline by airline. Yeah. That's less true for Delta. That's more so true for the spirits airlines and the, um, frontiers and so forth. But generally speaking, all the profitability and then some comes from ancillary fees.
Speaker 1:My goodness. Wow. So if they had not started doing that, they might still be unprofitable.
Speaker 2:Well, yes and yes and no. Look, if you're going to fly to, um, Disney World, for example, with the family, you're gonna have bags. So<laugh>, it's not fair to say that, you know, no one flies to Disney World without bags. Yeah. The value proposition is still underpinned, if you will, by the fact that you need to go from A to B. So I think this is just a clever way of segmenting the menu of services, if you will. But ultimately, you're really charging the customer to get from A to B. Right. And of course, they're going to want to print out their ticket. Of course, they're going to want to sit near a window or near the aisle and, and these things, you know, it is just a way of getting the most price sensitive person to fly with you and fill up the plane.
Speaker 1:Right. So actually, I guess it's more that if they weren't charging separately for these fees, just the base fair would be higher, would you know? Yeah. You know, the, the popular stereotype is that, of course, it's the business class traveler where they, that it's very profitable. You know, it can cost, you know,$5,000 for a business class ticket, you know, to California or to Europe versus, you know, a few hundred for the coach ticket. Um, why, so why, uh, you know, you mentioned, for example, Southwest doesn't have a business class. Like why have they passed up that opportunity to, to charge more to some travelers? Uh, and, and first of all, is it true that, you know, like American, Delta, United, do they make a disproportionate share of their money from their business class
Speaker 2:Travelers? Well, it's absolutely true. And, and, and you touched on the reason why. It's, uh, it's the business model that these, uh, airlines are leveraging. The network carriers are geared towards the business traveler. That's why they have an hub and spoke network, because hub and spoke networks are more, uh, flexible and, um, provide, simply provide more options in terms of coverage and, uh, and and frequency to various destinations. They are catering to the business customer. So 70% of their revenue comes from 25 to 30% of their customers. And those are the folks sitting up front now that's clearly not true for the southwest of the world or the spirits of the world who simply don't have a first class or a business class. And they thusly are getting more of their, uh, revenue, quote unquote, from the ancillary services.
Speaker 1:So you were talking about the period when there are a lot of airlines started up, and, and I was looking at some of the, the smaller airlines that are around today, like Frontier, uh, spirits on country. Yeah. You know, the last time, really the last, uh, sort of the most, the newest of the sort of top 10 airlines in the US is JetBlue, which when it started flying in two thousands, that was 20 years ago. Um, so it seems like it ha has it become harder to start up an airline? And if so, why?
Speaker 2:So yes, I, I would say JetBlue is probably the newest airline to enter the market, but the current iteration of Spirit Airlines started in 2007 when Indico partners. Right, right. Uh, took them over. So, in my opinion, the 2000 post 2007 Spirit Airlines is a different airline than pre 2007, and thusly represents, uh, entrance into the market. Um, but to answer your question directly, yes, I think it is more difficult to, uh, start an airline today versus 20 years ago. Uh, the barriers to entry, uh, are, are significantly higher. And when I say barriers to entry, I mean, look, anyone can start a poorly run airline. Anyone can start an airline that fails. Uh, when I say barriers to entry, I mean meaningfully impacting the established players and gaining, uh, meaningful market share. I think the barriers to entry, they are higher simply because the market's more consolidated. Uh, the existing players have, uh, economies of scale. They have more lane density. They are better able to employ predatory pricing tactics that will drive, uh, fledgling competition out of the market. Uh, for example, um, their yield management system, their yield management systems today are far more signi, uh, uh, sophisticated than they were 20 years ago. They can look at how much they're pricing for every route for every time of day, and they know exactly when that new entrance is attempting to enter a market, let's say four o'clock flight from Cincinnati to Texas somewhere. Uh, and they can just, for that singular flight, uh, they can drive the price all the way down and take a loss on that route. But because they're so big and making so much money elsewhere, to be frank, it won't impact their financials. And that fledgling, fledgling airline will be no more so mm-hmm.<affirmative>, the only offset I can think to that is interest rates. Uh, interest rates are certainly lower today than they were 20 years ago. Airlines are capital intensive businesses. To the extent you're going to borrow millions of dollars to do something, I suppose it's probably easier today than 20 years ago. But every other, uh, factor, market force I can think of, uh, makes it harder today to start an airline. Mm-hmm.<affirmative>,
Speaker 1:Do you think we've seen the, the end of the consolidation or, or are there further mergers to
Speaker 2:Come? There probably are further mergers to come. If you listen to the conference calls, I would say Alaska Air sees itself as an acquirer. Um, JetBlue sees itself as an acquirer. Uh, there isn't much left to acquire. Right. But<laugh>, um, but they seem pretty focused on going it alone. Uh, Alaska Air, for example, recently purchased, uh, Virgin Air. Uh, Alaska Air, again is a Lowcost network carrier. It's one of those in between business models that ultimately looks more like a Delta than say, a Spirit Airlines. On the ultra lowcost carrier end of the spectrum, they're a West coast focused airline. They're think of them as a regional delta. Um, in a perfect world, I think they would like to see themselves as perhaps acquiring JetBlue and becoming bigger. Cuz JetBlue is more focused on the East coast. They're more focused on the West coast. So the, the two would make sense. So you're right, uh, there isn't a whole lot left to acquire, but I I think we may have one or two more mergers left to go.
Speaker 1:Okay. So, so it, it's interesting. So airlines are one of the few industries it seems that are kind of immune to, you know, disruption from, from the internet. I mean, Amazon is, uh, you know, I don't know, who knows? Maybe Amazon could start up an airline, but, uh, but yeah, I mean it's, um, it just seems like it's, you know, you do, the whole point of flying is to physically move people Yeah. From one place to another, which is kind of hard to, uh, to do in any other way unless somebody perfects the home. Star Trek. Uh,
Speaker 2:I would, I would say the biggest impact that the, the, the internet has had in the industry is probably just price discovery. I mean, yeah, 20 years ago you had to call a flight, um, a travel agent to, to book a flight and to perhaps pick the best flights for you. And I'm not entirely sure how much of the market, any individual flight attendant, uh, uh, travel agent could see. Um, today, everything's on your phone, on your computer screen. You can see every price for every airline, uh, going to the destination of your choice. And, uh, so that price discovery and transparency is a lot higher today. And that's probably put some downward pressure on, um, ticket prices.
Speaker 1:Yes. Yeah. Well, certainly I think in, you know, in inflation adjusted terms, flying is, uh, cheaper today than, than it was 30, 40 years ago. And, and of course, deregulation played a role in that as well, uh, back in the seventies. Let's talk about a, a shorter term threat to the industry, uh, coronavirus. Uh, but, uh, is this having an impact is clearly having an impact on flights in and out of China. The, I know that the volume of so many airlines have eliminated their flights for a while, uh, to and from China. But, um, you know, are you have, have any of the airlines started talking about this? So, you know, for, you know, recently Apple talked about the impact of, of the coronavirus on its supply chain. Uh, are you, are we seeing any early, uh, comments from airlines on, uh, what's happening to traffic as a result
Speaker 2:Of this? Not a lot. Um, it seems that, so first of all, this actually only applies to the network carriers. For the most part. They're the only, uh, carriers, uh, within the United States that connect to international destinations. Um, and then some sub segment of that is going to Asia and some smaller sub sub segment is going to China. So far it looks like it's going to be a low single digit headwind to revenue, um, to date. The longer this goes, the more of an impact it'll have, but it really, it's a low single digit impact to the, to, to business so far.
Speaker 1:Uh, well, I think that's what all the questions, uh, we have time for. So, uh, Nigel, thanks again for joining us.
Speaker 2:Thanks for having
Speaker 1:Me. And, uh, we'll talk to you again soon. Sounds
Speaker 2:Good.
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