Why the Economics of the Airline Industry are Hopeless

By: Money_Morning

Martin Hutchinson writes: American Airlines (NYSE:AMR) filed for Chapter 11 bankruptcy Nov. 28, and the move reinforced once again what many have learned the hard way: The airline industry is an incredibly disappointing investment.

Previous airline flops like this prompted an old saying - possibly untrue - remarking that the airline industry has lost money since the Wright Brothers first flew.

They've also inspired tall tales of time-traveling bankers from the future having been seen at Kitty Hawk on Dec. 14, 1903 trying to shoot down Wilbur Wright and prevent the whole economic disaster from taking place.

Yet, investors keep putting money into these operations.

For anyone who hasn't yet learned to avoid airlines, let me give you this look into the industry's hopeless economics. You'll see there's no change of fortune ahead - and no confident signs of profitability for investors.

The Odd Economics of Transportation
The airline business has peculiar economics.

It is very high in fixed cost, both for initial operation and per flight, but the marginal cost of an additional passenger is almost zero. Pricing can be infinitely arcane, but service is very difficult to differentiate. Labor costs tend to be very sticky downwards - especially in unionized operations like AMR Corp.

This dismal economics is not unique. Two other industries have shared it: railroads and shipping.

With railroads, the initial railroad construction boom was when fortunes were made. This is largely because the revenue available from a sound railroad when completed was more than able to amortize the railroad bonds used to construct it.

But once the U.S. railroad network was substantially complete by 1890, shippers found they could play competing railroads against one another to hold down freight rates. In single-railroad "monopoly" areas, the Interstate Commerce Commission prevented the monopoly railroad from raising rates. With the marginal cost of shipping an additional passenger or additional ton of freight being so low, tariffs were forced down towards this marginal cost, preventing railroads from servicing their debt or providing an adequate return on their stock.

In each recession - 1893, 1907, 1920, and 1932 - a number of railroads went bankrupt, reducing their debt servicing costs. This further increased the strain on any railroads that had not defaulted.

By the 1930s the result was a general industry default and debt reorganization, which for many railroads was the third or fourth such event. The railroad industry failed to invest in necessary infrastructure improvement, so it was hopelessly unable to compete when trucks, buses, and airlines appeared.

Similar economics have ruled the shipping industry since 1973. Variable costs are low, so most of the time shipping rates are driven down to levels that fail to service shipping debt, let alone provide an adequate return for investors. Only occasionally, in times of capacity scarcity, do shipping rates rise sufficiently to provide a profit, at which point huge amounts of excess capacity are built in the world's state-subsidized shipyards.

Like its fellow transportation industries, airlines have now been forced into a vise of unprofitability.

The Unprofitable Airline Industry
The airline industry, like railroads, was once profitable during its rapid expansion period, which in the United States was before 1969 and in East Asia before 1997.

Now it's condemned to unattractive economics.

Only an occasional operator can make a profit by ignoring the rules and union contracts by which the oligopolists are bound. If the profitable operator grows, however, it loses its niche. Either it becomes subject to the same cost constraints as others, or the oligopolists free themselves from their cost constraints and drive down costs and tariffs, making everyone equally unprofitable.

Naturally, airlines seek ways out of their dilemma. Three commonly explored solutions include adding service, providing hidden rebates to favored customers, and getting government subsidies.

But there's little opportunity to add service. The general experience of flying is so universally unappealing that an airline competing on superior service is like a dentist competing on the basis of having a more comfortable chair.

Airlines' attempts at rebate offers have backfired. They've created a consumer determination to "game" the airlines to get the best deal. Not only has this eliminated profitability, but it has triggered a huge and justified resentment among other customers who paid a substantial premium for exactly equivalent service.

As for handouts, the airlines have already used this technique both directly, like the $15 billion subsidy after 9/11, and indirectly - playing the governments of the few aircraft suppliers against each other. Both manners have done little to improve airline companies' long-term financial positions.

It would probably make sense for airports to pay landing fees to airlines, rather than the other way around as is currently the case. After all, the airlines are bringing millions of captive customers to the airports' shopping centers and food courts. Those subsidies would be modest for hubs like New York and Boston, which airlines would need because of their commercial links, and much larger for places like Las Vegas, which without air travel would be a mere desert oasis.

However, that's not going to happen any time soon. So the airline industry is a lousy investment.

In fact, there's only one airline I see that could rise above the industry's substandard profitability: Singapore Airlines (PINK ADR: SINGY). Its routes derive from international agreements, so are relatively uncompetitive. It also has an exceptionally high proportion of long-haul business class travelers, and to attract them it offers a distinctly better flying experience than most of its competitors.

It's doubtful these advantages will last forever, but for now, investing in Singapore Airlines is like flying in 1965: a comfortable, potentially profitable experience.

Source :http://moneymorning.com/2011/12/08/why-the-economics-of-the-airline-industry-are-hopeless/

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