The premise of our investment is simple: The next few quarters are uncertain at best, but I believe that industry demand and earnings will be far higher over the next several years. The question, then, is whether certain individual businesses have the resilience to reap the benefits of that growth, and whether the offered price gives us an attractive return with room to be wrong. In both cases I believe the answer is yes. Most domestic airline equities suffered sharp price declines this summer due to a confluence of factors, and I believe this creates an attractive opportunity over a multi-year horizon. As always, the test remains our willingness to own these securities – partial ownership stakes in businesses – for the next five or 10 years. On that basis, I’m comfortable having a material portion of our capital invested in these companies.
Before going further a brief comment on the industry is required. (There is more background information in the Appendix.) The domestic airline industry has undergone a dramatic restructuring in the past 5-10 years and I think it will support a bright future. I’d had an interest in the sector for years, but a combination of inertia and an ingrained bias against airline investments had kept me from doing any meaningful research. When I finally did, beginning in the summer of 2016, a few features stood out:
Industry structure and financial strength – Competition remains tough in many individual markets, but consolidation has changed the overall pricing dynamic and created a level of profitability and stability that is unprecedented in the industry. Current operating margins are generally in the 10-20% range – a level that generates ample free cash flow – and I estimate that most airlines will generate significant profits even in a downturn. Balance sheets and cost structures are also far healthier and they will be able to withstand future cyclical downturns and exogenous shocks.
Fares and fees – It is far cheaper to fly in the U.S. today than it was a few decades ago but pricing is also far more rational. This is still a high-fixed and low-variable cost business, but consolidation has enabled the airlines to compete without destroying each other in the process. As a partial offset to lower inflation-adjusted fares and the recent capital spending, the airlines now generate material revenues and high-margin profits from non-ticket fees and loyalty/mileage programs tied to credit cards. Cyclicality has not been eliminated but it has been muted to a large degree.
Ultra-low-cost carriers (ULCCs) – Customers want low prices, and that simple fact dictates the entire business model. An airline taking a passenger from point to point is offering something close to a commodity, and price is by far the most important factor in the purchase decision. There is some customer loyalty for certain companies, and mileage programs can help, but these are not true brands that affect behavior on a large scale. A customer with his own money is likely to pick an airline that will save him $50, and the business with the lowest cost will often win in these circumstances. Low costs that are “reinvested” in lower prices can also create an enormous advantage over time. Airlines like Southwest and Ryanair are good examples of these concepts, and when I pulled my head out of the sand to look at what made them two of the world’s most successful businesses what I saw would be familiar to any analyst looking at Costco, Amazon, Nucor, or IKEA. A cost advantage is hard to establish and easy to lose, but if maintained it makes life miserable for the competition. In the U.S. market the ULCCs have a material and growing cost advantage that will enable years of future growth at attractive margins and returns on capital.
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