One of the most important things you can do as an investor is understand the industry of any company you want to invest in. There are always great values available on companies in poorly performing industries -- for just that reason. Yet investors often look at the cheap valuations and declare these companies "too cheap not to buy." My favorite example of that is airline stocks.
True, there are above-average operators in the space: Southwest Airlines
I like to examine industries through the lens of Michael Porter's five-forces analysis. This framework judges an industry based on the bargaining power of its suppliers, the bargaining power of its customers, threat of entry, threat of substitute products, and the competition within the industry. I'm going to look at just two of these five for airlines; no further analysis will be needed.
Bargaining power of suppliers
The key suppliers to the industry are aircraft manufacturers, fuel suppliers, labor, and airports. When looking at these suppliers, you'll mostly find monopolies and duopolies. It does not take a deep analysis to understand that this is not good for the business.
1. Aircraft manufacturers: For the most part, airlines are buying from only two companies, Boeing
(NYSE: BA) and Airbus. Airlines do benefit when these companies have excess supply, perhaps because of an economic downturn. However, without much competition, these plane makers can keep prices artificially high.2. Labor: The majority of U.S. airline employees are unionized. The airlines that are not unionized are also affected because they are forced to give similar salaries and benefits to compete for employees with their unionized competitors.
3. Airports: Airports have regional monopolies over the gates in important commuter cities. There is virtually no excess gate availability, and if some came online it would be at a great premium.
4. Oil: Airlines are also hostage to the price of oil. While some have used hedging strategies to try to protect costs, most airlines have not had much success.
Industry competition
Pricing may be the biggest issue that airlines face in their battle with one another. Per flight, almost all of an airline's costs are considered fixed, and its planes need to be in the air whether they are filled with customers or not. Any seat that goes unused is a sunk cost with no revenue in return. So airlines will lower prices way below the average cost to fill excess seats.
All price information is so freely available today on the likes of priceline.com and Expedia, so customers are able to shop and compare these prices. As one airline reduces prices, it pressures the others to do the same. Further, airline customers face virtually no switching costs by choosing one airline over another. To put it simply, airlines don't really have much pricing power.
I tend to stay away from industries in which the companies have no pricing power and no bargaining power over the suppliers, which is why I am bearish on the airlines. For more analysis, watch the video below:
