Why Investors Should Give Airlines a Second Chance

From the late 1970s into the late 2000s, the airline industry performed abysmally, and investors across the board tended to stay away from airline stocks. But recently, Warren Buffett -- who had famously called the airlines a "death trap" -- invested some $10 billion in the industry, and many investors are starting to take a second look at airlines.

In this segment from Industry Focus, analyst Sarah Priestley and Motley Fool contributor Adam Levine-Weinberg explain the history of the airline industry, how it looks today, how it went from a "death trap" to what looks to be a new turnaround period, and what investors need to know about the industry.

A full transcript follows the video.

This video was recorded on Sept. 14, 2017.

Sarah Priestley: Today, we're going to be talking about the U.S. airline industry, as we primed for last week. The industry has had a pretty bad reputation and has been avoided for decades by investors. Looking through the numbers, it's clear to see why. The sector suffered combined losses of $52 billion between 1977 and 2009. Warren Buffett even went so far as to call the industry a death trap in 2013, famously, or now infamously, after his change of tune. However, we argue that the industry today is not what it once was, and may, in fact, deserve a second look by a lot of investors. This is a huge topic, and I briefly want to offer some background. I believe the history of the airline industry is pretty fascinating.

Adam Levine-Weinberg: It certainly is.

Priestley: It looks a lot different now than it has in the last 30 years. A lot of M&A, some successful, some not so successful, a lot of deregulation in the 1970s really ushered in a new era of competition and cheap transatlantic travel offered by British airlines, pressured the U.S. companies to lower prices. So, you had a lot of new carriers entering the market, opening new routes, and dropping fares. Unsurprisingly, this forced a lot of carriers to fold, or succumb to takeovers, which is why you have the environment that you do, that was created. At the end of this, and after the recent U.S. Airlines and American (AAL -2.18%) merger, the top four major U.S. airlines left standing are American, Delta (DAL -2.62%), U.S. and Southwest (LUV -0.54%). The top four have gone from a combined market share of 68% in 1990 to around 85% now. So, Adam, traditionally, as we've said, the airline industry has not been interesting to a lot of investors. So if someone wanted to take a fresh look at airline stocks, what industry basics should they be aware of?

Levine-Weinberg: As you just mentioned, the top four airlines now, American, Delta, United (UAL -2.52%), and Southwest combined, have about 85% of the U.S. market. And that figure varies depending on how you measure it. But the point is, they are much bigger than the rest of the competition. Behind them, you have Alaska Airlines and JetBlue, which each have about 5% of the market, and then the rest is pretty small carriers. You have some interesting ones like Spirit Airlines and Frontier Airlines that are these really deep discounters, everything is a la carte, you pay for a seat in the plane and if you want extra legroom, you pay for that. If you want to drink, you pay for that. If you want to bring a bag, even just a carry-on bag, that costs more, as well. You have a bunch of different business models, but the four top airlines in the country really do dominate the market right now. So that has made it a little bit easier for them to earn money. Of the four, historically, Southwest Airlines has been consistently profitable, and the other three, which are the larger carriers, big international networks, and they also are the ones which serve smaller communities in the United States, as well. They have historically been death traps for investors, as Warren Buffett said. But the interesting thing is, Warren Buffett, through Berkshire Hathaway, now owns nearly 10% of all four of those top airlines.

Priestley: Yeah, he invested $10 billion, right?

Levine-Weinberg: He put a lot of money into the industry. We'll take a look today about why it is that he did that. In terms of the investment highlights, on the cost side, the two things to be aware of are labor costs and fuel costs, which represent the bulk of airlines' cost structures. If we were doing the show four years ago, I would say that fuel costs are, by far, the most important, but with the way that oil prices have come down in the last several years, especially since 2014, that's changed. It used to be that most Airlines were spending between 30%-40% of their revenue on fuel.

Priestley: That's a huge amount.

Levine-Weinberg: Yeah. Now it's generally in the 15%-20% range for most of these carriers. So it's definitely an important cost factor. But when fuel costs go up by 10%, it's no longer the sort of thing that takes an airline from being profitable to losing billions of dollars.

Priestley: Yeah. I think we should also comment that labor costs have been increasing. I think it was 7% year over year last year, and they've been able to absorb that cost because of the oil price fluctuations.

Levine-Weinberg: Yeah. That's true. Some of the savings in fuel costs has been offset in increases in labor costs, and you see that particularly on the pilot side. For a lot of these airlines, the pilots alone could be 15% of the labor force, maybe 20% at most, but they're making 40% of the payroll, or close to that.

Priestley: Which I'm OK with.

Levine-Weinberg: Yeah, you want your pilots to be making enough money that they're happy and well rested and content and going to fly the plane well. But it does mean that they have a lot of bargaining power, so you've seen pretty substantial wage increases for pilots, to the point where the wage rates for the captains with experience flying overseas routes, the wage rate is over $300 an hour at most of these carriers today, which is a lot higher than it was just five years ago.

Priestley: It sounds incredibly high. When you consider the fact that there's not that many people available, that's the reason that the talent is constricted. And also, it's not the pleasant job that I think a lot of people think it is. It's a lot of traveling, it's a lot of being away from your family. So yes, that's playing a huge role.