There's an old joke about the airline industry that goes like this:
Q: How do you make a small fortune in the airline business?
A: Start with a large fortune!
There's more than just a small grain of truth to that. Delta Air Lines (NYSE:DAL) is flirting with bankruptcy. United Airlines and US Airways are bankruptcy court regulars. More than one former titan, including Eastern Airlines, is extinct. Only a few U.S. airlines, notably Southwest Airlines (NYSE:LUV) and relative newcomer JetBlue (NASDAQ:JBLU), seem to have found the secret to consistent profitability.
What's the trouble? There's little if no moat protecting one airline from competition from another. There's little that distinguishes them; if you've ridden in one plane, you've basically ridden in them all. That really leaves only one way for an airline to attempt to stand out: by offering the lowest fares. Inevitably, though, when one company slashes fares, others follow suit, leaving no one with an advantage. Coupled with extremely high fixed costs -- planes are far from free -- and fuel costs that don't always behave, you've got quite a headwind. There's practically no surer way to waste capital than operating in commodity businesses like that.
At Motley Fool Inside Value, these are precisely the sort of companies we avoid. At our value investing newsletter, we favor companies that have brands people care about and, more importantly, pay premium prices for. We like and have recommended companies like Coca-Cola (NYSE:KO) and Anheuser-Busch (NYSE:BUD), both of which possess extremely valuable brands.
Like airlines, Coca-Cola and Anheuser-Busch have high fixed costs, but their respective brands help conquer that potential problem. Consumers actively seek out Coke and Bud Light, and are willing to pay premium prices to buy them. Even better, because consumers love their products, Coca-Cola and Anheuser-Busch can easily raise prices.
Brand differentiation -- giving customers a reason to seek out your product over your rival's -- is critical if a company hopes to avoid the commodity trap where only the lowest-cost provider survives. Airlines seem trapped in a permanent price war, but both Coke and Budweiser have established their brand loyalty, and with it, their spots in the Inside Value portfolio. (To read about these and other Inside Value picks, click here to take a free 30-day trial.)
JetBlue and Southwest are taking steps in the right direction. They don't use the onerous hub-and-spoke system older, conventional airlines use. JetBlue offers much-better-than-average amenities, and Southwest features humorous flight attendants and is the cost leader on the routes it serves.
Serving peanuts, soda, and astronomical costs
It's instructive for value investors to study airlines and other troublesome businesses, if only to know better how to avoid them. The biggest problem in the air travel business is the extremely high fixed costs. One airplane can cost upwards of $245 million, according to major manufacturer Boeing's (NYSE:BA) website. Also, regardless of how many people do or don't pack the plane, it needs fuel to fly. With oil hovering around $60 a barrel, a lot of money gets paid to airline fuel suppliers like BP (NYSE:BP). Add maintenance, grounds crews, flight attendants, pilots, baggage handlers, and various other costs that have to be paid regardless of the number of passengers, and the sky high fixed costs of running an airline become apparent very quickly.
Given those costs, having a large number of passengers is critical to success. Once an airline decides to fly a plane on a route, the costs are pretty well-known and established, regardless of the number of folks on the plane. Each additional passenger costs almost nothing -- essentially the price of a bag of peanuts and a soda, plus maybe a little overhead for extra fuel and the like. Because of this, in a competitive market, the prices for a given ticket can vary wildly. An airline needs to cover its fixed costs to stay in business, but as long as each passenger pays more than the additional costs associated with being on board the plane, the airline is better off with that passenger than without.
However, if an airline faces competition on a route -- and they usually do -- price wars quickly become the rule of the game. When newer low-cost airlines like JetBlue enter the mix, the picture turns especially ugly for the entrenched carriers.
The siren song
Given the nightmare scenario of trying to run a high-cost business in an extremely competitive environment, why would anyone consider investing in the first place? The answer, of course, is they see a way to profit. That same high fixed cost structure that makes profitability such an elusive goal makes profits very easy to grow, once those fixed costs are covered. Assume for the sake of discussion that it takes $20,000 in fixed costs, plus $30 a passenger, to fly a 180-passenger plane on a particular route. If the airline charges an average of $200 a seat for that route, the airline's gross profit for the flight looks like this:
|
Passengers | Flight costs | Flight revenue | Gross profit | Profit margin |
|---|---|---|---|---|
| 1 | $20,030 | $200 | -$19,830 | -9,915% |
| 10 | $20,300 | $2,000 | -$18,300 | -915% |
| 50 | $21,500 | $10,000 | -$11,500 | -115% |
| 100 | $23,000 | $20,000 | -$3,000 | -15% |
| 118 | $23,540 | $23,600 | $60 | 0.25% |
| 130 | $23,900 | $26,000 | $2,100 | 8.08% |
| 150 | $24,500 | $30,000 | $5,500 | 18.33% |
| 180 | $25,400 | $36,000 | $10,600 | 29.44% |
Once that 118th passenger pays for a seat, the rest is pure gravy. All but $30 of each additional fare falls straight through as gross profit. But, see, the problem again is that all airlines probably have charts similar to that for every route they serve, and they no doubt fiercely fight to reach that allegorical 118th passenger. The resulting price competition knocks down fares prices and margins at all the carriers, thereby making it tougher for any airline to profit.
The antidote
How do good companies avoid such a quagmire? By building and protecting powerful brands. Coca-Cola and Anheuser-Busch have set their brands apart from competitors through taste, image, and other branding-specific factors. That branding power acts as a moat, allowing both to lead their markets, in spite of being constantly pursued by lower-cost rivals.
Want to learn what other companies have sustainable brands that can help them thrive in the face of competition? Get a free 30-day trial to Inside Value by clicking here to find out. Subscribe now and you'll get a free copy of "Blue-Chip Report 2005." The report's subtitle says it all: "10 Monster Stocks for the Next Decade."
At the time of publication, Fool contributor and Inside Value team memberChuck Saletta had no financial stake in any companies mentioned in this article. The Motley Fool has adisclosure policy.
