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Jan102014

« A Walk Across the Last Five Business Cycles »

On Monday January 13, 2014 I am pleased to be joining two panels at the 93rd meeting of the Transportation Research Board in Washington, DC.  On one panel, Airline Consolidation: Impacts on Stakeholders and the Industry, I will be joined by my MIT colleague Mike Wittman to speak to a series of MIT white papers on small community air service.  The panel will be moderated by one of the industry’s good guys, Paul Aussendorf of the Government Accountability Office.

The other panel, Economic Deregulation of Airlines: A Promise Realized?, will have as its moderator another industry good guy in Robert Peterson of Boeing.  Some might say deregulation is a tired topic, but there are many critical lessons to learn from the past 35 years as we anticipate what’s ahead for investors and stakeholders in today’s industry.

ACROSS THE BUSINESS CYCLE

With shareholders now demanding profitability across the entire business cycle, I’ve analyzed the industry since deregulation across five distinct economic rounds.  It was interesting to look back on each of the five cycles and what insiders and observers said about the airline business. Consider Alfred Kahn, the so-called Father of Deregulation, who in 1977 admitted he did not know one plane from another.  “To me,” he said, “they are all just marginal costs with wings.”

Based on that over-arching simplification by the man in charge, the industry was being led down the marginal cost path all the while that a fully allocated cost approach should have been adopted.  Ah, hindsight. It was too late, but the story is a great one.  It’s got colorful characters like Marty Shugrue and Frank Lorenzo, smart guys like Michael E. Levine and Warren Buffet, and current wisdom from the guys now running the big airlines, including Jeff Smisek and Richard Anderson.

A hard look at the financial data shows that the industry actually made a few pennies on a pre-tax basis through the fourth quarter of 2001, the end of the third business cycle.   The average cost of fuel was then $0.62, down from $0.84 during the first business cycle.  On a cost per seat mile basis, labor costs were managed with a deft touch during the entire 35-year period, despite that fact that the average cost per employee grew roughly at the rate of inflation.  Average wage growth outpaced productivity growth.  And any financial or economic efficiencies were competed away in the form of low and lower fares.

Warren Buffet said it best:  “The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines.”

All told, the industry lost $36 billion on a pre-tax basis, or 1.2 cents on every dollar of revenue.  But that is changing.  Load factors are up over 14 points across the last two business cycles as capacity growth slows. The current cycle is producing an operating profit margin that is 1.2 points higher than that earned during the best performing cycle – and after 17 quarters, the macroeconomic indicators are starting to be true tailwinds.

I can’t overstate the effect of load factor and ancillary revenue on unit revenue.  In the current cycle, the increase in unit revenue actually outpaces the increase in the consumer price index – an achievement long overdue.  Yet despite what is described by one prominent analyst as a “Goldilocks economy,” margins remain below the targeted level.

The first four cycles were defined by cost cutting and sheer survival.  Given that there is little low hanging expense fruit remaining on many airline income statements, the current cycle is all about the revenue.  As it should be.

WHAT COMES NEXT?

Whereas the current cycle shows incredible promise for profits, without some technological breakthrough that allows us to fly faster and longer, where will we find the efficiencies on the expense side of the ledger? Spirit and Allegiant are prospering by carrying passengers that the network carriers cannot afford to carry.  So how much more can airfares rise before an Ultra Low Cost Carrier (ULCC) revolution breaks out in the US domestic market?  As we test the limits of price elasticity, cost creep is a reality in labor and non-labor unit costs. 

Near-term, all things point bullish on the airline sector.  However, we know that growth prospects are limited for the higher cost network carriers in the domestic market.  Internationally, the next logical step (or the only step remaining after joint ventures) is to allow cross-border mergers. Is that the answer? I think not, at least if I am a US carrier looking to buy something outright.  Removing barriers is a good thing, but I can’t see too many U.S. carriers buying a European alliance partner that operates at 21 cents a seat mile - a cost that likely goes higher before it goes lower.

With all going so well, why even bring this up?  Because we need to be thinking from the position of financial strength that has taken so long to reach.  I trembled a couple of weeks ago when a headline in the Washington Post read:  GDP Grows an Adjusted 4.1%.  With indifferent macroeconomic indicators in play during the first phase of this business cycle quickly becoming tailwinds today, one hopes that the lessons learned this decade stick.  The cost creep found in some areas of the income statement gives pause particularly if one believes, as I do, that the industry is approaching a passenger revenue inflection point.

Robust periods of past business cycles have led to some bad management decisions.  I hope the leaders of today’s airlines will not repeat them.

References (7)

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    A Walk Across the Last Five Business Cycles - Aviation Articles and Commentary - Swelblog / Swelbar on Airlines
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    A Walk Across the Last Five Business Cycles - Aviation Articles and Commentary - Swelblog / Swelbar on Airlines
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    A Walk Across the Last Five Business Cycles - Aviation Articles and Commentary - Swelblog / Swelbar on Airlines
  • Response
    A Walk Across the Last Five Business Cycles - Aviation Articles and Commentary - Swelblog / Swelbar on Airlines
  • Response
    A Walk Across the Last Five Business Cycles - Aviation Articles and Commentary - Swelblog / Swelbar on Airlines
  • Response
    A Walk Across the Last Five Business Cycles - Aviation Articles and Commentary - Swelblog / Swelbar on Airlines
  • Response
    A Walk Across the Last Five Business Cycles - Aviation Articles and Commentary - Swelblog / Swelbar on Airlines

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