Following the Morningstar approach to evaluating a company's durable competitive advantage, the airline sector is arguably one of the worst industries within the business realm. Low barriers to entry and intense competition have benefited consumers immensely, pushing down inflation-adjusted yields (ticket prices) 2% per year during the last 71 years compared with a 4% annual increase in overall inflation, according to the Air Transportation Association. As a result, the industry has experienced an astonishing number of failures, and investors have been burned often. In fact, even value investor Warren Buffett denounced the airline industry in 1999, quipping:
"I like to think that if I'd been at Kitty Hawk in 1903 when Orville Wright took off, I would have been farsighted enough, and public-spirited enough--I owed this to future capitalists--to shoot him down. I mean, Karl Marx couldn't have done as much damage to capitalists as Orville did."
Despite this negativity--admittedly supported by the recent bankruptcies of industry behemoths US Airways (LCC), Delta (DAL), Northwest, and United (UAUA) --we note that there have been a few prolonged outperformance exceptions, both in invested capital and investor returns. In this report, we will explore this outperformance, investigate what would make the airline industry (mainly legacy carriers) more profitable, and highlight a few companies that could be considered for an investor's portfolio.
Surprising Outperformance for Some Players
The airline industry is an integral part of economic activity. Based on 2006 data, the Federal Aviation Administration calculated that commercial aviation, which includes airlines and manufacturers, annually contributes approximately 5.2% ($700 billion) to the United States' gross domestic product. Furthermore, in 2008, commercial airlines' operating revenues alone accounted for 1% of GDP ($156 billion) based on data from the Bureau of Transportation Statistics. Considering this sizeable economic impact, it is clear that the airline industry is essential, and we think that the potential for respectable profitability should exist.
However, given the plethora of airline bankruptcies since deregulation in 1978, one can see that airlines as a whole have experienced suboptimal performance from a market-return and a return-on-invested-capital basis. This is evident especially in the abysmal performance in the AMEX Airline Index (XAL), as a $100 investment in 1992--the index's inception--would be worth a paltry $60 as of this writing compared with $249 for the same investment in the S&P 500.
That said, we've compiled the list of airlines that have actually outperformed the S&P 500 Index since their inception, measured on an annualized total return basis, which is displayed below.
Each of these airlines is unique in its own right: Southwest (LUV) perfected the low-cost business model in the United States while Ryanair has done the same in Europe. SkyWest (SKYW) capitalized on lucrative regional carrier contracts, where the firm receives a cost-plus reimbursement from its legacy carrier partners for connecting passengers to their hubs. Gol (GOL) is akin to Southwest in Brazil with its low-cost model, but it also has benefited greatly from the massive economic expansion in South America (the Brazilian economy grew almost 2.5 times faster than the U.S. economy from 2006 through 2008 according to Central Intelligence Agency figures). Copa (CPA) and Lan (LFL) benefited both from the impressive growth in South America and operating efficient hub-and-spoke models in less competitive markets.
In addition to this equity outperformance--which is noteworthy considering the holding period for some of these firms includes the 2008 market collapse--we also compared the returns on invested capital delivered by these companies versus a handful of wide-moat firms within the Morningstar coverage universe.