Macro Wrap – How Do You Become a Millionaire? Make a Billion Dollars and then Buy an Airline

Even Warren Buffett, the perennial optimist, can hardly find anything positive to say about airlines.  Some of his thoughts on the industry over the years:

How do you become a millionaire? Make a billion dollars and then buy an airline .

 

If a capitalist had been present at Kitty Hawk back in the early 1900s, he should have shot Orville Wright. He would have saved his progeny money. But seriously, the airline business has been extraordinary. It has eaten up capital over the past century like almost no other business because people seem to keep coming back to it and putting fresh money in. You’ve got huge fixed costs, you’ve got strong labor unions and you’ve got commodity pricing. That is not a great recipe for success. I have an 800 (free call) number now that I call if I get the urge to buy an airline stock. I call at two in the morning and I say: ‘My name is Warren and I’m an aeroholic.’ And then they talk me down.

Buffett had a bad experience with an investment in U.S. Airways that he made in 1989, and has been adamantly opposed to investing in the industry ever since.

Over the past 2 years, airlines have actually been one of the strongest performing sectors in the U.S.  Buffett would argue that it’s another bout of misplaced optimism, though airline investors counter that the industry’s structural dynamics (after a bout of consolidation in the past 5 years) are significantly improved.  The weekly chart over the last decade shows that the sector has not been such a dismal performer despite its terrible reputation:

Weekly chart of XAL, the NYSE Airline Index, Courtesy of Bloomberg

Weekly chart of XAL, the NYSE Airline Index, Courtesy of Bloomberg

But this year’s huge rally (XAL was up nearly 40% as of the end of July) has encountered aggressive selling in the past 2 weeks.  Yesterday’s downdraft was caused by the DoJ’s decision to oppose the AMR / LCC merger on antitrust grounds.

The rally in the airlines sector has clearly not coincided with increased customer satisfaction.  In fact, the airlines’ success has been in part due to policies that have made the flying experience even more frustrating for travelers (most notably, all the incremental charges).  However, these policies have bolstered earnings.  A major reason they have stuck is due to the consolidation that has reduced the competition in the industry, after Continental and Northwest were gobbled up by United and Delta respectively.

The DoJ, in its complaint, pointed out that executives at US Airways have admitted as much in prior statements, as the WSJ noted yesterday:

In a suit filed Tuesday, the Justice Department said the combined company would reduce competition in local markets and result in higher airfares. The government’s complaint attempts to use the words of US Airways executives against them in making the case that the merger would be bad for consumers.

According to the suit, U.S. Airways President Scott Kirby in 2011 said three separate price increases were put in place “because of consolidation.” At a 2012 industry conference, Kirby said consolidation “allowed the industry to do things like ancillary revenues… That is a structural permanent change to the industry and one that’s impossible to overstate the benefit from it.” Parker has also stated that “fewer airlines” is a “good thing,” according to the complaint.

Those comments are reasons the Justice Department is skeptical about another merger in the industry, which has already seen big tie-ups such as Delta Air Lines and United Continental Holdings Inc.UAL -7.47% take place in recent years, according to the suit.

“In essence, industry consolidation has left fewer, more-similar airlines, making it easier for the remaining airlines to raise prices, impose new or higher baggage and other ancillary fees, and reduce capacity and service,” the complaint says. “This merger positions US Airways’ management to continue the trend—at the expense of consumers.”

US Airways and American are perhaps a bit unlucky that their merger proposal comes after two other large tie-ups.  So the DoJ is in less of an accommodating mood.  But consumers will feel no pity, as the obvious trend in the airline business is worse service for a higher price.  While executives at both airlines expressed confidence yesterday that the merger will still be approved after the courts hear the case, investors in the airlines stocks were less optimistic.  Given the industry backdrop and trends, I think the courts could be difficult dance partners for the airlines as well.

Unfortunately, none of this drama is likely to mean that any of us will be excited to fly the not-so-friendly skies.  And that is a shame, whatever happens to investors.

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