The Airline Industry: How to Make Good Money From a Bad Business

[Editor's Note: Robert L. Crandall, the former president and chief executive of American Airlines Inc. operator AMR Corp. (NYSE: AMR), once described the airline industry as a "nasty, rotten business" - and even told an interviewer that "I'm an airline manager [but] I don't invest in airlines." Money Morning guest writer Kent Lucas believes there's a lot of money to be made in unattractive sectors ... and has a much more upbeat view of the airline industry's profit potential.]

After years of off-and-on conversation, UAL Corp.'s United Airlines (NASDAQ: UAUA) is getting into bed with Continental Airlines Inc. (NYSE: CAL) in a merger deal valued at $3.7 billion. The merged entity, keeping the "United" name, will be the largest airline in the world. It will have close to $30 billion in combined revenue, 700 aircraft, and service to 370 destinations in 59 countries, according to BusinessWeek. Early estimates predict savings to reach $1 billion to $1.2 billion annually.

Is a Merger Better Than Bankruptcy?

The deal makes a lot of sense, if only because the alternative was to lose more and more money. In an industry that is incredibly competitive, any means to reduce costs, take advantage of economies of scale, or improve productivity is desperately welcomed. (Mergers, in the airline industry, and in other, similarly struggling industries, often come down to one key reason - survival).

In case you forgot, let me remind you just how bad off these companies were - and still are (though hopefully to a lesser extent). The better-run airline, Continental, has declared bankruptcy twice, had to borrow money from the U.S. government, and has lost more than $1 billion since Sept. 11.

United has had an equally unimpressive past, with its own extended bankruptcy, ongoing (contract) tensions with labor, elimination of its huge pension plan, and many failed strategies and merger attempts.

Airline Mergers Historically Experience Turbulence

Will the merger be a success? If history is any guide, it won't be easy. Since the government deregulated the industry in the late 1970s, this is the 20th merger or acquisition by a major airline.

Only two of those have gone smoothly, while all the others faced serious headwinds in such areas as labor and union disputes, equipment (fleet) priorities, clashes of different corporate cultures, cost-cutting and customer service.

In a lot of areas, these two companies are like polar opposites, so I can only say "good luck" to the new combined management team. Skipping the details, let's just say Continental is the much better airline in many areas (including customer service, union relations, lost baggage and having a newer fleet, to name just a few). Getting United to adapt - or to perform at Continental's level (instead of the other way around) - will be a major challenge.

A Temporary Solution

Aside from the merger issues, the newly combined airline would still face the horrendous fundamentals of a crummy business. On the image side of things, airlines have had an illustrious past. Ever since the invention of the airplane, the industry has been one of the world's most eye-catching. The allure of flying and global air travel has always drawn capital to the industry: Finding money has never been the problem - making consistent profits has always been the challenge.

The industry is much better known for losing money than for making it. When trying to understand what's wrong with airlines, it's important to remember that the industry is:

  • Very capital-intensive.
  • Heavily dependent on economic cycles.
  • Faced with strong labor unions with a history of dubious labor relations.
  • Hamstrung by high fuel (oil) costs.
  • Selling what is essentially a commodity (airline seats).
  • A real bankruptcy risk.

This all adds up to create a pretty unattractive picture. Essentially, over the course of multiple economic cycles, these companies can't earn more than their costs to operate.

A common metric used in assessing the profitability of a company or industry is "return on invested capital," or ROIC. Imagine that you own a bank and that you pay depositors an interest rate of 7% on the money they give you. With that deposit money, you would go out and lend it to businesses looking to grow or to other consumers looking to buy a house or car, and they paid you 5% to borrow that money.

As you can see that's not a good business to be in. Your cost of doing business - in this case, acquiring capital - is 7%. But you are earning only 5% on what you are lending. That's the case with airlines in terms of "capital in" versus "profits out." It's tough to survive when your return on invested capital - the amount you earn on the business - is less than your cost to acquire that capital.

And, to be clear, the airline industry is not alone, as its industry characteristics are shared among several other notorious sectors. The same applies for other cyclical businesses with large fixed costs, including automobiles, capital goods, and certain machinery companies and commodity-based segments.

All of these industries operate in challenging environments, whether it's due to labor costs, large capital-investment requirements, or cyclical end-markets.

But You Can Make Money Here

David G. Neeleman, former CEO of JetBlue Airways Corp. (Nasdaq: JBLU), once said that "people who invest in aviation are the biggest suckers in the world." And he's not alone - there are several famous quotes about how bad the airline industry is. In his 2008 letter to shareholders, investing icon Warren Buffett even talked about the unattractiveness of the industry.

As investors, over many years, it is tough to make money holding onto these stocks. Given all the issues I mentioned above, these leaders are right - you can't sleep at night or put your stock in a coffee can when talking about the airline industry - either as a CEO of an airline or as a long-term investor.

But you can still make a lot of money trading these industries (taking a shorter-term view).

At certain points in the cycle, these stocks move, one way or the other, in large percentages compared to the overall market. As a contrarian investor, I want to buy these stocks before they come back into favor, in order to catch the next move - which is almost always a big move - usually in an economic up cycle.

Here is a chart showing the price performance of airline stocks relative to the Standard & Poor's 500 Index. The chart is for the past six months: Notice how much these stocks have moved (up from more than 50% to more than 230%) - in a broader market that's up 15%.

If you look at a similar long-term chart - say, 10 years or so - you'll notice many periods when these stocks really outperform (as they did during the period depicted by the preceding chart), as well as other periods where these stocks really underperform. In the latter situation, you can make money just as effectively by shorting these stocks - as profits turn to losses, as the economy heads into a downturn, or as the price of oil rises meaningfully.

Looking at another similar industry, the automotive industry, Ford Motor Co. (NYSE: F) is another great example of how to make money in a bad area of the market. Ford shares are up sevenfold since last March.

The lesson here is that you don't have to be afraid of terrible industries. Just think of moves of these types as six-to-12-month trades - as opposed to longer-term investments. It takes a lot of confidence, experience and nimbleness, but a bad industry can still deliver good (and sometimes great) returns.

[Editor's Note: The airline sector is just one area that Lucas Kent Lucas, the editor of the Taipan Safe Haven Investor and Taipan Daily, is targeting. Lucas is also introducing his readers to a perfect "coffee can" stock no one is talking about - a stock that that is chock-full of long-term growth potential and pays a nice dividend to boot. You can learn about this opportunity - plus four other hot stock picks - in this new exclusive report, "5 Hot Stocks for 2010." It's yours free. And as a bonus, we'll also make sure you receive Taipan Daily, the investment e-letter that's easily the most profitable five minutes of your day. All you have to do is sign up now.]

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