Airline Stocks: Great Trades But Lousy Long-Term Investments

Airlines probably aren’t a great play for long-term investors, but there’s plenty of opportunity to book a short-term gain.

– Elliott Gue, Stocks on the Run

The news on Friday (Aug. 27^th) that the U.S. Department of Justice had cleared the final regulatory hurdle for the merger of UAL (NasdaqGS: UAUA) and Continental Airlines (NYSE: CAL) sent both stocks skyward by more than four percent. Investors love airline mergers because consolidation means less competition and less competition means fuller planes (a.k.a. higher “passenger load factors”), higher airfares, and more profits for the remaining players.

Curb Your Enthusiasm

There’s just one problem with investors’ euphoria over airline consolidation: it doesn’t last. The U.S. airline industry was deregulated in 1978 and, since then, barriers to entry are virtually nil. Anyone with the cash to buy a plane and hire a pilot can fly. Consolidation of existing players can reduce supply – temporarily – but, sure enough, when word gets out that the airline industry is making good profits, somebody somewhere will come up with the brilliant idea to start a new airline.

Since 1978 deregulation, more than 250 new airlines have started up in the U.S. Most go bankrupt but succeed in destroying profitability for the entire industry before they leave the scene. And what’s amazing is that new airline startups keep coming despite this history of bankruptcies, evidently convinced that they have found the secret to success that eluded all their predecessors that came before.

Richard Branson Should Know Better

One of the latest examples is Virgin America, which commenced U.S. operations in August 2007. Surprise, surprise, it’s losing money. What’s funny is that Virgin’s owner, Richard Branson, knows better but can’t help himself. Back in the 1990s he was asked how to become a millionaire, and he allegedly responded: “There’s really nothing to it.  Start as a billionaire and then buy an airline.”

Since airlines are incredibly capital-intensive with extremely high fixed costs, managers need to fill those planes anyway they can to generate revenue and recoup those high fixed costs. Every seat that goes unfilled is a revenue opportunity lost forever. During times of excess airline supply – either due to weaker demand or more competition — managers engage in ruinous price discounting to fill those seats!

Warren Buffett Should Have Known Better

The commodity nature, extreme cyclicality and high costs of running an airline have historically made it a horrible business to invest in. Warren Buffett found this out the hard way back in 1989 after he invested $358 million in 9.25% convertible preferred shares of U.S. Airways (NYSE: LCC) right before the industry entered a severe cyclical downturn.

In a 1994 talk at the University of North Carolina’s business school, some smart-ass student with an English accent asked him why he had invested in US Air (see the 30:50 mark on the video). Always leave it to a Brit to emphasize the shortcomings of an American icon. Buffett’s short answer was “temporary insanity.” He then gave his view of the airline business:

There’s no worse business of size that I can think of than the airline business. You’re selling a commodity product with no variable costs. Huge fixed costs. It’s a terrible business.

I have an 800 number now which I call if I ever get an urge to buy an airline stock. I say, ‘My name is Warren, I’m an air-aholic,’ and then they talk me down.

In his 1996 shareholder letter, Buffett went into further detail about his US Air mistake:

My analysis of USAir’s business was both superficial and wrong. I was so beguiled by the company’s long history of profitable operations, and by the protection that ownership of a senior security seemingly offered me, that I overlooked the crucial point:  USAir’s revenues would increasingly feel the effects of an unregulated, fiercely-competitive market whereas its cost structure was a holdover from the days when regulation protected profits. These costs, if left unchecked, portended disaster, however reassuring the airline’s past record might be. (If history supplied all of the answers, the Forbes 400 would consist of librarians.)

Immediately after we purchased our preferred stock, the imbalance between the company’s costs and revenues began to grow explosively. In the 1990-1994 period, USAir lost an aggregate of $2.4 billion, a performance that totally wiped out the book equity of its common stock.

US Air stock had lost 90% of its value by 1994. Don’t feel bad for Buffett, however. The airline industry entered a cyclical upswing soon afterwards and by 1997 the stock had skyrocketed ten-fold from under $7 to $73 and his investment actually made money! Of course, US Air later went bankrupt twice, but that’s the nature of the airline business. Up, down, up, down.

Airlines Are Not Long-Term Investments

Over the long term, airlines don’t make any money. As Robert Crandall, former CEO of American Airlines, said in 2005:

For a variety of reasons, including very intense competition, which limits any one carrier’s pricing power, the airline industry has consistently failed to earn adequate profits; cumulatively, the industry has lost money since its inception

Take a look at a long-term chart of an index of airline stocks:

Source: Bloomberg

Over the past 18 years, an investment in airline stocks has gone nowhere! Talk about the antithesis of a growth stock. Yet, share prices have been extremely volatile.

It just goes to show you that one should never “buy and hold” airline stocks. In contrast, trading airline stocks can be extremely profitable if you time the industry cycles right.  As CNBC’s Jim Cramer said earlier this year, “airlines have always been trading vehicles. They’ve never been investment vehicles.”

The Airline Industry is in a Strong Up Cycle

For traders only, now looks like a good time to buy airline stocks. The industry is in one of its up cycles and the consolidation of Continental and UAL will keep the good times going for a while. A July 29^th research report from JP Morgan forecasts “record prosperity” for the airline industry in 2010 and 2011, including “unprecedented” operating income and EBITDAR (earnings before interest, taxes, depreciation, amortization, and rent). Wow. Sounds like an uptrend worth participating in.

In fact, the Stocks on the Run trading service has recommended an airline stock to buy right now. According to Elliott and co-advisor Yiannis Mostrous:

The cycle is positive for the airlines right now because of strong fundamentals. The main upside catalyst is that air traffic is on the rise again, with business passengers leading the way. Airlines are a play on recovering corporate spending.

Which airline stock are Yiannis and Elliott recommending that you buy? With the industry in the middle of one of its huge up cycles, knowing which airline stock to buy now for maximum profits could be very valuable.

Check out Stocks on the Run today to find out. You can obtain a monthly subscription for only $5.