Flanking the Price War

Mohammed is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

It should be no surprise to anyone if it were said that the airline industry is a lousy business to be in. Airlines have been shedding money left and right. It seems that every couple of years one hears of another Airline filing for protection from creditors. American Airlines just filed for bankruptcy last year, Delta (NYSE: DAL) the world's largest airline by fleet size and number of passengers carried filed for chapter 11 in 2005 and reemerged in 2007, and US Airways (NYSE: UAL) went bankrupt twice in the past decade! In fact more than 30% of US airlines filed for chapter 11 bankruptcy in the past decade.

50-60 years ago, in the so called Golden Age of Air travel when people dressed up for international flights, most people probably wouldn't have expected Pan Am the largest US air carrier from its birth in 1927 to go belly up in the early 90s or for the evergreen airline industry to be in so much pain in the 21st century. 

The trouble for legacy airlines began with the Air Deregulation Act of 1978 which deregulated the airline industry. Before that the Civil Aeronautics Board, or CAB, regulated airlines as a public utility setting fares, routes, schedules, and market entry, and made sure airlines had an acceptable rate of return.

The removal of many barriers to entry resulted in the appearance of many leaner low-cost airlines that undercut the legacy airlines. One such company was Southwest Airlines (NYSE: LUV) led by Herb Kelleher which rode the deregulation wave to great success in the 80s and 90s. The company was featured in Peter Lynch's 1992 book 'Beating the Street' and was praised by the legendary mutual fund manager. 

Starting in the 80s, a price war ensued which hurt the legacy carriers due to their higher operating costs. The situation deteriorated further in the 2000s starting with the September 11th attacks and the rise in the price of oil throughout the decade. Imagine a situation in which your costs are increasing, and you are forced to reduce your prices due to competition. This is exactly what happened to the airline industry in the past decade, ticket prices during the decade decreased by 21% adjusted for inflation while jet fuel prices increased by an average 10% per year according to the ALPA, the largest airline pilot's union.

Warren Buffett who was recently a guest on the Charlie Rose program said about the airline industry:

"Well it happens when your selling something very much regarded as a commodity product; the incremental seat cost for an airline seat is nothing, so airlines have this temptation to fill in the last seat at any price and when you have 4 or 5 people trying to fill the last seat at any price you do not get very good prices, it is structurally set up so that is very difficult to have a sustainable competitive advantage. You have this very large investment in planes and now you are trying to fill in the seats and you're reading what your competitor is charging in the newspaper and you have to charge the same, it has terrible structural aspects to it..., and I bought into it! (Laughter)"

Interestingly enough, one of the most successful airlines gives almost all of its seats for the cost of fuel and taxes and gives a portion of its seats for free.

Ryan Air (NASDAQ: RYAAY) is an Irish airline with 8,500 employees and a fleet of 294 aircrafts, but has a larger market cap than Delta which has 76,000 Employees and a fleet of more than 700 aircraft.

The company's business model is closer to that of a retailer than an airline. It is commonly referred to as 'Wal-Mart with Wings'. It doesn't want to make money on the seats, It wants as many passengers as possible to fly on its planes and then make money by selling them everything else. Passengers pay very low fares but are charged extra for checked luggage, snacks, and bus or train transportation from the far-flung from town airports that the airline uses. The staff also sells a variety of merchandise on the planes such as MP3s and cameras, it offers online gambling on its website which is visited by over a 500 million people per year and is planning to introduce in-flight gambling, and the interior and exterior of the plane carry revenue producing ads.

The company also benefits from operating in Europe which has been better for airlines overall in spite of European deregulation. The continent has some features which make it more attractive for airlines such as higher cost for land travel due to taxes on gasoline, closer proximity to most of the world's population, a high number of incoming tourists with touristic destinations scattered all over the place, and longer days off from work with vacation time there almost being viewed as a civil right.

Flying is commonly referred to as the cheapest way to get around the continent (with Ryan Air helping in forming that perception) and while the US takes the top spot in tourist spend, the world's number one country in terms of number of incoming tourists is France with 76 million international visitors each year, 50% higher than the U.S

Things have been going well for Ryan Air. Revenue and Earnings have risen by 47% and 86% respectively over the past 3 years. Net Margins for the previous fiscal year are at 12% for Ryan Air compared to 2.7% for Delta, 0.6% for US Airways, 1.2% for Southwest, and a meager 0.5% for the entire global airline Industry according to IATA. This goes to show you that truly innovative companies can overcome the structural difficulties within their industry and beat the competition.

Pirlo0o has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Southwest Airlines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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