Delta Air Lines, Inc. (DAL), Southwest Airlines Co. (LUV): Airline Profitability Isn’t a Trend Worthy of Your Investment

Once the pariah of Wall Street, airline stocks are among the top performers in 2013. A combination of higher fares, lower competition, and improved load factors (percentage of seats filled) is behind rising profitability.

But can the good times continue on forever?

A historical anomaly

History is full of examples of poorly performing airline operations. Airlines are cited as one of the few industries where the cumulative historical profits are negative. That’s right. The sum of all income statements in airline companies results in a negative number.

If it weren’t for robust postal subsidies in the mid 20th century, the money pit of airline stocks would be even deeper.

Only recently have airline profits turned positive. Consolidation leaves the industry with only four major players controlling 85% of commercial flights. This gives existing operators pricing power at a time when capacity is lower than the historical average. Airlines reported the best load factor data since 1945, filling 82.3% of all seats in 2012.

Load factor is the single most important metric in the airline business. There are minimal – almost zero – additional costs for a jet that is 100% full compared to a jet that leaves only 60% full. Thus, a 1% change in load factor can result in proportionally larger changes in net income. Load factor is behind the recent surge in airline profitability and rising airline stocks.

Airline bears lay the case

Warren Buffett is a frequent critic of airlines. He cites cyclicality, competitiveness, and capital-intensity for the reasons he’s a long term bear. Airlines enjoy almost no customer loyalty, have few advantages over other competitors, and have fleets that look awfully similar, as all airlines fly the same planes and recruit pilots from the same schools and air force.

The economics of the business leave incentives for rivals to make decisions that erase profits. Executives, seeing the opportunity to grow market share, slash ticket prices. Incentives exist to fill the few remaining seats of a passenger jet at lower prices, increasing price competition on all flights.

Warren Buffett sees the cost structure (very high fixed costs, and almost no variable costs) as the reason why airlines have no history of profits. When capacity runs too high for one firm, it slashes costs, driving down profits for all airlines.