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.

Why it’s too early to declare airlines investable

One quarter or even one year of good performance does not make a trend. Major airlines are posting very good returns on invested capital (a measure of business quality). Delta Air Lines, Inc. (NYSE:DAL) posted ROIC of 11% in 2012, whereas United Continental Holdings Inc (NYSE:UAL) stacked up 8%, and Southwest Airlines Co. (NYSE:LUV) managed 7%. These are some of the best numbers to have ever come from the industry. Major players also indicated that they would not increase their fleets until their returns on invested capital moved even higher. That could add to higher prices and better load factors.

The market isn’t completely in the hands of the biggest airlines, however. Smaller Spirit Airlines Incorporated (NASDAQ:SAVE), which is built on top of a Southwest Airlines Co. (NYSE:LUV) strategy of using a single style plane and cutting costs, is a growing threat to bigger names. Should smaller airlines add more and more capacity, the returns for the whole industry will dwindle. Spirit Airlines told analysts it would target capacity growth of 15-20% per year, picking off routes of competitors to drive growth.

The airline business is still extraordinarily competitive. Rivals can pop up overnight, adding new jets to tackle new routes, driving down returns. Southwest Airlines Co. (NYSE:LUV) said it would not add another jet to its fleet until it earned 15% on its invested capital. Unfortunately, another player may very well be happy to steal some of its routes if the opportunity for 12% returns exist. Remember, it was only a few years ago that airlines were willing to lose money to keep their planes in the skies.

Competition and coercion: two big risks

Sky-high returns on capital will undoubtedly draw the interest of two very different groups of people: potential competitors and unions. Even if a monopolistic environment allows for stronger pricing power, airlines still have to shield their profits from unionized workforces.

Delta Air Lines, Inc. (NYSE:DAL) has the lowest exposure, but rockstar names like Southwest Airlines Co. (NYSE:LUV) have a strong union participation rate. More than four-fifths of Southwest’s employees are members of a union. Should unions demand more from their employers, high returns on invested capital come back to earth. Given the turbulence in the airline industry, union bosses are certainly waiting for the next opportunity to grab their fair share.

It takes only one party, a union or an airline, to threaten the profitability of the entire airline sector. A bet on airlines is a bet against greed. History says a bet against greed is a bet that ends with investment losses. Buyer beware.

Jordan Wathen has no position in any stocks mentioned. The Motley Fool recommends Southwest Airlines. The Motley Fool owns shares of SPIRIT AIRLINES INC. (NASDAQ:SAVE).

The article Airline Profitability Isn’t a Trend Worthy of Your Investment originally appeared on Fool.com.

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