The commercial airline industry was born on New Year’s Day 1914, when a single passenger paid for a 23-minute flight across Tampa Bay in Florida. One hundred years later, the industry is now global, but profitability remains on a knife edge. Are airlines simply too risky for the average investor?
Warren Buffett certainly thinks so. At the annual meeting of his Berkshire Hathaway company in 2013 the investment guru was pretty clear about his feelings. “Investors have poured their money into airlines for 100 years with terrible results,” Mr Buffett said. “It’s been a death trap for investors.”
So, perhaps unusually, airline investors have been well rewarded over the past few years. Shares in British Airways and Iberia owner International Consolidated Airlines Group (IAG) tripled in value between September 2012 and March 2014, with easyJet shares leapfrogging into the FTSE 100, gaining about 500pc between October 2011 and March this year. But things have now changed.
The market value of major airlines has been sliding since March, as the industry faces a number of headwinds. Shares in both easyJet and IAG are down by about a quarter, amid worries over future margins.
Making a profit in the airline industry is notoriously difficult. Sustaining profitability is even harder.
Figures compiled by International Air Transport Association (IATA), the industry’s trade body, demonstrate just how much is at stake if management makes even a slight misstep.
In 2013, the airline industry made a collective profit of $12.9bn (£7.8bn) on revenues of $708bn (£427bn), IATA calculated. That is a 1.8 per cent net profit margin. To put it another way, airlines made a profit on average of just $4.13 (£2.49) for each passenger they carry.
Last month, Air France-KLM issued a profit warning, blaming overcapacity on traffic to North America and Asia reducing air fares. It has since launched a five-year restructuring plan to drive down costs. Significantly for easyJet, part of this plan involves launching a new low-cost carrier as it increases its focus on short-haul markets.
Germany’s Lufthansa has also raised the idea of launching a low-cost airline, as it tries to deal with competition on long-haul routes from Middle Eastern carriers such as Etihad. It issued a profit warning in June that sent its shares falling 20pc in one day, blaming overcapacity on trans-Atlantic routes. In June, Air Lingus also warned that its annual profits could be a fifth lower than expected because of strike action.
The shooting down of MH17 over Ukraine and the mysterious loss of another Malaysian Airlines jet earlier this year added to the gloomy sentiment surrounding the industry.
Airlines had a further wobble earlier this month following a report that Russia was planning to restrict its airspace to European airlines in reaction to Western sanctions over Ukraine. This would results in long detours, with a consequent rise in costs that could wipe out delicate profit margins.
However, such a move would also hit Russian state-owned group Aeroflot hard, as the company receives about $300m (£181m) in fees each year from European airlines crossing Russian territory, so perhaps the fears are overdone.
In short, the industry is grappling with overcapacity, increased competition from new upstarts such as the Gulf airlines and a slowdown in passenger numbers, while some airlines are suffering their own unique problems.
Despite this backdrop, interim numbers from IAG, released on August 1, were pretty good. Operating profits in the second quarter beat City expectations, coming in at €380m (£303m) compared with a consensus view of about €355m (£283m). It also reiterated full-year guidance of an improvement in operating profit of €500m (£399m). This follows an improvement at its troubled Iberia operation which was losing €1.7m (£1.4m) a day a couple of years ago.
The most recent statement from easyJet, however, was disappointing. Management told investors the pre-tax profits in the year to September 30 would be between £545m and £570m – lower than the City had been expecting.
Positively for IAG, it also has an accident of geography acting in its favour. Many flag carriers have been suffering from competition from upstart Gulf airlines, but these companies are unable to compete on British Airways key trans-Atlantic routes.
However, it is clear that there are capacity issues on these routes. The Latin American economy, another important destination for British Airways, is also suffering from numerous problems that could keep demand low, including a sovereign debt default issue in Argentina.
For easyJet, the next few years could see an increase in rivals such as Norwegian grabbing market share – and the number of new carriers trying to eat its lunch could increase. There is also a resurgent Ryanair to deal with. In its favour, the company appears to have become adept at managing capacity.
Another risk is the fact that airlines and passengers are soft targets for taxes. Gouging airline passengers may provide short-term relief for governments with stretched budgets.
Aviation is a glamorous industry but don’t let the romance blind you. Airlines remain risky investments to own, despite impressive gains over the past few years.
Warren Buffett is an American business magnate, investor, and philanthropist. He is widely considered the most successful investor of the 20th century. Buffett is the chairman, CEO and largest shareholder of Berkshire Hathaway and consistently ranked among the world’s wealthiest people. He was ranked as the world’s wealthiest person in 2008 and as the3rd wealthiest person in 2011. In 2012, American magazine Time named Buffett one of the most influential people in the world.
Buffett is also a notable philanthropist, having pledged to give away 99% of his fortune to philanthropic causes, primarily via the Gates Foundation.
How much profit is generally made on other goods and services? Compared to airline tickets.
1. Washing machine. £25?
This website looks at the cost of a £200 washing machine, and suggests that a profit of up to £25 for the retailer, per machine, would not be unreasonable.
Profit margins for retail clothes are generally within a range of 4 – 13% according to industry analysts.
ie. on a £100 garment, the profit would be between £4 and £13.
3. Television set
Profit margins for retailers of TV sets are around 10 – 20%
ie. for a £200 TV set, the profit would be at least £20.
4. Restaurant bill
This American article suggests profit margins at restaurants can be between 1.5 – 6%. depending on the type or restaurant etc.
ie. on a £100 bill, the profit might be up to £6.
This suggests profit margins are about 4 – 7% or so.
ie. for a £50 haircut, there would be a profit of perhaps £3 or for a £100 salon session, a profit of £6.
6. Supermarkets and supermarket food
Profits of about 1 – 2%. Maybe 1.9% in 2010. Slightly higher for organic and gourmet foods, at about 3.5 – 6%.
ie. on a £100 shop, a profit (on regular items, not organic etc) a profit of about £2.
This American article from 2011 says:
” …. among the most profitable were jewellry, luggage, and leather goods stores, followed by clothing stores and specialty food stores. Interestingly, those product categories are typically popular during the gift-giving holidays. ….among the least profitable categories were stores selling office supplies, stationery and gifts ….had some of the lowest profit margins.”