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Skybus and the wealth-destroying nature of the airline industry
By Vaughn Cordle, CFA / May 2007
New low-cost airlines are good for the consumer, and "creative destruction" is what capitalism is all
about. Skybus's low-cost and profit-maximizing strategy - based on the Ryan model - has attracted
capital because the projected returns will be significantly greater than that of a typical airline. Ryan is
the super low-cost and low-fare airline based in Ireland. It is also the most profitable and valuable
airline in the world. It changed the competitive game by focusing intensely on costs and exceptionally
low fares. Unlike traditional airlines, Ryan charges for everything, and it is the low price of seats that
attracts customers to all its other services. Passenger growth has averaged almost 30% a year for the
past decade, and its 18% margins(1) are triple that of Southwest, the most efficient U.S. airline.
Skybus may not be viable over the longer term because it is a very risky investment proposition. The
business plan raised capital because capital providers believe that a Ryan-type airline can work in the
U.S. Growth in super competitive, low-cost capacity will force high-cost airlines to reduce uneconomic
capacity. In fact, the five major U.S. network airlines have reduced domestic capacity 20% or more
since 2000 and will continue to scale back as the economy cools.
Existing airlines will not be able to compete against an airline with such low labor and unit costs,
which are the key drivers of profitability. Flight attendant pay is a low $9 an hour, plus commissions.
First-year employees receive the lowest pay, and new aircraft have a maintenance holiday while under
warranty. Skybus will change the market price for domestic fares and labor if it is successful. This will
put additional pressure on incumbent airlines that have older and more costly employees.
Fundamentals are exceptionally bad in the airline industry because airlines tend to grow capacity too
fast for their own [and collective] good. This is great for the consumer and society in general, but not
good for shareholders. What is perfectly rational for the individual airline [in terms of growth] is
perfectly irrational for the industry because it destroys economic value. The airline industry has not
been able to earn its cost of capital over a full business cycle.
The major network airlines will have to adapt to the hyper-competitive marketplace and reinvent
themselves if they are to survive the war of attrition. Most will not be able to adapt fast enough, which
will result in ever-shrinking operations. Most will not be able to improve their competitive position at
the same rate as financially fitter and more profitable foreign competitors, which is why merging is the
best option for many of our old, feeble network airlines.
In my view, the old-line airlines will constantly have to restructure if they are to stay in business.
Because of the amount of debt and low returns, combined with an old employee base that perceives it
is underpaid, most airlines do not have the earnings power to renew fleets and pay higher labor costs.
They will be squeezed by more profitable and better-quality foreign airlines, and faster-growing and
lower-cost domestic airlines.
Labor costs have been reduced by $12 billion since 9/11 and labor wants their concessions back.
Given our updated earnings forecast of about $3.5 billion for the top 11 major airlines this year, it is
easy to see that any significant increase in labor costs will wipe out the bulk of the industry’s
earnings. High fuel costs - the NYMEX forward curve has oil averaging $67 for the rest of the year -
and a slowing economy are not good news for airline investors.
The market will force uncompetitive airlines to change. If they don’t, they will continue to shrink and risk
bankruptcy. Most stay in business because various suppliers prop them up when times get tough and
restructuring wipes out old shareholders and creditors get pennies on the dollar. Creditors become
the new shareholders and the game starts anew.
Consumers want low-cost air travel, and they couldn't care less about who provides the service. As
long as capital is available to fund upstart airlines, there will always be a source of new and lower-cost
capacity. Unfortunately for airline labor, the life cycle of an airline is getting shorter over time and
compensation is moving ever downward.
Old airlines cannot compete against young and faster growing airlines because the latter have lower
costs, higher earnings, and the advantage of lower leverage. Higher growth results in lower relative
costs and this widens the competitive advantage over time. The older airlines have become less
competitive also because of demoralized employees and a worn-out asset base. Throw in the fact that
capital expenditures are less than depreciation and it becomes apparent that many of our big network
airlines are on an unsustainable flight path. A few years of positive earnings will not alter this course.
Allegiant, Skybus, and Virgin America are able to raise capital because their projected economics
are/will be significantly better than those of the major airlines. Their strengths are the majors'
weaknesses.
Bottom line: The potential payoff for investors in new airlines is sufficient for the risk because of the
potential for an successful public offering, even as the odds of being successful over the long run are
not so good. Why? Bad industry fundamentals, which are driven by low barriers to entry and an ever
greater supply of low-cost capital and aircraft capacity.
(1) As measured by passenger revenue minus passenger costs
By Vaughn Cordle, CFA / May 2007
New low-cost airlines are good for the consumer, and "creative destruction" is what capitalism is all
about. Skybus's low-cost and profit-maximizing strategy - based on the Ryan model - has attracted
capital because the projected returns will be significantly greater than that of a typical airline. Ryan is
the super low-cost and low-fare airline based in Ireland. It is also the most profitable and valuable
airline in the world. It changed the competitive game by focusing intensely on costs and exceptionally
low fares. Unlike traditional airlines, Ryan charges for everything, and it is the low price of seats that
attracts customers to all its other services. Passenger growth has averaged almost 30% a year for the
past decade, and its 18% margins(1) are triple that of Southwest, the most efficient U.S. airline.
Skybus may not be viable over the longer term because it is a very risky investment proposition. The
business plan raised capital because capital providers believe that a Ryan-type airline can work in the
U.S. Growth in super competitive, low-cost capacity will force high-cost airlines to reduce uneconomic
capacity. In fact, the five major U.S. network airlines have reduced domestic capacity 20% or more
since 2000 and will continue to scale back as the economy cools.
Existing airlines will not be able to compete against an airline with such low labor and unit costs,
which are the key drivers of profitability. Flight attendant pay is a low $9 an hour, plus commissions.
First-year employees receive the lowest pay, and new aircraft have a maintenance holiday while under
warranty. Skybus will change the market price for domestic fares and labor if it is successful. This will
put additional pressure on incumbent airlines that have older and more costly employees.
Fundamentals are exceptionally bad in the airline industry because airlines tend to grow capacity too
fast for their own [and collective] good. This is great for the consumer and society in general, but not
good for shareholders. What is perfectly rational for the individual airline [in terms of growth] is
perfectly irrational for the industry because it destroys economic value. The airline industry has not
been able to earn its cost of capital over a full business cycle.
The major network airlines will have to adapt to the hyper-competitive marketplace and reinvent
themselves if they are to survive the war of attrition. Most will not be able to adapt fast enough, which
will result in ever-shrinking operations. Most will not be able to improve their competitive position at
the same rate as financially fitter and more profitable foreign competitors, which is why merging is the
best option for many of our old, feeble network airlines.
In my view, the old-line airlines will constantly have to restructure if they are to stay in business.
Because of the amount of debt and low returns, combined with an old employee base that perceives it
is underpaid, most airlines do not have the earnings power to renew fleets and pay higher labor costs.
They will be squeezed by more profitable and better-quality foreign airlines, and faster-growing and
lower-cost domestic airlines.
Labor costs have been reduced by $12 billion since 9/11 and labor wants their concessions back.
Given our updated earnings forecast of about $3.5 billion for the top 11 major airlines this year, it is
easy to see that any significant increase in labor costs will wipe out the bulk of the industry’s
earnings. High fuel costs - the NYMEX forward curve has oil averaging $67 for the rest of the year -
and a slowing economy are not good news for airline investors.
The market will force uncompetitive airlines to change. If they don’t, they will continue to shrink and risk
bankruptcy. Most stay in business because various suppliers prop them up when times get tough and
restructuring wipes out old shareholders and creditors get pennies on the dollar. Creditors become
the new shareholders and the game starts anew.
Consumers want low-cost air travel, and they couldn't care less about who provides the service. As
long as capital is available to fund upstart airlines, there will always be a source of new and lower-cost
capacity. Unfortunately for airline labor, the life cycle of an airline is getting shorter over time and
compensation is moving ever downward.
Old airlines cannot compete against young and faster growing airlines because the latter have lower
costs, higher earnings, and the advantage of lower leverage. Higher growth results in lower relative
costs and this widens the competitive advantage over time. The older airlines have become less
competitive also because of demoralized employees and a worn-out asset base. Throw in the fact that
capital expenditures are less than depreciation and it becomes apparent that many of our big network
airlines are on an unsustainable flight path. A few years of positive earnings will not alter this course.
Allegiant, Skybus, and Virgin America are able to raise capital because their projected economics
are/will be significantly better than those of the major airlines. Their strengths are the majors'
weaknesses.
Bottom line: The potential payoff for investors in new airlines is sufficient for the risk because of the
potential for an successful public offering, even as the odds of being successful over the long run are
not so good. Why? Bad industry fundamentals, which are driven by low barriers to entry and an ever
greater supply of low-cost capital and aircraft capacity.
(1) As measured by passenger revenue minus passenger costs
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