Why Are Airlines So Unprofitable?

08.13.21

In 2008, Warren Buffet famously skewered the airlines industry as a “bottomless pit” for capital in his letter to Berkshire Hathaway investors. “The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines,” wrote Buffet. He added: “If a far-sighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.” (Ultimately, Buffet ignored his own advice and has since reversed his stance on airlines several times).

Why are airlines perennially troubled? Few industries can claim sixty years of increasing demand and falling unit costs, yet still fail to post a profit, let alone cover the cost of capital. Despite decades of deregulation, the US airlines industry’s troubles began long before COVID, and today it has shrunk to an oligopoly of carriers — United, Delta, American, and Southwest — which control nearly 80% of the market.

Some, citing the dismal state of the industry, believe greater government regulation is called for. “The most central question is whether airlines are really for-profit commercial businesses any longer,” wrote Matthew Andersson, an industry veteran and president of Indigo Aerospace, in The Guardian. “The time may have finally arrived where air travel is seen for what it really is: a basic commodity and public utility, no different than an underground or commuter train, with standardized scheduling and comfortable seating, and low, everyday flat fares.”

Would airlines really be better off as wards of the state, left to stagger onwards like Amtrak? Many forget that fifty years ago the airlines were heavily regulated, and consumers, while happier, were few and far between. This week, as the airlines await $25 billion in fresh funding from the infrastructure bill, we examine the pros and cons of deregulation, and how it’s shaped our collective air travel experience today.

The Movement Towards Deregulation

Like many nascent industries, the airlines industry once enjoyed a cozy relationship with the federal government that shielded it from competition, external shocks, and financial accountability. As late as the 1970s, airlines were controlled by the Civil Aeronautics Board (CAB), a government agency which “approved routes and set fares that guaranteed airlines a 12 percent return on flights that were 55 percent full.”

This generous arrangement allowed airlines to model themselves after luxurious ocean liners, providing customers with full-course dining options (complete with white tablecloths, silver carafes, and fine china!), hostesses that spoke two, if not three languages, and an in-flight atmosphere worthy of putting on your Sunday Best for. As former CAB chairman John E. Robson characterized it, “By 1975, the airline industry was like a forty-year-old still living at home with his parents.”

The downside of dependency was inefficiency, higher costs, and a limited clientele equipped to afford punishing markups (one economist estimated that regulated routes had markups ranging from 20–95%). Routine leisure air travel remained the exclusive domain of “attractive people doing attractive things in attractive places,” as jet set photographer Slim Aarons captured so memorably in his artwork.

Glamour aside, even simple objectives, such as getting a new route approved, were Herculean tasks. For example, World Airways applied for a low-fare route change in 1967; the CAB studied the request for over six years, only to throw the application out because it was “stale.”

Interestingly, a group of progressives led the campaign for deregulation. President Carter, along with Senator Ed Kennedy, Ralph Nader, and Stephen Breyer, set out to improve accessibility and service by “dismantl[ing] anti-consumer cartels that had been sustained by government regulation.” Carter appointed Fred Kahn, a pragmatic regulatory scholar from Cornell University, to take over the CAB. An unromantic economist, Kahn once said, “I can’t tell one plane from the other. To me, they’re all just marginal costs with wings.” He saw the airlines for what they were: a coddled business propped up by the federal government.

Under Kahn’s direction, the Senate crafted and approved the Airline Deregulation Act of 1978, which removed federal control from interstate fares, routes, and schedules. The airlines industry vehemently complained — Delta Airlines’ CEO W.T. Beebe predicted that “once the public is faced with the chaos, disruption of service, economic demoralization of carriers, and concentration of service in the hands of the remaining few air carriers… a demand w[ill] arise that the government take restorative action” — yet President Carter signed the legislation with gusto.

Southwest and the Low-Cost Carrier

Deregulation paved the way for low-cost carriers (LCCs), the shoestring, no-frills business model most travelers associate with airlines today. Southwest, the first blockbuster LCC, was initially confined to serving three local Texan cities. Following deregulation, it unleashed its revolutionary business model — simple, point-to-point flights serviced by a single-aircraft type — on the rest of the industry.

Big ticket items such as maintenance costs, fine dining, and overeducated employees were stripped away or outsourced. Ingenious pricing schemes were introduced, including baggage fees, dining fees, and economy-only seats. As a result, many low-cost carriers could offer fares 40–60% lower than those of traditional airlines. Some LCCs even started extracting subsidies from airports for servicing them: in 2010, Ryanair convinced Verona airport, a remote Italian outpost desperate for a new international airline, to pay it €17.50 per departing passenger (the deal was later cancelled due to complaints, yet similar arrangements were struck with other small European airports).

Competition was rightly feared by legacy carriers, who struggled to match the simplistic business model and rock bottom prices of low-cost carriers. Ed Colodny, former CEO of US Airways, described one legacy carrier’s fortunes following deregulation. “The industry had never made a lot of money,” he said. “Even in the first ten years after deregulation, on operating revenue of $381 billion, the profit was $1.6 billion, a margin of less than one half of one percent. We were a money tube: a lot of money came in, a lot went out, and very little stuck.”

Legacy carriers, faced with the downwards pricing pressure of LCCs, often started their own LCC subsidiaries, deflating prices across the board. Even as demand increased, worldwide average revenues per ton-km fell from US $2.40 in the early 1970s to less than $0.80 per ton-km by 2000. One by one, the legacy carriers succumbed to mergers or bankruptcy, and today we are left with a diminished oligopoly of carriers.

Ironically, Kahn — perhaps the individual most responsible for democratizing air travel — never saw mass travel as a realistic long-term goal. “I don’t think it’s my highest aspiration to make it possible for people to jet all over the world,” admitted Kahn. “The future clearly has to belong to substituting telecommunications for travel.”

The Problem of Derived Demand

One reason the industry has fixated on low prices is that it remains one of the few variables airlines can directly control to stimulate demand. Demand for airlines is unusual in that it is derived from other activities. Nobody purchases a plane ticket simply for the joys of air travel: it simply serves as a means of transportation to reach another, more exciting end.

As a result, demand is unusually difficult to forecast. It is dependent on any number of external factors, including climate, exchange rates, regulatory environment, income levels, vacation policies, business culture, former migratory patterns, etc. Just as things appear to be going well for the industry, another external shock arrives to upend profits. The 2000 recession, combined with 9/11, the Iraq War, and SARS set the industry back six years: it posted its first industry-wide profit of US $12 billion in 2007, only to be immediately set back again by the Great Recession.

According to the Harvard Business Review, average economic profits of airlines were negative for twenty years until 2015, when the shale gas revolution awarded airlines their biggest recorded profits in history. For a few unprecedented years, airlines generated enough returns to cover their cost of capital, a short-lived fantasy that was quickly destroyed by COVID-19.

Another issue is that brief external shocks such as 9/11 and COVID-19 can generate long-lasting fixed costs and consequences that dramatically alter the experience of the traveler. The attack on the World Trade Center transformed airports from mundane transportation centers into high-tech, high-anxiety surveillance areas. The result is an environment more akin to a high-security prison desk than an entrance point for everyday travelers. What was once a casual, ten-minute stroll to the runway now amounts to an elaborate exercise in “security theater,” as some call it, filled with fun characters such as the TSA officer, the drug-sniffing dog, the metal detectors and X-ray machines, the public disrobement, and the bioidentifiers, etc.

Loyalty Programs as Lifelines

How the airline industry will recoup its losses from nearly two years of depressed business travel — its most lucrative segment — plus increased sanitation and labor costs, is anyone’s best guess. In 2020 alone, the industry collectively amassed more than $180 billion worth of debt, more than half of total annual revenues. Rising ticket prices, decreased service, and increased government intervention seem inevitable.

McKinsey projects that air traffic won’t return to 2019 levels before 2024, and it estimates a 3% rise in global ticket prices if the new debt is paid back in ten years. For now, the remaining US players have turned to collateralizing their loyalty programs. Loyalty programs, unlike the airlines themselves, offer consistently stable and predictable cash flows. In March of 2021, American Airlines secured $10 billion — the largest financing transaction in aviation history — from the IP and cash flows of its AAdvantage program.

Given the concentration of the industry, new mergers seem unlikely. As for cost savings, it’s difficult to imagine what fresh horrors might be unleashed on the basic economy traveler. Fees for flushing? (RyanAir has already tried limiting toilets.) Fees for seatbelts and sanitation? Standing room only? McSweeney’s Internet Tendency, an online humor publication, facetiously suggested offering “ten-minute leaning periods” for purchase, yet it’s not far off from the grim reality faced by most flyers today.

About Colbeck: Colbeck is a strategic lender that partners with companies during periods of transition, providing creative capital solutions to meet their evolving needs. You can reach the team at inquiries@colbeck.com.