- By Grahamites
On Dec. 17, 1903, Orville Wright and his elder brother, Wilbur Wright, successfully conducted the first airplane flight near Kill Devil Hills, about four miles south of Kitty Hawk, North Carolina. Since the invention of airplane by the Wright Brothers, airplane has become a revolutionary and crucial way of travelling for people as well as of the transportation of packages and goods.
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While air travel was revolutionary and fancy, the airline industry, for most of its existence, has proved to be a disaster of capital. As Warren Buffett (Trades, Portfolio) puts it in the 2007 letter to shareholders: "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. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down."
Mr.Buffett wasn't joking when he said the history of the airline industry has been a disaster of capitals. One way to validate that assertion is to look up the number of airlines that has gone out of business. Wikipedia has a list of defunct airlines of the United States (link). The list is lengthy. By my count, the number of defunct airlines in the U.S is 567. But as Wikipedia clarifies, some of these airlines have changed identities and/or FAA certificates and are still operating under a different name. So the actual number of defunct airlines is smaller than the list suggests.
The history of the airlines can be broken down to a few eras - each with its distinct characteristics. USA today wrote an excellent summary article on this. Below are excerpts from this USA today article that summarizes the major eras up until the deregulation:
"The early 20th Century - Airplanes were around the first few years of the 20th century, but flying was a risky endeavor not commonplace until 1925. In this year, the Air Mail Act facilitated the development of the airline industry by allowing the postmaster to contract with private airlines to deliver mail. Shortly thereafter, the Air Commerce Act gave the Secretary of Commerce power to establish airways, certify aircraft, license pilots, and issue and enforce air traffic regulations. The first commercial airlines included Pan American, Western Air Express and Ford Transport Service. Within 10 years, many modern-day airlines, such as United and American, had emerged as major players."
"Mid-20th Century - In 1938, the Civil Aeronautics Act established the Civil Aeronautics Board. This board served numerous functions, the two most significant being determining airlines' routes of travel and regulating prices for passenger fares. The CAB based airfares on average costs, so because airlines couldn't compete with each other by offering lower fares, they competed by striving to offer the best quality service. If the CAB found an airline's service quality was lacking on a certain route, it would allow other carriers to begin operating on that route. In this environment, established airlines enjoyed an advantage over startups, as new carriers found it difficult to break into existing routes. The Federal Aviation Agency, now known as the Federal Aviation Administration, was created in 1958 to manage safety operations."
There are two other articles (link 1, link 2) that detailed the era of commercial jets and the airlines bankruptcies in the 1980s. The essence of these two articles can be summarized as the following:
The introduction of the wide-body jets and the improvement in safety measures and efficiency measures resulted in the wide-spread adoption of air travel starting at the end of the 1950s. The deregulation of the American commercial aviation sector in 1978 had completely changed the face of civil aviation in the country, which led to a turbulent decade that is the 1980s, which the USA article nicely summarized as the following:
In the mid-1970s, Alfred Kahn, an economist and deregulation advocate, became chairman of the CAB. Around the same time, a British airline began offering exceptionally inexpensive transatlantic flights, awakening a desire for U.S.-based airlines to lower their fares. These influences led to Congress passing the Airline Deregulation Act of 1978, ushering in an era of unencumbered free market competition. The CAB disbanded a few years thereafter."
Post-deregulation, new carriers rushed into the market, and new routes directly connected cities previously accessible only via a string of layovers. Fares dropped as competition and the number of customers increased. A 1981 air traffic controllers strike brought a temporary setback to the growth, which continued throughout the 1980s. Some of the major carriers who had dominated the skies during the middle portion of the century, such as Pan American and TWA, began to collapse in the wake of competition. Such carriers disappeared completely following the Gulf War and subsequent recession of the early 1990s. Surviving airlines rode out the recession and returned to record profitability by the late 1990s."
In his book Dead Companies Walking, Mr. Scott Fearon wrote a story with Frank Lorenzo, which I think is a good recount of what was happening to the airline industry in the 1980s. Below are some direct quotes from the story:
"I chose to go bankrupt (with Continental). Before we went Chapter 11, Continental was the ham in the ham sandwich. Here's the sandwich, okay? Only it's not a sandwich. It's the airline industry. The top slice of bread is the legacy carriers, American, United, Pan Am, those guys. Now, everybody knows their prices are outrageous. They're way, way overpriced because they've got high labor costs. But they get away with it because business travelers use them. They're flying on a corporate expense account, so they don't give a damn what a ticket costs. Now, down here on the bottom of the sandwich, you've got this new low-fare company called Southwest. They don't care about frills. They sell you a cheap ticket and they say, 'Here, have some peanuts, pal, we'll be landing in an hour, the barf bag is in the seat pocket in front of you if you need it.' Let me tell you something, Mr.Fearon. Those guys at Southwest are kicking everybody's butts. They're completely changing this industry. These guys on top here, American and United and all the other legacy companies? They are in trouble, they just don't know yet. But in a couple of years, they're going to be in the same place Continental was. Continental was in the middle. We had the high labor costs of the legacy guys but we didn't offer the same level of service, so business travelers wouldn't fly with us. But because we had all those labor costs, we had to charge too much to compete with Southwest. So there you go. We were dead meat, unless we did something. So we did. It wasn't pleasant. A lot of people lost their jobs or took pay cuts. But it worked. The bankruptcy allowed us to renegotiate all of our labor contracts. We cut our least profitable routes, too. "
Mr.Buffett has written quite a bit about the U.S airline industry in the 1990s as a result of Berkshire's purchase of USAir preferred stock. His letters to shareholders gave remarkable explanations as to what have gone wrong for the U.S airlines during the 1990s. Let us review:
In making the USAir purchase, your Chairman displayed exquisite timing: I plunged into the business at almost the exact moment that it ran into severe problems. (No one pushed me; in tennis parlance, I committed an "unforced error.") The company's troubles were brought on both by industry conditions and by the post-merger difficulties it encountered in integrating Piedmont, an affliction I should have expected since almost all airline mergers have been followed by operational turmoil.
In short order, Ed Colodny and Seth Schofield resolved the second problem: The airline now gets excellent marks for service. Industry-wide problems have proved to be far more serious. Since our purchase, the economics of the airline industry have deteriorated at an alarming pace, accelerated by the kamikaze pricing tactics of certain carriers. The trouble this pricing has produced for all carriers illustrates an important truth: In a business selling a commodity-type product, it's impossible to be a lot smarter than your dumbest competitor.
However, unless the industry is decimated during the next few years, our USAir investment should work out all right. Ed and Seth have decisively addressed the current turbulence by making major changes in operations. Even so, our investment is now less secure than at the time I made it.
Last year I told you that our USAir investment "should work out all right unless the industry is decimated during the next few years." Unfortunately 1991 was a decimating period for the industry, as Midway, Pan Am and America West all entered bankruptcy. (Stretch the period to 14 months and you can add Continental and TWA.)
The low valuation that we have given USAir in our table reflects the risk that the industry will remain unprofitable for virtually all participants in it, a risk that is far from negligible. The risk is heightened by the fact that the courts have been encouraging bankrupt carriers to continue operating. These carriers can temporarily charge fares that are below the industry's costs because the bankrupts don't incur the capital costs faced by their solvent brethren and because they can fund their losses - and thereby stave off shutdown - by selling off assets. This burn-the-furniture-to-provide-firewood approach to fare-setting by bankrupt carriers contributes to the toppling of previously-marginal carriers, creating a domino effect that is perfectly designed to bring the industry to its knees.
Seth Schofield, who became CEO of USAir in 1991, is making major adjustments in the airline's operations in order to improve its chances of being one of the few industry survivors. There is no tougher job in corporate America than running an airline: Despite the huge amounts of equity capital that have been injected into it, the industry, in aggregate, has posted a net loss since its birth after Kitty Hawk. Airline managers need brains, guts, and experience - and Seth possesses all three of these attributes.
There was one other memorable line in the 1989 Annual Report: "We have no ability to forecast the economics of the investment banking business, the airline industry, or the paper industry." At the time some of you may have doubted this confession of ignorance. Now, however, even my mother acknowledges its truth.
In the case of our commitment to USAir, industry economics had soured before the ink dried on our check. As I've previously mentioned, it was I who happily jumped into the pool; no one pushed me. Yes, I knew the industry would be ruggedly competitive, but I did not expect its leaders to engage in prolonged kamikaze behavior. In the last two years, airline companies have acted as if they are members of a competitive tontine, which they wish to bring to its conclusion as rapidly as possible.
Amidst this turmoil, Seth Schofield, CEO of USAir, has done a truly extraordinary job in repositioning the airline. He was particularly courageous in accepting a strike last fall that, had it been lengthy, might well have bankrupted the company.
Capitulating to the striking union, however, would have been equally disastrous: The company was burdened with wage costs and work rules that were considerably more onerous than those encumbering its major competitors, and it was clear that over time any high-cost producer faced extinction. Happily for everyone, the strike was settled in a few days.
A competitively-beset business such as USAir requires far more managerial skill than does a business with fine economics. Unfortunately, though, the near-term reward for skill in the airline business is simply survival, not prosperity.
In early 1993, USAir took a major step toward assuring survival - and eventual prosperity - by accepting British Airways' offer to make a substantial, but minority, investment in the company. In connection with this transaction, Charlie and I were asked to join the USAir board. We agreed, though this makes five outside board memberships for me, which is more than I believe advisable for an active CEO. Even so, if an investee's management and directors believe it particularly important that Charlie and I join its board, we are glad to do so. We expect the managers of our investees to work hard to increase the value of the businesses they run, and there are times when large owners should do their bit as well.
Top honors go to a mistake I made five years ago that fully ripened in 1994: Our $358 million purchase of USAir preferred stock, on which the dividend was suspended in September. In the 1990 Annual Report I correctly described this deal as an "unforced error," meaning that I was neither pushed in the investment nor misled by anyone when making it. Rather, this was a case of sloppy analysis, a lapse that may have been caused by the fact that we were buying a senior security or by hubris. Whatever the reason, the mistake was large.
Before this purchase, I simply failed to focus on the problems that would inevitably beset a carrier whose costs were both high and extremely difficult to lower. In earlier years, these life- threatening costs posed few problems. Airlines were then protected from competition by regulation, and carriers could absorb high costs because they could pass them along by way of fares that were also high.
When deregulation came along, it did not immediately change the picture: The capacity of low-cost carriers was so small that the high-cost lines could, in large part, maintain their existing fare structures. During this period, with the longer-term problems largely invisible but slowly metastasizing, the costs that were non-sustainable became further embedded.
As the seat capacity of the low-cost operators expanded, their fares began to force the old-line, high-cost airlines to cut their own. The day of reckoning for these airlines could be delayed by infusions of capital (such as ours into USAir), but eventually a fundamental rule of economics prevailed: In an unregulated commodity business, a company must lower its costs to competitive levels or face extinction. This principle should have been obvious to your Chairman, but I missed it.
Seth Schofield, CEO of USAir, has worked diligently to correct the company's historical cost problems but, to date, has not managed to do so. In part, this is because he has had to deal with a moving target, the result of certain major carriers having obtained labor concessions and other carriers having benefitted from "fresh-start" costs that came out of bankruptcy proceedings. (As Herb Kelleher, CEO of Southwest Airlines (LUV), has said: "Bankruptcy court for airlines has become a health spa.")
Additionally, it should be no surprise to anyone that those airline employees who contractually receive above-market salaries will resist any reduction in these as long as their checks continue to clear.
Despite this difficult situation, USAir may yet achieve the cost reductions it needs to maintain its viability long-term. But it is far from sure that will happen. Accordingly, we wrote our USAir investment down to $89.5million, 25 cents on the dollar at yearend 1994. This valuation reflects both a possibility that our preferred will have its value fully or largely restored and an opposite possibility that the stock will eventually become worthless. Whatever the outcome, we will heed a prime rule of investing: You don't have to make it back the way that you lost it.
When Richard Branson, the wealthy owner of Virgin Atlantic Airways, was asked how to become a millionaire, he had a quick answer: "There's really nothing to it. Start as a billionaire and then buy an airline."
Unwilling to accept Branson's proposition on faith, your Chairman decided in 1989 to test it by investing $358 million in a 9.25% preferred stock of USAir.
I liked and admired Ed Colodny, the company's then-CEO, and I still do. But my analysis of USAir's business was both superficial and wrong. I was so beguiled by the company's long history of profitable operations, and by the protection that ownership of a senior security seemingly offered me, that I overlooked the crucial point: USAir's revenues would increasingly feel the effects of an unregulated, fiercely-competitive market whereas its cost structure was a holdover from the days when regulation protected profits. These costs, if left unchecked, portended disaster, however reassuring the airline's past record might be. (If history supplied all of the answers, the Forbes 400 would consist of librarians.)
To rationalize its costs, however, USAir needed major improvements in its labor contracts - and that's something most airlines have found it extraordinarily difficult to get, short of credibly threatening, or actually entering, bankruptcy. USAir was to be no exception. Immediately after we purchased our preferred stock, the imbalance between the company's costs and revenues began to grow explosively. In the 1990-1994 period, USAir lost an aggregate of $2.4 billion, a performance that totally wiped out the book equity of its common stock.
For much of this period, the company paid us our preferred dividends, but in 1994 payment was suspended. A bit later, with the situation looking particularly gloomy, we wrote down our investment by 75%, to $89.5 million. Thereafter, during much of 1995, I offered to sell our shares at 50% of face value. Fortunately, I was unsuccessful.
Mixed in with my many mistakes at USAir was one thing I got right: Making our investment, we wrote into the preferred contract a somewhat unusual provision stipulating that "penalty dividends" - to run five percentage points over the prime rate - would be accrued on any arrearages. This meant that when our 9.25% dividend was omitted for two years, the unpaid amounts compounded at rates ranging between 13.25% and 14%.
Facing this penalty provision, USAir had every incentive to pay arrearages just as promptly as it could. And in the second half of 1996, when USAir turned profitable, it indeed began to pay, giving us $47.9 million. We owe Stephen Wolf, the company's CEO, a huge thank-you for extracting a performance from the airline that permitted this payment. Even so, USAir's performance has recently been helped significantly by an industry tailwind that may be cyclical in nature. The company still has basic cost problems that must be solved.
In any event, the prices of USAir's publicly-traded securities tell us that our preferred stock is now probably worth its par value of $358 million, give or take a little. In addition, we have over the years collected an aggregate of $240.5 million in dividends (including $30 million received in 1997).
Early in 1996, before any accrued dividends had been paid, I tried once more to unload our holdings - this time for about $335 million. You're lucky: I again failed in my attempt to snatch defeat from the jaws of victory.
In another context, a friend once asked me: "If you're so rich, why aren't you smart?" After reviewing my sorry performance with USAir, you may conclude he had a point.
After Berkshire exited the USAir preferred stock position, the industry still operated under rough conditions. The early 21st century has continued proved that the airline industry is a tough business, According to the USA today article: "in 2001, the industry dealt with the effects of another economic downturn, as business travel decreased substantially while labor and fuel costs increased. The events 9/11 greatly magnified the airlines' issues, leading to a sharp decline in customers and significantly higher operating costs. Losses continued for years; the industry as a whole didn't return to profitability until 2006. A relatively stable period followed, although controversies arose over service quality and passenger treatment in terms of flight delays, particularly those involving planes waiting on the runway. In 2010 and 2011, the U.S. Department of Transportation issued a series of rules mandating that the airlines provide adequate modifications for passengers in extenuating circumstances."
After a century of disastrous performance, the remaining players (AAL, UAL, DAL, LUV)in the airline industry have come to the realization that changes are needed. Post the 2008-2009 financial crisis, a series of changes have taken place that may have made the airline industry a better business now.
This article first appeared on GuruFocus.
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