Steve Bleiberg (00:03):
Hello and welcome to Actively Speaking, I'm your host, Steve Bleiberg. Join us each episode as we discuss current issues concerning capital markets and portfolio management from the perspective of an active manager.
Steve Bleiberg (00:17):
Hi, welcome back to another episode of Actively Speaking. Um, today, we're gonna be talking about airlines and my guest is Nigel Frankson, who is an analyst here at Epic and part of the capital reinvestment team. Welcome, Nigel.
Nigel Frankson (00:30):
Thank you, thanks for having me.
Steve Bleiberg (00:32):
Um, so the airline industry is kind of notorious as one that, for a long, long time, was not particularly profitable and-and there's the famous interview that Warren Buffett did, almost 20 years ago, this was in 2002, he was with the, I'm sorry, the Telegraph in London, and he said, if a capitalist had been present at Kitty Hawk back in the early 1900's, he should've shot Orville Wright, he would've saved his progeny money.
Steve Bleiberg (00:59):
But seriously, the airline business has been extraordinary, it has eaten up capital over the past century like almost no other business because people seem to keep coming back to it and putting fresh money in. You've got huge fixed costs, you've got strong labor unions, and you've got commodity pricing, that's not a great recipe for success.
Steve Bleiberg (01:16):
I have an 800 number now that I-that I call if I get the urge to buy an airline stock. I call at two in the morning and I say, my name is Warren and I'm an aero-holic, and then they talk me down, closed quote.
Steve Bleiberg (01:27):
Uh, more recently, though, Warren Buffett has, uh, made headlines a couple years ago because he took a stake in Southwest Airlines. So, Nigel, what changed between 2002 and the recent years, such that Warren Buffett was pretty darn skeptical of-of investing in airlines 20 years ago, is now an airline investor.
Nigel Frankson (01:48):
It's important to look at the, uh, airline industry in two distinct periods. There is the pre-financial crisis and the post-financial crisis. While 9/11 essentially brought the industry down to its knees, the great financial crisis was really the tipping point that really changed the psychology throughout the management teams and changed how these companies were run and, in my opinion, permanently so.
Nigel Frankson (02:14):
Prior to the financial crisis, you had a more fragmented industry, the top four carriers accounted for about 63% of the, uh, of all traffic in the domestic market. You had an empire building psychology, the goal was going after market share by any means necessary. There were not returns or cash flow, uh-uh, focused.
Nigel Frankson (02:37):
What changed with the great financial crisis were bankruptcies, poor financial performances, plummeting stock prices, and something clearly had to change. Since the great financial crisis, we've had several mergers that took place in the space.
Nigel Frankson (02:53):
As a result, when you look at the industry today, the top four carriers account for about 85% of domestic traffic versus 63% or so prior to the great financial crisis. So noteworthy M&A transactions are Northwest Airlines with Delta, I think that was the, I mean, there were-there were mergers prior to that, but I think the Northwest Delta combination in 2010, I believe it was, was really the trigger for this industry to really consolidate and for the, uh, the network carriers, in particular, to get their act together.
Nigel Frankson (03:30):
This evolution of the industry is really focused on the network carriers, that's your Delta Airlines, your United Airlines, and your American Airlines. These airlines have been around forever and they're the ones that have changed the most dramatically over the last several decades.
Nigel Frankson (03:46):
I would view Delta Airlines as the class of the network airlines. They were essentially the first to have a meaningful merger, they are the first to rationalize their fleet, they were the first to, uh, acquire discipline as far as capacity is concerned, uh, managing their balance sheet, simple things such as bringing ancillaries and charging you for bags or changing your seat, they were the first amongst the network carriers to employ these various tactics that improved returns and improved margins.
Steve Bleiberg (04:18):
Okay, so, I mean, well, first of all, so, clearly, consolidation, you're saying, has played a big role-
Nigel Frankson (04:22):
Yes.
Steve Bleiberg (04:23):
... in the, uh, sort of move towards profitability. I always like to point out that at one point in our history we had airlines covering practically every point on the compass. We've had, we still have Northeast Airlines, became part of Delta a long time ago, there was Eastern, there was Southeast, there was Southern, which also eventually ended up in, actually, in Delta, but a torturous path, they actually became part of Republic, which then became part of Northwest, which then became part of Delta.
Steve Bleiberg (04:51):
Uh, we still have Southwest Airlines, we had a Western Airlines, became part of Delta, we had a Northwest Airlines, that's part of Delta-
Nigel Frankson (04:58):
So, you're-you're referring to the, um, post-1978, so in 1978, the industry deregulated, as a function of that, you saw a lot of competition and literally something like 24, uh, airlines were started between 1978 and 1985. Most of the ones you're mentioning as well, I would say, by the early 2000's, if not sooner, those 24 airlines, ultimately, compressed back down to two.
Nigel Frankson (05:27):
Yeah, that-that proliferation of airlines really started in 1978, and then petered out probably by the '90s.
Steve Bleiberg (05:35):
Right. Um, so, yeah, so consolidations played a role. You mentioned, you know, Delta charging for bags, stuff like that, it seems like that was also a significant change in the industry, there were things that used to be free, like food, uh, checking your bags, uh, that they were able to make fees stick for that there was, I think, annoyance, at first, you know, people were kind of annoyed that now they had to pay to check a bag or they had to pay to buy food on the plane.
Steve Bleiberg (06:03):
Of course, nobody objects when you get on an Amtrak train and they charge you for food, nobody expects to get free food. But simply because there was a time when they used to give you food for free and it changed, there was resistance. But the point is it has stuck and what role do those fees, like food, baggage, and also, unfortunately, the change fees, if you wanna make a change to a reservation, it can cost like $150? What role do those fees play in the profitability of these airlines today?
Nigel Frankson (06:32):
Uh, they're quite significant, but I think it's important to, um, to highlight certain things about the industry before we get into the fee structures because they're leveraged very differently depending on the airline and depending on the type of airline. There are, I would say, four different business models within the industry.
Nigel Frankson (06:50):
It's easiest to highlight the differences between them by looking at the extremes. First, on one side, you have the network carriers. Network carriers leverage a hub and spoke network geared towards maximizing the destination, number of destinations and frequency to those destinations, they have segmented cabins, they have heterogeneous fleets, if you will, different sized aircrafts that have different ranges to service different markets depending on where they are and how far they are and so forth.
Nigel Frankson (07:19):
Uh, these airlines are mature business models, they're GDP growers and, um, again, those are the American Airlines of the world, the United, the Deltas, et cetera. Historically, you buy one ticket and you pretty much get everything, you can check in as many bags as you want, you get an in-flight meal, it's the standard airline experience that we, that most of us grew up with.
Nigel Frankson (07:41):
On the other end of the spectrum, you have the ultra low cost carriers. They fly a homogeneous fleet, so maybe the, uh, Boeing 737, for example, which is the Southwest Airline aircraft type, they fly those exclusively. They have virtually no cabin segmentation, so there's no business class, no first class, uh, it's a point to point network. It's geared towards leisure passengers, and they do some un-bundling of pricing. In fact, the Spirit Airlines of the world will nickel and dime you for everything you can conceivably think of. These carriers tend to be smaller, they tend to be plus GDP growers.
Nigel Frankson (08:23):
And then you have business models that are in between the ultra low cost carrier and the network carriers. And these in between business models leverage components of-of either side, depending on where along the spectrum they care to lie. So, for example, Alaska Airlines you could consider a low cost network carrier, they probably look more like Delta than a Spirit Airlines.
Nigel Frankson (08:48):
And then you have someone like a JetBlue, which is more of a low cost carrier, without the network, and they probably look more like Spirit than like Delta, so these intermediate business models fall between somewhere in that spectrum.
Nigel Frankson (09:04):
Uh, the low, the ultra low cost carrier business model kind of started in 2007, 2008, and really picked up steam post-financial crisis. And it's this business model that started to, that was, again, plus GDP growers, taking market share and kind of forced the hand of the rest of the industry to more aggressively un-bundle the price of the ticket. That allows you to reach more travelers, it allows people to pay for exactly what they want, if you want to fly from New York to Disneyworld, for example, but for whatever reason, you don't want to carry any bags, you don't have to pay for any bags, it becomes a cheaper flight for you, it becomes more likely that you will fly.
Nigel Frankson (09:49):
Uh, so that ultra low cost carrier and the success that it's had over the last ten years is what's fostered this culture of price un-bundling. So, as a competitive response to the ultra low cost carriers and the Spirit Airlines of the world, the network carriers like the Deltas and Americans had to, in order to defend market share, had to start un-bundling the ticket price, to some extent, they are nowhere near as un-bundled as the ultra low cost carriers, but they have given a little, uh, with, um, the comeuppance, for example, of the basic economy section of the airplane, with charging for bags, with charging for change fees, that's why you're seeing that with the network carriers.
Nigel Frankson (10:34):
As far as the profitability of these ancillary services, it can be shown that, if the global airline industry produced about, and these are rough numbers, $20 billion in net income for 2019, $80 billion of that was ancillary fees. It's literally well more than-
Steve Bleiberg (10:56):
Wait, wait, you said $20 billion in profit, but $80 billion-
Nigel Frankson (11:00):
Yes, yes. So, if you excluded all the change fees, all the baggage fees, all the ancillary add-ons, and so forth, and most of these add-ons are pure profit features that you're charging for as a airline service provider, the industry would be negative by billions of dollars.
Steve Bleiberg (11:16):
Oh, oh, wow, wow, I see. That's where all the profits come from.
Nigel Frankson (11:22):
Yes.
Steve Bleiberg (11:22):
More than a 100% of the profits are coming from those fees.
Nigel Frankson (11:22):
Yes. Now, that depends, that-that's different airline by airline-
Steve Bleiberg (11:26):
Yeah.
Nigel Frankson (11:26):
... that's less true for Delta, that's more so true for the Spirit Airlines and the Frontiers and so forth, but generally speaking, all the profitability and then some comes from ancillary fees.
Steve Bleiberg (11:38):
My goodness, wow, so if they had not started doing that, they might still be un-profitable.
Nigel Frankson (11:42):
Well, yes and-yes and no, look, if you're going to fly to, um, Disneyworld, for example, with the family, you're gonna have bags, so it's not fair to say that, you know, no one flies to Disneyworld without bags.
Steve Bleiberg (11:58):
Yeah.
Nigel Frankson (11:59):
The value proposition is still underpinned, if you will, by the fact that you need to go from A to B, so I think this is just a clever way of segmenting the menu of services, if you will, but ultimately, you're really charging the customer to get from A to B-
Steve Bleiberg (12:18):
Right, right.
Nigel Frankson (12:18):
... and, of course, they're going to want to print out their ticket, of course they're going to want to sit near a window or near the aisle and these things, you know, it's just a way of getting the most price sensitive person to fly with you-
Steve Bleiberg (12:31):
Right, right.
Nigel Frankson (12:31):
... and fill up the plane.
Steve Bleiberg (12:32):
Right, so actually, I guess it's more that if they weren't charging separately for these fees, just the base fare would be higher, but-
Nigel Frankson (12:37):
Right.
Steve Bleiberg (12:37):
... you know, yeah. You know, the-the popular stereotype is that, of course, it's the business class traveler where they, is very profitable, you know, it can cost, you know, $5 thousand for a business class ticket, you know, to California or to Europe, versus, you know, a few hundred for the coach ticket.
Steve Bleiberg (12:53):
Um, why, so why, you know, you mentioned, for example, Southwest doesn't have a business class, like, why have they passed up that opportunity to-to charge more to some travelers? And, first of all, is it true that, you know, like, American, Delta, and United, do they make a disproportionate share of their money from their business class travelers?
Nigel Frankson (13:13):
Well, it's absolutely true and-and you touched on the reason why. It's, uh, it's the business model that these airlines are leveraging, the network carriers are geared towards the business traveler, that's why they have a hub and spoke network because hub and spoke networks are more flexible and, um, provide, simply provide more options in terms of coverage and, uh, and frequency to various destinations. They are catering to the business customer.
Nigel Frankson (13:39):
So, 70% of their revenue comes from 25 to 30% of their customers and those are the folks sitting up front. Now that's clearly not true for the Southwests of the world or the Spirits of the world who simply don't have a first class or a business class and they, thusly, are getting more of their revenue, quote unquote, from the ancillary services.
Steve Bleiberg (14:02):
So, you were talking about the period when there were a lot of airlines started up, and I was looking at some of the-the smaller airlines that are around today, like Frontier, Spirit, Sun Country, yeah, you know, the last time, really, the last, sort of the most, the newest of the sort of top ten airlines in the US is JetBlue, which when it started flying in 2000, that was 20 years ago.
Steve Bleiberg (14:25):
So it seems like, it, has it become harder to start up an airline, and, if so, why?
Nigel Frankson (14:31):
So, yes, I would say JetBlue is probably the newest airline to enter the market, but the current iteration of Spirit Airline started in 2007 when Indigo Partners took them over.
Steve Bleiberg (14:43):
Right, right, okay.
Nigel Frankson (14:43):
So, in my opinion, the post-2007 Spirit Airlines is a different airline than pre-2007 and, thusly, represents an entrance into the market.
Nigel Frankson (14:54):
Um, but, to answer your question directly, yes, I think it is more difficult to, uh, start a new airline today versus 20 years ago. Uh, the barriers to entry, uh, are-are significantly higher.
Nigel Frankson (15:05):
And when I say barriers to entry, I mean, look, anyone can start a poorly run airline, anyone can start an airline that fails, uh, when I say barriers to entry, I mean meaningfully impacting the established players and gaining meaningful market share. I think the barriers to entry there are higher simply because the markets more consolidated, uh, the existing players have economies of scale, they have more lane density, they are better able to employ predatory pricing tactics that will drive fledgling competition out of the market.
Nigel Frankson (15:39):
For example, um, their yield management system, their yield management systems today are far more, uh-uh, sophisticated than they were 20 years ago, they can look at how much they're pricing for every route, for every time of day, and they know exactly when that new entrant is attempting to enter a market, let's say, four o'clock flight from Cincinnati to Texas somewhere. Uh, and they can just, for that singular flight, they can drive the price all the way down and take a loss on that route, but because they are so big and making so much money elsewhere, to be frank, it won't impact their financials and that fledgling airline will be no more, so-
Steve Bleiberg (16:22):
Mm-hmm (affirmative).
Nigel Frankson (16:23):
... the only offset I can think to that is interest rates. Interest rates are certainly lower today than they were 20 years ago, airlines are capital intensive businesses, to the extent that you're going to borrow billions of dollars to do something, I suppose, it's probably easier today than 20 years ago, but every other factor, market force I can think of, uh, makes it harder today to start an airline.
Steve Bleiberg (16:46):
Mm-hmm (affirmative). Do you think we've seen the-the end of the consolidation or are there further mergers to come?
Nigel Frankson (16:52):
There probably are further mergers to come, if you listen to the conference calls, I would say Alaska Air sees itself as an acquirer, um, JetBlue sees itself as an acquirer. There isn't much left to acquire, but-
Steve Bleiberg (17:06):
Right.
Nigel Frankson (17:09):
... um, but they seem pretty focused on going it alone. Alaska Air, for example, recently purchased Virgin Air, Alaska Air, again, is a low cost network carrier, it's one of those in between business models that ultimately looks more like a Delta than, say, a Spirit Airlines on the ultra low cost carrier end of the spectrum. They are a west coast focused airline, think of them as a regional Delta.
Nigel Frankson (17:36):
Um, in the perfect world, I think they would like to see themselves as perhaps acquiring JetBlue and becoming bigger, 'cause JetBlue is more focused on the east coast, they are more focused on the west coast. So the two would make sense.
Nigel Frankson (17:50):
So you're right, there isn't a whole lot left to acquire, but I think we may have one or two more mergers left to go.
Steve Bleiberg (17:57):
Okay, so-so it, it's interesting, so airlines are one of the few industries, it seems, that are kind of immune to disruption from-from the internet, I mean, Amazon is, uh, you know, I don't know, who knows, maybe, Amazon could start up an airline. But-but, yeah, I mean, it's, um, it just seems like it's, you know, you do, the whole point of flying is to physically move people-
Nigel Frankson (18:18):
Yeah.
Steve Bleiberg (18:18):
... from one place to another, which is kinda hard to-to do in any other way, unless somebody perfects the old Star Trek technique.
Nigel Frankson (18:26):
I would say the biggest impact that the internet has had on the industry is probably just price discovery. I mean-
Steve Bleiberg (18:32):
Yeah.
Nigel Frankson (18:32):
... 20 years ago, you had to call a, um, a travel agent to book a flight and to perhaps pick the best flights for you, and I'm not entirely sure how much of the market any individual flight attendant, uh, travel agent, could see. Um, today, everything's on your phone, on your computer screen, you can see every price for every airline going to the destination of your choice. And, so the price discovery and transparency is a lot higher today and that's probably put some downward pressure on ticket prices.
Steve Bleiberg (19:04):
Yes, yeah, well, certainly, I think in, you know, in inflation adjusted terms, flying is cheaper today than-
Nigel Frankson (19:09):
Yeah.
Steve Bleiberg (19:10):
... than it was 30, 40 years ago. And of course deregulation played a role in that as well, back in the '70s.
Steve Bleiberg (19:16):
Let's talk about a-a shorter term threat to the industry, uh, coronavirus, but is this having an impact? It's clearly having an impact on flights in and out of China, I know that the volume of so many airlines have eliminated their flights for a while to and from China, but, um, you know, are you, have any of the airlines started talking about this?
Steve Bleiberg (19:37):
You know, for, recently, Apple talked about the impacts of the-the coronavirus on its supply chain, are you, are we seeing any early comments from airlines on what's happening to traffic as a result of this?
Nigel Frankson (19:50):
Not a lot, um, it seems that, so, first of all, this actually only applies to the network carriers, for the most part, they're the only carriers within the United States that connect to international destinations, and then some subsegment of that is going to Asia and some smaller subsegment is going to China.
Nigel Frankson (20:11):
So far, it looks like it's going to be a low single digit headwind to revenue, um, to date. The longer this goes, the more of an impact it'll have, but it really, it's a low single digit impact to the-to-to business so far.
Steve Bleiberg (20:26):
Uh, well, I think that's about all the questions we have time for, so, uh, Nigel, thanks again for joining us.
Nigel Frankson (20:32):
Thanks for having me.
Steve Bleiberg (20:33):
And we'll talk to you again soon.
Nigel Frankson (20:35):
Sounds good.
Steve Bleiberg (20:39):
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Speaker 3 (20:54):
The information contained in this podcast is distributed for informational purposes only and should not be considered investment advice or recommendation of any particular security, strategy, or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
Speaker 3 (21:11):
The information contained in this podcast is accurate as of the date submitted, but is subject to change. Any performance information referenced in this podcast represents past performance and is not indicative of future returns, any projections, targets, or estimates in this podcast are forward looking statements and are based on Epic's research, analysis, and assumptions made by Epic. There can be no assurances that such projections, targets, or estimates will occur and the actual results may materially be different.
Speaker 3 (21:40):
Other events, which were not taken into account in formulating such projections, targets, or estimates may occur and may significantly affect the return or performance of any accounts and/or funds managed by Epic. To the extent this podcast contains information about specific companies or securities, including whether they are profitable or not, they are being provided as a means of illustrating our investment thesis, past references to specific companies or securities are not a complete list of securities selected for clients and not all securities selected for clients in the past year were profitable.
