Airsick airline investors

April 17, 2011

One of the downsides to my work is the extensive amount of air travel that I have to do.  My journeys, a few times a month, are primarily to various parts of Europe (east and west), India, the Far East and Africa.

In the past couple of months I have flown on numerous airlines: large established international carriers such as Lufthansa, Singapore Airlines and British Airways, newer international upstarts Emirates and Etihad, smaller international airlines (Swiss), large domestic/regional airlines (Jet Airways, Kingfisher), domestic budget carriers (Jet Lite) and small regional players (Oman Air, Austrian Air, BMI).  

On one recent flight, as I witnessed an unfortunate fellow passenger regurgitate his breakfast in to the leak-proof air sickness bag provided by the airline, it struck me that he symbolised what most investors in airlines probably feel all the time.
Why is it that investors in airline shares and debt are perpetually in a state of airsickness?

As a private equity investor, there are only three sectors in which I will categorically never put any money into, in any part of the world.  One of these is the airline industry.  There have been airlines that have made some investors money, but these cases are extremely rare and all have a common story.  
A handful of airlines in young markets have provided healthy returns for investors in the early stages of their businesses, but later investors in these companies have been violently sick.  

As an example, SkyEurope, a budget carrier, was established in Slovakia in 2002 and its start-up private equity investors made many multiples of their investment in the three years that the company took to list on the Vienna and Warsaw markets.

The airline, however, never made a single Euro of profit in its seven years of existence, and finally this summer it filed for bankruptcy, leaving the later public equity investors holding shares worth zero.  And, of course, stranding passengers across Europe.
Just reading about airline woes the past few weeks is enough to make one feel very nauseous.  Airlines of all sizes, across the globe, whether local, regional or international, budget or full service, are bleeding cash.  

Air India, the flying Maharaja, made a rather princely loss of over US$1.2bn in its last financial year.  The flagship Japan Airlines posted even more impressive red figures in the six-months up to September, losing a staggering US$1.47bn.  

The International Air Transport Association (IATA) has estimated that in 2009 the global airline industry will post losses of US$9bn.  Even in the glitzy markets of the Middle East, losses for the year are estimated to top US$1.5bn.  

One might be forgiven for thinking that this is simply a reflection of the greater global financial malaise, and that the industry will return to rosy-cheeked health as the world economy improves.  

But even in the best of times airlines have struggled to produce a profit and an adequate return for bondholders and shareholders.  I cannot recall any period of length in the past ten years when there was a not an airline in the USA filing for Chapter 11 bankruptcy protection.  
The best proof as to how difficult it is for airlines to fly a turbulence-free path and land with smiling investors is the Indian market.  The Indian economy has grown in leaps and bounds in the past 5-10 years, even taking in to account the recent temporary dip in growth.  

During this period domestic air traffic growth exploded, aided by a plethora of new private carriers taking on the government-owned monopolist Indian Airlines, famous for frumpy disinterested staff.

The new carriers, both budget and premium, offered a quantum improvement in the level of service, drove down ticket prices, and created new routes to previously un-serviced destinations, resulting in huge growth in sectors, numbers of flights and passengers.  The good times, it seemed, had truly arrived for the Indian aviation industry.  

Or had it?  In the four years from April 2006 through March 2010 the Indian aviation sector will lose about US$5.4bn.  In the five years to date the Sensex stock index at the Bombay Stock Exchange has risen by 160 per cent, whilst shares of the two largest private airlines, Jet Airways and Kingfisher, have lost 54 per cent and 60 per cent respectively.

Kingfisher Airlines is probably one of the best-known new private carriers in India. Established in 2005 by the ‘Indian Richard Branson,’ Vijay Mallya, a charismatic businessman with a penchant for publicity, Kingfisher even won the ‘Best New Airline of the Year’ Award for 2005 in the Asia-Pacific & Middle East region from the Centre for Asia Pacific Aviation.  

The company was initially funded by Dr Mallya’s UB Group and private equity investors. The company’s original business plan forecasted profits of US$65 million for the financial year 2008/09.

Instead, it turned in a stomach-churning loss of US$350mn.  Investors, backing a business plan and acquiring stakes with valuations based on the original forecast, have certainly lost a chunk of their capital.  Public shareholders buying shares at the company’s initial public offering in June 2006 would now have 60 per cent of their capital wiped out.  

This exercise is not about singling out Kingfisher: in the past five years, with the exception of a couple of airlines in a couple of quarters, none of the Indian carriers has made a profit.

Why is it so difficult for airlines to make money?  The answer lies in another question: what purpose do airlines suit?  Airlines exist to transport people from point A to B.  

Unlike a car, whose fundamental utility is also in transporting a person from one point to another, airlines do not serve any aesthetic, aspirational or technical purpose.  
Most airline passengers have no idea as to the technical capabilities of the plane they are flying in and don’t care how the machine looks or what colours the seats are.  

Price is the prime reason why one chooses a certain flight over another.  Convenience is the only other factor that counts.  What this means is that airlines command little customer loyalty.  In order to attract a paying passenger, an airline simply has to offer the best price, regardless of what is happening to its cost structure.  

On the other hand, whilst only price commands some loyalty, even a slight mishap with service will drive the customer towards rival carriers.  Therefore, like me flying on numerous airlines, very few customers ever stick to one airline.  It’s this lack of customer ‘stickiness’ that has prompted airlines to try to ‘buy’ passengers through loyalty programmes, and in order to make loyalty programmes attractive airlines have banded together to form alliances.

So why does anyone invest in airlines? Primarily because of nationalism and ego.  National flag carriers are anachronisms, but yet they persist.  Governments continue to invest in airlines, as they are deemed necessary to project the image of a country.  

The bankruptcy of Swissair a few years ago highlighted the cost of nationalism, a cost that eventually the Swiss tax payer was not willing to continue paying.  The Indian government has painful decisions to take with regards to its ailing maharajah.  

Egos of businessmen (never businesswomen!) successful in other fields have driven irrational investments in airlines: Vijay Mallya, Richard Branson and Niki Lauda are but a few of the names the public is familiar with.  Owning an airline is based on the same psychology that leads other men to want to own football clubs, another rather dubious business model.

Investors in air carriers, both direct and indirect (the tax payers), should be plied with free supplies of airsickness bags by their airlines.  These bags will continue to be much needed.

Vijai Gill runs an international private equity business, Salamander Capital. He is also chairman of The Global Green Company (India), and is a manager at Ibn Hyan (Oman).