I don’t think he’s particularly concerned with capital. It’s the lack of competitive advantage that is key. Insurance (the classic financial services industry that is Buffet’s life blood) is one of the most capital intensive industries.
Airlines lack substantial economies of scale, customer captivity, captive supply, or regulatory protections. The airline industry is a textbook case of an industry with no durable competitive advantages, thus the only performance factor is operational efficiency.
Insurance on the other hand, there are substantial economies of scale (large fixed costs and also larger insurance companies are more diversified thus less costly/risky) and high customer captivity (high switching cost, high search cost).
You're right! I was lazy with my words, it's definitely the durability that he's concerned with. The word durable, from the quote, is even emphasized in the original text.
Airlines have huge economies of scale due to network effects. Most customers will only buy a ticket if they can reach their final destination on a single airline with only one (or at most two) transfers. Code share agreements with partner airlines only partly mitigate this.
The other major factor which prevents airlines from ever sustaining high profits is pilot unions. The pilots will demand most of the extra profits, and usually get it because a strike instantly shuts down the entire airline.
Pilot unions have gotten the shit kicked out of them for years. 1970 wants its argument back.
Tickets are fungible and people will make insane choices to save a dollar. The constrained resource is gates. The network effects that make big airlines viable are expensive, so without regulation there’s always upstarts who drive the price as low as possible. That’s why Emirates is fancy.
If you live near NYC, there is an airport in Newburg that attracts weird financial engineering airlines that leverage leases to fly international cheaply. When I saw Hamilton, I flew Norwegian airlines from NY to London for $24. The long term parking cost more.
It’s an industry where the low barrier to entry ensures that the industry as a whole is barely profitable.
Economies of Scale and Network Effects are distinct business powers.
"Network Effects" means the Nth person doing business with the company generates more value for the business's service to everyone else, all else equal. I don't think airlines have network effects. There isn't much benefit to flying a highly-trafficked airline vs a lower-trafficked airline, provided they have the same routes. (If anything, this might be marginally inversely correlated? Small airlines seem to have a better experience than the big ones)
"Economies of Scale" means that cost of goods sold becomes a lower percentage of revenue as revenue grows. This doesn't hold true for airlines, because jet fuel & taxes thereon, and leasing gate space make up the biggest fixed costs IIRC. Bigger airlines don't have a lot of negotiating edge vs small ones, here. Plus, big airlines have an exponential logistical problem to solve, which is costlier to solve "at scale". Thus, profit scales basically linearly (some might argue sub-linearly) with revenue.
There are indeed regional economies of scale for those airlines that invest in monopolizing growing transit hubs. Virgin Airlines and Southwest built their businesses on them, and are well-studied examples. But they are not durable over a long enough time horizon, and don't "scale" up to bigger footprints.
Airlines "own" far too little of their costs, and startup cost is far too low, for them to be durable and large business.
The dynamic is terrible for value investors like BRK, but arguably quite great for consumers (fliers). And not too shabby for early-stage investors, either.
Having a higher route coverage is a function of size absolutely. However, it is definitely not a significant competitive advantage. Economies of scale is applicable in absolute and relative terms.
Airline A can have 100% coverage everywhere in the world and be the largest airline. But if Airline B enters a specific route, there is no advantage to a customer whether they ride with A or B for that specific route. This is why there are so many entrants into the industry.
The biggest factor to the lack of durable profits in the airline industry isn’t labor or unions. It’s the ease of entry into the market which puts tremendous pressure on price. There are no substantial barriers to entry, prices go down until profits are close to zero. So in classical value based investment lingo, it is an industry with no competitive advantages.
The airlines industry in aggregate has never had a ROIC greater than its cost of capital over the long term (>1 yr) for the lifetime of the industry.
There were attempts to introduce artificial scarcity with loyalty programs. I used to be a more frequent flyer and still fly enough that I will pay a premium (up to a point) to get the benefits - upgrades and free-personal travel. Locking in business-traveler loyalty has long been a key to profitability in airlines.
I think our definition of profits are different. You’re referring to financial profits, ie earnings. Yes loyalty programs increase customer captivity and can enable market leaders to make marginal financial profits through some periods.
However, for investors, we care about profits from capital deployment, or returns from invested capital minus cost of capital. The marginal earnings that leading airlines generate from loyalty programs and business traveler accounts do not make up for the huge demand for capital, thus insufficient to break even the cost of capital.
Airlines lack substantial economies of scale, customer captivity, captive supply, or regulatory protections. The airline industry is a textbook case of an industry with no durable competitive advantages, thus the only performance factor is operational efficiency.
Insurance on the other hand, there are substantial economies of scale (large fixed costs and also larger insurance companies are more diversified thus less costly/risky) and high customer captivity (high switching cost, high search cost).