United Airlines’ December 9 bankruptcy filing came as no surprise to those who understand the airline industry, in which even America’s most successful living investor, Warren E. Buffet, could not turn a profit. Buffett once observed, “In a business selling a commodity-type product it’s impossible to be a lot smarter than your dumbest competitor.” Mr. Buffett’s investment company, Berkshire Hathaway Inc., lost money by purchasing convertible preferred stock in U.S. Air in 1989, a decision he later termed “a mistake” in his annual letter to shareholders. At the time of purchase, he told them, “We have no ability to forecast the economies of the investment banking business, the airline industry, or the paper industry.” Two years later, he observed, “At the time some of you may have doubted this confession of ignorance. Now, however, even my mother acknowledges its truth.” U.S. Air later filed for bankruptcy, one of more than 125 carriers to do so since the 1978 federal deregulation of the industry.
The economics of the airline industry are lousy even when the economy is expanding. Carriers face high capital costs (the purchase of new airplanes) and have difficulty making price increases stick. Pre-deregulation airlines were protected from competition and could pass their high capital structures on to consumers in the form of higher ticket prices. Today, they face intense competition and industry economics made worse by an economy in contraction. Seventeen carriers filed for bankruptcy during two recessions in the 1980-82 period, and 11 more went bankrupt in the 1990-91 recession. UAL, United Airlines’ parent company, followed Midway Airlines in filing for bankruptcy during the current recession. In its last quarterly report to the Securities and Exchange Commission (SEC), United’s management listed some of the challenges involved in operating an airline: “The airline business is subject to seasonal fluctuations. Additionally, beginning in 2001, the weakening U.S. economy had a significant impact on the airline industry as corporations reduced their business travel budgets and changed their travel behavior. During the first six months of 2001, the industry began experiencing significant revenue declines as a result of the decrease in business traffic.”
The September 11 terrorist attacks, the U.S. war against Afghanistan, and the impending war against Iraq have made operating an airline even more difficult. In a November 26 pre-bankruptcy SEC filing, United’s management reported, “Some factors that could significantly impact the company’s performance and financial condition include, without limitation: the economy and the demand for air travel; the effects of any hostilities or act of war (in the Middle East or elsewhere) or any terrorist attacks; the higher costs associated with new airline security directives and any other increased regulation of air carriers; the significantly higher costs of aircraft insurance coverage for future claims caused by acts of war, terrorism, sabotage, hijacking and other similar perils, and the extent to which such insurance will continue to be available; the ability to raise and the cost of financing in light of the Sept. 11 events and the possibility of any further credit downgrades to the company; the cost of crude oil and jet fuel.” Other carriers in the industry face similar challenges, according to their SEC filings, and still more bankruptcy filings are possible.
United’s ultimate fate is yet to be determined, but other carriers filing for bankruptcy have survived with a different corporate structure. U.S. bankruptcy courts have encouraged bankrupt carriers to continue operations. They can charge fares below industry costs because they do not incur the capital costs faced by solvent carriers. Herb Kelleher, CEO of Southwest Airlines, the most successful domestic airline, is reported to have observed that “Bankruptcy court for airlines has become a health spa.”
Deregulation in the past quarter-century has made air travel possible for a broader cross section of America’s middle class, and, thus, it is unlikely to be repealed. Nor are Americans likely to support government nationalization of the sector. The industry may gradually come to resemble another one with high capital costs and a falling price structure: the automotive industry. Instead of many airlines characterized by product differentiation à la Southwest, the industry may become an oligopoly.