I’ll focus on Southwest and Ryanair in this post, since Dart Group, as I mentioned previously, is not a pure airline, but also has a tour operation and logistics business attached. It is really a vertically integrated tour operator, and they’ve been successful at using their seasonal Jet2 airline to provide an all-inclusive tour product to customers. However, this gives them a margin and business profile that is a bit different than most airlines, which skews comparisons. So, we’ll focus on Southwest and Ryanair, which are two of the most successful airlines over an extended period of time.
So what are the characteristics that set Southwest and Ryanair apart? As mentioned previously, both are low-cost carriers and are less levered than most airlines. Southwest was owner-operated for most of its history and Ryanair is still owner-operated. We’ll explore all of these characteristics in more depth.
It’s important to remember, for context, that airlines are a cyclical, asset-heavy, high fixed cost business. An airline needs lots of assets (airplanes) to operate, and to make returns that are sufficiently high for equity holders, these assets are typically purchased with borrowed money (either in the form of aircraft financing or operating leases). However, borrowed money adds to a company’s fixed cost base (interest payments and lease payments have to be made every year, regardless of the airline’s performance) which is problematic since airlines are cyclical. Therefore, in bad times (recessions, periods of high oil prices, pandemics), airlines have trouble servicing their fixed costs and there are lots of bankruptcies. There are, of course, other elements that make airlines a challenging business, but this is a major part.
What this means is that a large part of being a successful “compounder” in the airline industry is simply surviving – not going bankrupt in the bad times so that you have a chance to make money in the good times. And you can help these odds of survival greatly by keeping your fixed costs low, which means limiting the amount of money you borrow. It also means keeping ample liquidity on hand to help ride out bad times. We can see this clearly in the current COVID pandemic; liquidity is the name of the game right now, and every airline is struggling to raise as much cash as possible to ride out the no-revenue period.
So let’s start with investigating how Southwest and Ryanair managed their debt levels and liquidity as compared to other airlines. Before we start, I want to mention that I’ve compiled all the data in this article here so that you can check it out yourself.
Liquidity
Source: S&P CapitalIQ
We measure liquidity as cash + unencumbered assets as a percentage of revenue. Unencumbered assets are fixed assets (primarily aircraft) that the airline owns outright (all debt secured by the aircraft has been paid down). In times of crisis, these encumbered assets can be borrowed against or sold and leased back to raise liquidity, as most airlines have done recently due to COVID. A higher percentage means more liquidity.
The chart is self-explanatory. Both Southwest and Ryanair have averaged more than one standard deviation greater liquidity than the global average airline. Both airlines are widely considered to be in a much better position than the overall industry going into COVID-19.
Leverage
Leverage is difficult to measure historically, as accounting rules changed (for the better, in my opinion) in 2019 by requiring companies to show operating lease liabilities as debt on the balance sheet. Since lots of airlines lease aircraft instead of buying outright, any comparison of debt levels pre-2019 would have made airlines that lease aircraft look less levered. The change in 2019 puts all on a level playing field, so we’ll stick with comparing 2019 leverage levels and not look at historical data.
We measure leverage as the ratio of net debt (total debt - cash) to EBITDAR (earnings before interest, taxes, depreciation, amortization, and rental expense). The following is a histogram of leverage across all airlines I looked at.
Source: S&P CapitalIQ
Since it’s not visible from the histogram, Southwest has a net debt/EBITDAR ratio of 0, and Ryanair of 0.43. Both fall into the left-most two bins. In airlines, an ability to manage leverage is also an indication of an ability to properly manage growth. Often, there is a temptation for airlines to grow too fast, adding massive capacity to their networks and losing money hand over first as passenger yields drop and operating costs rise. Such overexpansion is often accompanied by a spike in leverage. Both Southwest and Ryanair, while growing nicely over the years, have avoided such costly overexpansion.
Costs
The other important factor in airlines (arguably the most important) is costs. Warren Buffett has said the following about airline costs:
“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… Eventually a fundamental rule of economics prevailed: in an unregulated commodity business, a company must lower its costs to competitive levels or face extinction.” - Berkshire Hathaway 1994 Letter to Shareholders
Historically, airlines have won and lost not based on service but on price. The lowest cost provider wins, making airlines an “unregulated commodity business”, in Buffett’s words. There are two ways we can look at Southwest and Ryanair’s costs relative to others – cost per available seat mile/kilometer (CASM/CASK, a popular unit cost measure in the industry) or net margin (if prices are fixed at levels governed by supply and demand, margins will be determined by costs).
You might argue: doesn’t service matter in airlines too? Don’t Emirates and Singapore Airlines win based on service? The problem is that it’s much easier for a high cost airline to make itself a “premium” airline by adding premium fare classes and buying bigger planes than it is for a high-cost airline to renegotiate labor costs, landing fees, etc. to become low-cost. This means that there is always more competition in the “premium” market, and new entrants have a tendency to take share by engaging in price wars. And all high-cost carriers lose in price wars, regardless of service level. As for Emirates and Singapore Airlines, my hunch is that they’ve been successful primarily by having government-sanctioned dominance at centrally located, slot constrained airports. If you don’t have such government support, your premium concept is highly vulnerable to competitive attack.
On the other hand, the lowest-cost carrier is much better equipped to survive, and even thrive, through price wars since it can make money at price levels where their competitors bleed cash. As Buffett said in reference to airlines in his 1990 shareholder letter, “in a business selling a commodity-type product, it’s impossible to be a lot smarter than your dumbest competitor”. Being the lowest cost allows you to be the “dumbest competitor” and drive everyone else out of business in the process. With that all in mind, let’s move on to the data.
The following graph shows the cost per available seat mile of all major U.S. carriers, adjusted by average flight length (cost per mile tends to be higher for shorter flights, since there are less miles to spread the overhead costs over). The data is from 1995-2018.
Source: MIT Airline Data Project
It’s a bit hard to see, but Southwest was the consistently lowest-cost U.S. carrier until 2009, when it was overtaken by Allegiant and then the other ultra low-cost carriers (Spirit, Frontier). Following deregulation in 1978, the U.S. airline industry was notoriously high-cost and inefficient, and Southwest was by far the lowest cost carrier for much of its history, giving it a phenomenal advantage.
Similar point-in-time data is available for Europe from 2014.
Source: CAPA - Center for Aviation (2014)
Ryanair is clearly the lowest cost airline in Europe on a CASK basis, followed closely by Wizz Air. The bloated cost structures of the major flag carriers (Lufthansa, Air France-KLM) is clearly visible here. Unsurprisingly, both Lufthansa and Air France-KLM both received or are about to receive massive state bailouts to deal with COVID.
Source: S&P CapitalIQ
A net margin analysis yields similar results. Ryanair has earned consistently above-average margins, and so did Southwest until the mid to late 2000s, when it lost its status as the lowest cost carrier in the U.S. Southwest’s margins picked back up above the global average in the last decade, but this coincides with the consolidation in U.S. airlines that I mentioned in my previous post.
The key takeaway is that the low-cost model is the only one that has worked consistently in airlines post-deregulation.
Growth
Companies rarely shrink their way to shareholder returns. Southwest has grown revenue 14.7% annually since IPO in 1978 (and 20.2% annually from IPO until founder Herb Kelleher’s retirement in 2001). Ryanair has grown revenue 19.8% annually since its IPO in 1997. Over time, shareholder returns generally track growth in the business.
Of course, consistent, rapid revenue growth is not possible without proper liquidity and leverage management or consistent profitability. You can’t grow if you keep going bankrupt. And as mentioned previously, in an asset heavy business like airlines, growth can destroy value if done too quickly or without attention to profitability. Growth only matters if it is combined with the other attributes discussed.
Putting it all together, the following factors distinguished Southwest and Ryanair’s success over the years:
Owner-operated
High liquidity
Low leverage
Low cost relative to others in region
Consistent growth
All of this suggests that these are the characteristics to look for in an airline investment.