David Kuo: Shares fly on a wing and a prayer

Investment Insider: Investors need a leap of faith to put their money into airlines – even national carriers

Richard Branson once quipped that the best way to become a millionaire is to start out a billionaire then go buy an airline.

Warren Buffett said something similar. In his annual letter to Berkshire Hathaway shareholders in 2008, he wrote that the worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. He said an airline's durable competitive advantage has proven elusive ever since the days of the Wright brothers. He mused that if a far-sighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favour by shooting Orville down.

We don't have to go quite that far, but as investors it is worth heeding the danger signs emitted regularly by airlines. Just consider the airlines that have faced financial ruin over the years. They include Pan Am, US Airways, Air Canada, Delta Air Lines, Japan Airlines, Swissair, Sky Europe and XL Airways. It doesn't matter whether you are a large flag carrier or a small-time operator, the same rules apply.

The issue is high operational gearing, which is another way of saying that airlines need to fill as many seats on each flight as possible simply to recover the high overheads. Once they have succeeded in doing this, then even very small improvements to turnover can provide a huge boost to profits. It is worth bearing in mind, though, that high operational gearing is a double-edged sword: any deterioration in sales can swiftly wipe out profits, too.

Low-cost operators have long since identified operational gearing as the main culprit that undermines any airline's performance. So, to avoid the pitfall, budget operators have worked hard at keeping a lid on costs, almost to the point of being unpleasantly frugal. They also aim to fill their planes as near as possible to capacity, even if it means selling tickets at seemingly giveaway prices.

However, the latest caution from the airline industry association IATA is a chilling reminder that the fortunes of some airlines may only be hanging by a thread. It said airline profits, which were set to total some £18bn in the three years through to 2012, may be unsustainable. It appears that overcapacity and impending regulatory costs concerning pollution could weigh on margins.

IATA also pointed out that an economic slowdown could see airline profits slump by more than 30 per cent. In an even more distressing revelation, it said the industry has lost money in seven of the past ten years even as global sales doubled to almost £340bn.

The shock waves sent shudders through AMR Corporation, which owns American Airlines. Shares in AMR, which has lost 70 per cent of its value this year, slumped further last week on worries that it may be forced to seek bankruptcy protection. Flybe, Europe's biggest regional airline, tumbled by over 30 per cent last week after it missed first-half revenue targets. The shares are down almost 80 per cent since flotation last December. Elsewhere, Lufthansa could not even provide a profit estimate for the full year. The best it could do was to say that operating profit would be at the "upper end of the three-digit-million-euro range".

There is too much capacity, which in turn means that yields are too low for operators to make money. However, this has not stopped Sir Stelios Haji-Ioannou, the founder of easyJet, from revealing plans for a new airline, FastJet. Whether this will take off remains to be seen. On the face of it, there appears be little merit in another airline. But this is an industry that is wrapped up in misguided entrepreneurial spirit and national pride. And we all know what comes after pride. Investors should beware that airlines can be a long-fall flight.

David Kuo is director of financial advice site fool.co.uk

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