69: Keeping Analysis Simple: An Example From The Airline Industry
What's the new cruising altitude for returns on capital in airlines?
Stephen Clapham, who wrote the book “The Smart Money Method” writes Behind the Balance Sheet on Substack. I thought his most recent post on the airline industry (link and excerpts below) was a good reminder to keep it simple when it comes to investing.
Even a simple industry like airlines can seem daunting when you crack open the 10K. Delta Airlines’s most recent 10K, for example, runs to 120 pages. Opening that document you might be tempted to run away and hide (or worse, turn on Jim Cramer).
The airline business is super simple at its heart: moving “stuff” (people, and/or cargo) from Point A to Point B. Getting that accomplished takes capital. Clapham cites a Bloomberg article and estimates that it takes $3 of capital to generate $1 in revenue. To earn a decent return on capital it seems obvious that pretty high margins are required. To earn 10% on $3 means you need to earn $0.30. On $1 revenue that’s a 30% margin. Yikes!
I’ll admit up front I don’t know the airline industry, I haven’t studied it in-depth or over time. I did some back-of-the-envelope math on Delta (DAL) and found that in 2021 it had capital employed of about $38 billion and generated revenues of $30 billion. So its capital/revenue was about $1.25. DAL earned $1.9 billion pre-tax, or a margin of 6.3%. Dividing margin by capital/revenue we get a pre-tax return on capital of 5%.
Now, 2021 was impacted by the pandemic. If DAL earned the same 14% margin it did in 2019, ROC would be 11.2%.
The point isn’t necessarily the math, although I do include it to serve as a framework. What’s most important are the operations and economics behind the numbers:
Will margins get back to 2019 levels? What might cause that to happen? What might prevent it?
Could high fuel prices dampen demand, and therefore reduce capital turnover?
What might cause the industry to require more or less capital?
What will competition do, and how will that affect revenues and/or margins?
From listening to Buffett talk about airlines and doing some very limited reading on the industry I know it basically all comes down to cost per seat mile. Southwest did so well for so long because they focused on being the low-cost provider. In a commodity industry that’s rule #1. (And even then it’s no guarantee of success.)
This is getting long but I hope it was instructive. Here’s a link to Stephen’s original post and an excerpt from it.
But this simple example cited in the magazine article tells you all you need to know about investing in the airline industry – if it takes $3 of direct fixed assets to generate $1 of sales and those sales are not super high-margin, super long-lived, or sticky subscription income, chances are it’s not a very good business.
Many new investors trying to educate themselves and improve their skills give up early because they find the financials daunting and accounting confusing. It doesn’t need to be that way. All you need to do is use your common sense. If you own a stock for the long term, then as Warren Buffett’s business partner Charlie Munger said, the most important element is the return on capital employed:
"Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return—even if you originally buy it at a huge discount.”
More importantly...
“Conversely, if a business earns 18 per cent on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with one hell of a result.”