Airlines Overview

Industry background

Prior to October 24, 1978, the airline industry was heavily regulated by the government which caused limited price competition and new entrants. After deregulation, start-up airlines with low fares began to take market share from legacy airlines. There are two business models: Hub and spoke, which is used by legacy airlines (UAL, DAL, AMR, LCC), and point to point, which is used by start-ups (LUV, JBLU).

Since deregulation in 1978, the airline industry has collectively lost more than $37B and has seen hundreds of bankruptcies. In between, there have been cycles when the airline industry has been very profitable (1983-1989, 1993-2000, 2006-2007, 2010-2011) but years coinciding with recessions have been very bad (1990-1992, 2001-2005, 2008-2009). This has caused airlines stocks and credits to be trading vehicles rather than investments.

There are many structural problems with the industry including:

1)      High fixed costs with variable demand

2)      Airlines add too much capacity in order to take market share

3)      Low barriers to entry cause too much competition

4)      Capital intensive with high operating and financial leverage

5)      Government over-regulates operations

6)      Exogenous shocks such as terrorism and natural disasters


The standard unit of supply is ASM (Available Seat Mile), which is defined as the number of planes times the number of seats times the number of miles flown. This is also known as capacity. Airlines can increase capacity is 4 ways:

1)      Increase utilization (each plane makes more trips)

2)      Add more seats per plane

3)      Bring back parked planes

4)      Buy new planes

ASM is a closely watched metric because if the industry increases capacity, it will most likely lead to pricing pressure, especially if capacity increases during an economic slowdown.


The measure for demand known as traffic or RPM (revenue passenger mile), calculated by the number of passengers times miles flown. Load factor is PRM/ASM (demand over supply or utilization). Yield is passenger revenue /RPM. PRASM is passenger revenue per available seat mile. RASM is total revenue per available seat mile.

Airlines individually release monthly RASM numbers for the previous month around the middle of the month. Consensus expects RASM for the industry to be up 5% in 2012. However, a slow economy could take RASM to flat in 2012.

Business travels typically account for 40-45% of traffic and 55-60% of revenues (65% for legacy airlines). Business travel tends to fluctuate with economic activity and has a short bookings window (50% made 2 weeks or less in advance) while leisure bookings have a longer lead time.

Other sources of revenues:

Cargo accounts for about 3% of revenues

Ancillary fees account for about 6% of revenues

Sales of frequently flyer miles account for about 6% of revenues

Cost structure:

Fuel costs are 33% of sales : fuel is driven by flight hours but airlines with older fleets consume more gallons per seat mile. Current brent crude price of $110 per barrel equates to about $3.10 per gallon of jet fuel.

Labor costs are 28% of sales: About 50% of U airline employees and more than 90% of airline pilots are unionized. Unlike other industries, airline union contracts do not expire, but become amendable at the end of their stated term. The existing contract remains in effect until a new contract is negotiated. Unions are not allowed to strike and management cannot impose a contract without government permission.

Capital costs are 12% of sales: These costs include depreciation, aircraft rent, and net interest expense. More airlines are leasing rather than buying partly because their large NOLs (net operating losses)  do not allow them to take advantage of the tax benefits of accelerated depreciation and partly due to lower costs and increased flexibility. Although US accounting rules do not require airlines to put most lease obligation on the balance sheet, the investing community typically capitalizes these obligations at 7x annual aircraft rent.

Maintenance costs are 8% of sales

Distribution costs are 8% or sales: This includes travel agents, reservation systems, credit card fees and advertising.

The most common measure of airline costs is CASM (Cost per available seat mile).

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