Occasional recessions, market crashes, and COVID-19 notwithstanding, there is little doubt that life has improved steadily in recent decades. Products and services that were once the province of the rich became widely available as living standards rose. No business better exemplified the democratization of services than the airline industry. The low-cost carriers (LCCs) were at the forefront of that movement. However, much of the progress achieved by the LCCs has now come into question. A comprehensive analysis can help investors to see where the airline industry might be headed during and after the coronavirus crisis.
The Changing Face of Air Travel
In the old days, flying was an experience in itself. Airlines primarily catered to affluent and business travelers. Flyers were a pampered lot, plied with food and wine. In those days, flights were seldom full. One could stretch out on the adjacent empty seat and enjoy forty winks in the hushed passenger cabin.
After the rise of low-cost carriers, those benefits were only available to the relatively few who traveled business or first-class. Such amenities and luxuries were nothing more than a pipe dream for the vast majority going economy class. For those travelers, flying became an unpleasant experience that had to be endured. Air travel featured overcrowded flights, inevitable delays, lengthy security procedures, noisy cabins, and few freebies.
The coronavirus pandemic brought new challenges, while strangely solving old problems. In addition to time-consuming security processes, weary air travelers had to contend with virus containment measures. Furthermore, much of the once abundant free food disappeared—perhaps temporarily—due to fear of the virus. On the other hand, those seeking more space have gotten their wish. Demand dried up, leaving most flights largely empty. What is more, social distancing guidelines could give passengers extra room for the duration of the crisis.
The Rise of Low-Cost Carriers
While many bemoaned the decline in quality, the number of complaints was not exceptionally high compared to the greater number of air travelers. That was because airfares dropped substantially after adjusting for inflation. Consumers have always known that you get what you pay for. Paying cheap fares for no-frills air travel was a bargain accepted by the majority of air travelers. Those who pined for the glamour days of flying always had the option of paying more for first-class.
Pioneers, such as Southwest Airlines Co. (LUV), ushered in mass air travel in the U.S. during the 1970s. In that same decade, the deregulation of the U.S. airline industry accelerated the widespread use of low-cost carriers. The 1978 Airline Deregulation Act partly shifted control over air travel from the government to the private sector. That led to the termination of the once all-powerful Civil Aeronautics Board (CAB) in 1984.
The CAB previously had an iron grip on critical aspects of the U.S. airline industry. It controlled the pricing of airline services, agreements between carriers, and mergers within the industry. Airlines were only able to compete on tangible factors, such as food, service quality, and cabin crew. Their hands were tied concerning the most crucial consideration for most consumers—ticket price.
The Results of Deregulation
The liberalization of the airline industry yielded spectacular results. The number of U.S. air traveler enplanements soared from 205 million in 1975 to a record 927 million by 2019. Adjusting for inflation, the average price of a domestic round-trip ticket in the U.S. fell from $566.10 in 1990 to $367.34 in 2019. That's a decline of about 35%, but the drop mostly took place between 1990 and 2005. Airlines also went from filling about 54% of seats in 1975 to using 85% of their seating capacity in 2019.
Around the World
The low-cost carrier revolution spread worldwide between 1990 and 2020. The LCCs came to Europe in the 1990s and Asia in the 2000s. Flagship national airlines still exist in most countries. Italy even renationalized Alitalia during the coronavirus crisis. Low-cost carriers had been making progress for years. However, the extreme stress of dealing with the coronavirus put their survival at stake, especially in newer markets.
Why Low-Cost Carriers Soared
The success of low-cost carriers before 2020 can be attributed to many innovations and developments since the 1970s.
The Point-To-Point Model
Many large airlines were quick to adopt the hub-and-spoke model after deregulation. In that model, a major airport becomes the hub, and other destinations become the spoke. However, LCCs abandoned that system in favor of the point-to-point model.
The hub-and-spoke system allows airlines to consolidate their passengers at the hub and then fly on to their ultimate destinations (the spokes) in smaller aircraft. That boosts the percentage of seats filled, which helps to drive down fares. Furthermore, the hub-and-spoke system increases the number of possible destinations. However, it also has some drawbacks, such as the high costs required to maintain such a complex infrastructure. The hub-and-spoke system also imposes longer travel times on customers who must transit through the hubs. Finally, it is vulnerable to cascading flight delays caused by hub congestion.
The point-to-point system, on the other hand, connects each origin and destination via nonstop flights. That provides substantial cost savings by eliminating the intermediate stop at the hub, which gets rid of costs related to hub development. The point-to-point system also reduces total travel time and enables better aircraft utilization. Limited geographical reach is the major constraint of the point-to-point model. Unfortunately, direct flights are not economically viable for many city pairs.
The higher efficiency and better fleet utilization of LCCs, coupled with less overhead, means that they could offer significant price discounts. Ticket pricing is now the biggest competitive factor for airlines. The vast majority of consumers want to reach their destinations quickly and economically. They are also willing to give up in-flight food and entertainment in pursuit of the lowest price. This drive for economy also extends to business travelers, as companies increasingly clamp down on travel costs.
The widespread adoption of ticketless travel and Internet distribution has been a boon for LCCs. It decreases the need for complex and expensive ticketing systems used by legacy airlines to handle their complicated pricing structures. Technology also reduces the industry's costly reliance on travel agents to sell airline tickets. The emergence of the Internet as the primary medium for booking tickets has dramatically increased the transparency of ticket pricing. That works in favor of the low-cost carriers because of their lower ticket prices.
A significant benefit of the point-to-point model is that LCCs can use a single fleet type. They frequently do not have much variability in passenger demand between the major city pairs that they serve. Traditional carriers often need larger planes to carry passengers between hubs, and smaller ones for flights to the spokes. The fleet uniformity of low-cost carriers leads to lower training and maintenance costs.
Several LCCs prided themselves on the high motivation levels of their employees. They motivated employees through competitive compensation, incentives like profit-sharing, and a strong corporate brand identity. Most LCCs tend to fly shorter routes too. That means employees are only away from home for a few hours, as opposed to a couple of days or longer for long-haul flights. More time at home can also be good for morale.
Impact of the Coronavirus Pandemic
First and foremost, the coronavirus means dramatically fewer flyers. According to Airlines for America, the total global number of commercial flights declined about 75% between March and May in 2020. At the same time, U.S. passenger airlines reduced flights by 74% domestically and 93% internationally. Even worse, domestic flights fell from an average of between 85 and 100 passengers to only about 10. However, the average number of passengers rebounded to around 30 by the middle of May. It was quite clear that airlines could not survive at this level.
The airlines won a $60 billion bailout from the U.S. government, saving the industry from bankruptcy. However, there were strings attached that have significant consequences for potential investors. The airlines had to agree not to make any layoffs, stock buybacks, or dividend payments. The dire situation for airline earnings was already highly unfavorable to buybacks and dividends, so no damage was done there. On the other hand, the restrictions on layoffs limit their ability to restructure to deal with a dramatically different environment. Nonetheless, the bailouts represent a significant win for the airlines and their employees.
Buffett Bails Out
Legendary investor Warren Buffett sold all his shares in the airline industry during in 2020. His holdings were in larger airlines, but that included a substantial stake in the large low-cost carrier Southwest Airlines. Buffett's company, Berkshire Hathaway, initially invested between seven and eight billion dollars in the airlines. However, Buffett sold all the shares for less, making it a rare loss for Buffett and his firm. "I don't know that three, four years from now people will fly as many passenger miles as they did last year," Buffett said. "You've got too many planes."
The New Normal?
As long as the coronavirus crisis continues, it is clear that airlines will be operating very differently. Chronic losses, dependence on subsidies, and increasing political control over operations seem to be in the cards. While the movement to reopen the economy is helpful, merely lifting lockdowns is very unlikely to restore the airline industry to its former glory. Any analysis of demand must include the fear of the coronavirus among potential leisure travelers. Furthermore, business travel could decline permanently because of the growing shift to video communications services, such as Zoom.
A Return to Normalcy?
The coronavirus crisis must eventually end, and that will bring a return to normalcy. The development of treatments, vaccines, and herd immunity all contribute to a future where the coronavirus no longer disrupts air travel. The flu pandemic following World War I was much worse by most measures. Yet, Warren Harding won in a landslide in 1920 by promising a "return to normalcy." Far from being afraid of travel, people rushed to embrace the iconic airlines founded during the 1920s. Northwest Airlines, Trans World Airlines (TWA), and Eastern Airlines all started in the 1920s.
Startup Success Stories?
The environment after the coronavirus pandemic could be extremely favorable to new firms in the low-cost carrier space. Fear of the virus is likely to decline dramatically under most scenarios, unleashing repressed demand. A recession and even a depression will not necessarily stop this process. For example, Continental Airlines was actually founded at the bottom of the Great Depression in 1932. The contraction of the airline industry promises to leave many older planes on the market and empty gates at airports. That means low startup costs for new low-cost carriers. These new LCCs in the airline industry will also be free of the massive debts and restrictive agreements with governments weighing down existing carriers. Finally, all airlines will benefit if oil prices remain low.
The Biggest LCCs in the U.S.
While startups seem likely to emerge in the future, large existing low-cost carriers have a reasonable chance of surviving the downturn in some form. If they do, their prices will hit bottom at some point. Those who take the risk with the right airline stocks at the right time stand to profit substantially. The biggest U.S. LCCs in the airline industry are listed below.
Southwest Airlines Co.
Dallas-based Southwest Airlines (LUV) began operations in 1971. It became the largest U.S. carrier in terms of originating domestic passengers boarded and also operated the world's largest fleet of Boeing aircraft. Southwest had a market capitalization of $14.1 billion as of May 15, 2020, down about 56% since the beginning of the year.
JetBlue Airways Corp.
JetBlue (JBLU), also known as "New York's Hometown Airline," commenced service in February 2000 and grew to become one of the largest U.S. passenger carriers. It focused on some of the largest U.S. travel markets. JetBlue differentiated itself by offering the most legroom in coach class, as well as free TV and broadband Internet service on its flights. It had a market capitalization of $2.2 billion as of May 15, 2020, a decline of around 56% from the start of 2020.
Spirit Airlines, Inc.
Spirit (SAVE) had operations in the U.S., Latin America, and the Caribbean. The airline's strategy was to offer an unbundled, stripped-down "Bare Fare" and make customers pay for options like baggage, seat assignments, and refreshments. Spirit had its IPO in May 2011 and had a market capitalization of just $710 million as of May 15, 2020. That represents a stunning decline of more than 80% since the beginning of the year.
Allegiant Travel Co.
Allegiant Travel (ALGT) is the parent company of Allegiant Air, which was founded in 1997. Allegiant focused on the U.S. domestic market, flying passengers from small and mid-sized cities to top holiday destinations like Las Vegas and Honolulu. Allegiant Travel had a market capitalization of $1.3 billion as of May 15, 2020, down about 57% from the start of 2020.
The Bottom Line
Whether one calls them low-cost carriers or LCCs, budget airlines were a risky investment in 2020. However, high risks sometimes give investors high returns. Fear of the coronavirus seems likely to subside, particularly among less vulnerable groups. Doctors keep developing vaccines and treatments, while more people build immunity. As that happens, investors in the surviving airlines could make impressive gains.