Summary analysis of the dramatic consolidation in the U.S. domestic air travel market over past 30 years.

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Raji Khabbaz
March 28, 2017
Thoughts on U.S. Airline Companies’ Common Shares
On investing in airlines, Warren Buffet famously said,
“…if a farsighted capitalist had been present at Kitty Hawk, he would have done
his successors a huge favor by shooting Orville down.”
The point of his joke was that investors had poured money into airline shares for a century with
only horrible results to show for the effort. The companies’ equities were the worst of value traps,
according to him, and investors were advised to steer clear of them.
In remarkable turnaround, Buffet made a major investment in the airline sector in late
2016. At a 2017 Daily Journal meeting, Buffet’s long-time partner, Charlie Munger, shared the
following explanation on the change in view on airline stocks,
“railroads are no damn good, too many of them, truck competition.’ We were right
— it was a terrible business for about 80 years. Finally, they got down to four big
railroads, and it’s a better business. Something similar is happening in the airline
business.”
What is Munger talking about?
The railroad industry in the U.S. experienced a large amount of consolidation beginning
in 1980. This industry transformation was a result of the Staggers Rail Act of 1980, which
deregulated the American railroad industry and led to an increase in merger activity. In 1980,
there were 33 Class 1 railroads in the United States; today, there are only 7 (excluding Amtrak
which is a passenger rail company). Class 1 railroads in the U.S. are defined as having annual
revenues of $250 million or greater.
Through railroad mergers, rail-to-rail competition was reduced and railroad market
power increased. For example, today there are two major effective duopolies for grain
transportation in the U.S.; Burlington Northern Rail and Union Pacific dominate the Western
U.S. and CSX and Norfolk Southern dominate the Eastern U.S. The top four Class I railroads
account for 85% of grain and oilseed traffic in the U.S., compared to only 53% in 1980.

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And what did consolidation do for railroad stocks? Let’s look at Union Pacific’s share
price performance from the beginning of 1980 to today. Over this period, the company shares
appreciated nearly 31 times, versus a 19.5 times appreciation in the S&P 500 over the same
period. The other major U.S. railroad companies all saw similar strong share price
outperformance over the same period. That is what Munger is talking about.
In 2016, does the U.S. airline sector represent the same opportunity as the rails in 1980?
Munger said the dramatic consolidation in the airline sector reminded him of what
happened to U.S. railroads. The table below illustrates the significant transformation of the
competitive landscape in the U.S. airline sector. In 1990, there were 12 major U.S. airlines. Today,
there are 6, and the top 4 control 80% of the domestic market.
Number of Major U.S. Airlines
1990 2001 2017
American American American
TWA
U.S.
Airways
United
Continental
U.S. Airways
America
West Delta
America
West Southwest Southwest
Southwest Delta Alaska
Delta Northwest JetBlue
Northwest United
United Continental
Continental AirTran
Eastern JetBlue
Alaska Alaska
Pan Am

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According to a recent Associated Press analysis, today at 40 of the 100 biggest airports in
the U.S., a single airline flies a majority of passenger seats, compared to 34 airports ten years ago.
At 93 of the largest 100 airports, two airlines fly a majority of the seats, compared to 78 ten years
ago.
Can the commercial air travel business be as good a business as the railroads proved to be?
No, we do not think so, but it still can be very good business, following the dramatic industry
consolidation. We list some of the major differences between the railroad shipping and air travel
industries in terms of quality of business.
1) The railroads’ assets; the track and depot network, are far more valuable than airline hub
and spoke route networks. No one is going to build from scratch an entirely new national
or regional rail network. One cannot launch a low-cost railroad in the U.S. in the same
way Spirit Airlines did to provide very low cost air travel. In many markets, rails operate
as effective duopolies.
2) Railroads do face competitive pressure from the long-haul trucking industry, but their
dramatic fuel cost advantage over trucking represents a “wide moat”, giving them almost
insurmountable competitive advantages over trucking over long transport distances.
3) Oil is a lower cost factor for railroads than airlines. Historically(before the sharp collapse
in oil prices that began in September 2014), fuel costs represented 20% of railroads’ cost
structure and one-third to 40% of airlines’ cost structure. Railroads also charge a fuel
surcharge typically based on a lagging two-month index of fuel prices. The surcharges
help offset any increase in the price of fuel (they work in the different direction when fuel
prices are falling), making the rails less sensitive to changes in oil prices than the airlines.
4) Railroads do not face any competition from non-American railroad companies. Airlines
face significant competition across all their international routes. Furthermore, the
international air travel market has not consolidated as is the case with the domestic U.S.
travel market, and operates generally at lower load factors and is more competitive.
The data shows the consolidation has already dramatically improved operating performance
In 2008, U.S. airlines collectively lost $3.3 billion. In 2009, performance improved and the
industry generated $2.5 billion in profit. In 2015, the industry earned $25.6 billion. Obviously, a
major reason for the profit improvement was the sharp drop in the price of jet fuel. However,
looking beyond the change in fuel price, one sees evidence of a dramatically improved competitive
industry structure, which we believe is the byproduct of dramatic consolidation.

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Airline companies operate with a largely fixed cost structures. It costs the same to fly a
plane that is full or empty. Accordingly, small changes in load factor (the industry term for
measuring how full flights are) can produce a large impact on operating profit. In the early 2000s,
the load factor for the commercial airline sector bounced around the low 70s % level. In 2009,
industry load factor was 73%. At the end of 2016, it was 83%.
Beyond the improvement in load factors, the other sign of stronger pricing power is the
growth in non-ticket fees. After 2008, airlines unbundled their services, imposing new fees on
travelers for things like checking in baggage, changing flight reservations, in-flight food, and
access to onboard entertainment. While these changes might seem trivial, they produced billions
of dollars in new revenue for the industry.
The American Airlines and U.S. Airways merger, completed at the end of 2013, capped
off a decade or so of significant consolidation. This transformed the industry into one that now
more and more resembles other highly profitable U.S. industries that are dominated by a handful
of major players, such as the railroads, cable TV, or internet advertising.
Why have the U.S airline companies traded at such low valuations for so long? Are they value
traps?
As a general rule, we would rather pay 15x earnings for a company that should be trading
at 20x, than pay 7x for company that should be trading at 10x. The reason is the adverse selection
bias that exists when investing in companies that trade consistentlyat lowmultiples. Alowmultiple
ofearnings is veryoften an indication ofan inferior business, a heavilyleveraged capital structure,
or an extremely poor management team running the company.
While airline profitability improved significantly from the economic trough of late 2008
and early 2009, the common shares of the three largest airline companies, American Airlines,
Delta Air Lines, and United Continental Holdings, remained confined to a single digit range of
price/earnings multiples over the past three years. Today, the three companies still only trade at
9-10x consensus estimates of 2017 earnings and 8x estimates for 2018. Southwest Airlines trades
at 14x 2017 estimated earnings and at 11x 2018 estimated earnings. Compare that to the S&P
Index, which is now trading at 18x estimated 2017 earnings and 16x estimated 2018 earnings. The
low trading multiples represents a very pessimistic view of the long-term earnings potential for
the airline companies.
Examining other sectors of the market, in the current environment we find companies that
trade at single digit P/E multiples in highly cyclical businesses that are near a potential peak in
their cycle, like autos, or in businesses facing secular decline in demand, as is the case for example

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with Gilead Sciences, a pharmaceutical company facing a multi-year decline in its core Hepatitis
treatment franchise.
Could we be at a peak in demand for air travel? Is the industry facing negative demand
trends sometime in the near future? The table below, which highlights annual growth in global
passenger demand between 2005 and 2016, shows a consistent picture ofdemand growth, stronger
than U.S. GDP growth. During the economic collapse in 2009, the industry saw a relatively small
negative decline of only 1.2%, which in comparison to many other industries was remarkably
resilient. In January 2017, global passenger traffic grew by 9.6% on a year-over-year basis, the
fastest growth in 5 years. Air travel demand by historical measures is not cyclical. Rather, it has
exhibited fairly steady growth.
Year Annual Growth in Global Passenger Demand
2005 +8.9%
2006 +6.9%
2007 +7.9%
2008 +2.4%
2009 -1.2%
2010 +8.0%
2011 +6.3%
2012 +5.3%
2013 +5.2%
2014 +5.7%
2015 +7.4%
2016 +5.9%
Source: IATA
Historically, the problem with the airline business is not travel demand but price
competition.
For decades, the U.S. commercial air travel experienced frequent and aggressive price
wars that wrecked industry profitability. Between 2001 and 2011, the sector lost an incredible $51
billion. Since 1981, the industry lost money in approximately 50% of the years. Six major

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airlines went through bankruptcy between 2000 and 2010. From 1979 (this date is important for
understanding the problem) to 2014, U.S. airlines lost $35 billion. No wonder Warren Buffet
advised investors for years to stay the hell away from the sector.
Why has the industry produced such a dismal record of profit generation? The answer lies
in the complete lack of pricing power enjoyed by the airline companies. From 1978 (again the
1978-1979 period is very important to the case study of the airline business) to 2017, cumulative
consumer inflation, as measured by the CPI index, was 274%. Things that cost $1 dollar in 1978
cost on average $2.74 today. Yet, over this period, airfares in the U.S. fell 50%! Why? One word.
DEREGULATION.
More explicitly, the 1978 Airline Deregulation Act deregulated the airline industry. It
eliminated the federal government’s control over ticket prices, flight routes, and the number of
airplanes operating. It created a free market. Following passage of the Act, the number of flights
greatly increased, ticket prices fell dramatically, and passenger miles flown exploded upwards.
Before 1978, the government determined who, where, and for how much airlines could fly
passengers. With a strict limit to competition, airlines operated with an implicit guaranteed level
of profit. Those were the days of luxurious air travel, involving lavish services, such as silverware
and fine dishware. For a majority of Americans, air travel was unaffordable.
During the energy crisis of the 1970s, airfare pricing rose sharply. In response, the
government began analyzing the case for a less regulated, free market structure in the industry.
The 1978 Airline Deregulation Act was the outcome of that process. The impact of that Act was
dramatic. The number of air travel passenger has more than tripled since 1978. In 1965, less than
20% of Americans had ever flown on an airplane. Today, over 50% have flown on at least one
plane trip a year. In the mid-1970s, the minimum allowed fare for a New York City to Los Angeles
flight was $1,440 dollars. Today, you can find a ticket for the same flight for under $300.
Deregulation of the industry led to an increase in airline companies operating in U.S.,
intensive competition, and a decades long period of vicious price wars. In the words of Robert
Crandal, the former CEO of American Airlines,
“The airline business is the closest thing there is to legalized warfare.”
Will the dramatic airline industry consolidation transform coal into diamonds?
In early January 2012, American Airlines announced its interest in merging with U.S.
Airways. In December 2013, the merger was completed. The deal possibly represents that last

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major airline merger that will be allowed to occur in the U.S., and caps a 13-year period of dramatic
industry consolidation that ends with 4 major airline companies controlling roughly 80% of the
domestic air travel market.
The competitive hell (heaven if you were a passenger paying lower and lower airfares since
1978) unleashed on the domestic airline industry by deregulation should now be more and more a
thing of the past. A less competitive and more consolidated industry has emerged. This industry
transformation is what Munger referenced in explaining Berkshire Hathaway’s amazing reversal
of opinion on investing in airline stocks.
If the U.S. airline industry follows the script that the U.S. railroad industry followed after
it went through dramatic consolidation, then the airline sector could be poised to deliver superior
investment returns over the next decade, and maybe even decades. It is an intriguing possibility to
consider.
If the long-term prognosis above is correct, then when you look out 5 years, 10 years, or
more, both EPS should grow dramatically and the perception of the airline business attractiveness
should improve, resulting in much higher average trading multiples for airline company shares.
That would result in cubic appreciation, rather than just linear appreciation, in share prices. In
other words, a huge investment score.
Why have valuation multiples for airline stocks not improved more than three years after last
mega merger in the sector?
The share price performance for the four major U.S. airline companies, American Airlines,
Delta Air Lines, Southwest Airlines, and United Continental appreciated 103%, 66%, 64% and
120%, respectively, during 2014. The sector appeared to be following script similar to the one on
U.S. railroad consolidation. Ticket pricing was up. Load factors were improving, after the industry
rationalized capacity. Travel demand was strong.
Then something remarkable happened in 2015. Oil prices, which as we discussed earlier
are a major cost for airlines, dropped sharply in early 2015. A decline in oil prices typically results
in a rise in airline share prices, because the decline improves operating profitability. In 2015, the
price of West Texas Intermediate oil fell by approximately 70%. Instead of leading to strong
appreciation in the share prices of airline companies, the sector saw flat to negative share price
performance in 2015.

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There were a number of concerns in 2015 that weighed on the airlines’ shares. First,
investors assumed the sharp drop in oil prices were unsustainable, and likely to recover in
following years. In other words, the gains from the decline in oil price were only temporary. The
reason for that belief was that prices had fallen well below the assumed break-even levels for shale
drilling and offshore drilling (two areas of oil production that had largely contributed to the
dramatic increase in global oil production which caused the supply glut). Shale and offshore
production were expected on a lagging basis to sharply drop, and the subsequent and significant
reduction in oil rigs in operations proved that point.
We are not going to spend any time on the oil market in this summary discussion of the
airline industry, but we have done quite a bit of work on the sector and will address the state of the
energy market in separate research reports. Absent an unforeseen change in the supply market, we
think that it could take years for oil to get back to the $80 - $90 price level. U.S. oil production is
rising again and U.S. stockpiles of oil have, contrary to expectations, risen to new highs following
the implementation of the 1.8 million barrel per day cut by OPEC members.
Second, investors understood labor negotiations were approaching. Given the sharp
improvement in industry profitability, investors correctly assumed labor costs would rise in
following years, negatively impacting operating margins. The airline industry remains a largely
unionized industry.
However, the most important factor hurting the airline sector in 2015 (and again in 2016),
and the real key to unlocking a lasting improvement in investor perception and an upward
revaluation of the airline valuation multiples relates to the issue of industry capacity discipline and
PRASM growth. PRASM is the defined as passenger revenue for available seat miles. It is the
industry’s metric for measuring pricing on comparable basis.
In early 2015 and for most of 2016, the industry grew capacity a little bit in excess of
demand growth. Domestically available seat-miles (ASMs), a measure of industry capacity, on
U.S. airlines grew 2% in 2014. Then they jumped 5% in 2015 and 5% in 2016.

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Year-over-Year Change in Revenue
Passenger-Miles (RPMs)
Year-over-Year Change in ASMs
2014 2015 2016 2014 2015 2016
JAN 1% 4% 6% 0% 6% 5%
FEB 1% 4% 6% -1% 4% 7%
MAR 5% 4% 4% 2% 4% 6%
APR 3% 5% 5% 2% 5% 5%
MAY 3% 5% 6% 1% 6% 5%
JUN 2% 6% 6% 1% 6% 6%
JUL 4% 7% 4% 2% 6% 5%
AUG 4% 7% 3% 1% 6% 5%
SEP 4% 7% 4% 2% 5% 5%
OCT 4% 8% 3% 3% 5% 4%
NOV 2% 7% 4% 3% 6% 4%
DEC 4% 7% 3% 4% 5% 4%
Average Average Average Average Average Average
3% 6% 4% 2% 5% 5%
Source: U.S. Department of Transportation’s Bureau of Transportation Statistics
The capacity growth described above caused panic among investors. The bull case that
consolidation meant the destructive competition and price wars of the past were vanquished to
history was called into question. To the bears, it appeared as if the bad behavior had returned and
investors did not want to reenter Dante’s Inferno. As can be seen in table below which chronicles
quarterly changes in average domestic ticket pricing going back late 2013, pricing fell at
progressively worsening rates through late 2016. This resulted in a negative PRASM environment
and two years of declining industry revenue.

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Quarter Year-over-Year Change in Average
Domestic Airfare
3Q 2016 -8.8%
2Q 2016 -9.6%
1Q 2016 -7.8%
4Q 2015 -8.3%
3Q 2015 -6.2%
2Q 2015 -2.8%
1Q 2015 -1.7%
4Q 2014 +2.0%
3Q 2014 0%
2Q 2014 +2.5%
1Q 2014 +1.0%
4Q 2013 +0.3%
3Q 2013 +5.1%
Source: U.S. Department of Transportation’s Bureau of Transportation Statistics
The declining rate for average domestic ticket pricing in 2015 and 2016 (see above) appears to
support that bearish argument that nothing has changed and the industry is still prone to destructive
price wars.
We think the bearish conclusion above is likely the incorrect. First, available seat-miles
(ASMs), again the industry measure of capacity, did increase faster than revenue passenger-miles
(RPMs), the industry measure of demand, from the beginning of 2015 through the end of 2016,
but the excess growth in capacity was relatively small. Accordingly, the negative impact on
domestic load factors (see table below) was also relatively small. Average domestic load factor
was 84.5% in 2014. It rose slightly to 85.0% in 2015, and then dropped to 84.6%. That is hardly
evidence of an industry with catastrophic excess capacity growth.

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Domestic Load Factors on U.S. Airlines
2014 2015 2016
JAN 84.9% 83.8% 84.8%
FEB 84.9% 85.1% 84.5%
MAR 85.0% 85.2% 83.5%
APR 84.5% 84.3% 84.7%
MAY 84.9% 84.3% 85.2%
JUN 84.4% 84.9% 85.0%
JUL 84.6% 85.0% 84.3%
AUG 84.5% 85.3% 83.6%
SEP 84.3% 85.3% 84.9%
OCT 83.7% 85.8% 85.1%
NOV 84.1% 84.8% 85.2%
DEC 83.9% 85.7% 84.7%
Average Average Average
84.5% 85.0% 84.6%
Source: U.S. Department of Transportation’s Bureau of Transportation Statistics
Furthermore, towards the end of 2016, capacity growth slowed and supply demand came more
into balance. Is that not a sign of a far more rational industry dynamic, where excesses are
corrected and not allowed to get too far out of line.
Second, the decline in average domestic ticket prices from 2015 to 2016 needs to be
understood in the context of the sharper fall in fuel costs in percentage terms. According to the
U.S. Bureau of Transportation, the cost of a gallon of jet fuel fell 52% from $3.05 in 2013 to $1.45
in 2016. If the airline business was still a pure commodity-like business, where profit margins
remain razor thin due to excessive competition, then the dramatic improvement in operating
margins would have been largely eliminated through subsequent competitive price cutting.
In 2015, industry operating profits rose sharply due to the dramatic fall in fuel costs. Those
historically high profits fell 2016, but by a relatively small amount. Two years after the beginning
of the collapse of oil prices, industry profits were significantly above levels seen in 2014. Those
profits are expected to remain significantly above 2014 levels in 2017. If the airline industry was
a pure commodity-like industry with little to zero pricing power, the historic profits generated and
maintained over this period would have disappeared a while ago. Does that not suggest and real
and significant positive change in pricing power in the industry?

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Where are we today with respect to U.S. airline shares?
We are not making any recommendations to buy, sell, or short any individual airline
company shares or the airline sector as a whole in this report, and nothing presented in this report
should be interpreted as a recommendation of any investment action. Nor will we disclose any
portfolio positions that we currently hold. Our views and positions can and do change.
The report focuses on the dramatic consolidation of the U.S. domestic market for air travel
and related long-term implications. The report purposely avoids any real discussion or analysis of
U.S. airlines’ international markets and importance of developments in the oil market and related
impact on the jet fuel market. Both are critical factors to evaluating any investment in the sector.
With that in mind, let us look at the U.S. airline sector stock performance and flow of news since
the November 8th
presidential election last year.
Trump’s victory propelled many stock sectors upwards. That dynamic undoubtedly helped
airline shares appreciate sharply at the end of the year. Additionally, the subsequent disclosure that
Warren Buffet’s Berkshire Hathaway invested over $10 billion in the four major U.S. airline
companies added fuel to the rally in airline shares.
However, the most important development, the one that could set the stage for an extended
period of share price outperformance, was the increasing belief that domestic airline capacity
growth in 2017, in contrast to 2015 and 2016, was finally going to be restrained industry-wide and
come in at levels well below travel demand growth. This would result in improved domestic load
factors, positive PRASM performance, and positive industry revenue growth in 2017, following
two years of declines.
As we highlighted earlier in the report, capacity growth started to slow in late 2016. At the
end of last year, the four major U.S. airline companies in investor presentations and
communications all guided towards more restrained capacity growth in 2017. We will not delve
into the reasons for the restrained guidance nor the company specific guidance here. We will note
that many analysts pointed to the increase in labor costs and the belief that oil prices had bottomed
as factors encouraging capacity discipline for the purpose of improving future PRASM
performance. The end result was the consensus belief that 2017 would mark the return of revenue
growth to the industry.
That belief was greatly undermined recently with the announcement by United Continental
that they were increasing the guidance for 2017 domestic capacity growth to 3.5%-4.5% from
previous guidance of 1.5%-2.5% growth, a 200 basis points jump. United Continental added 47
flights at Chicago’s O’Hare International Airport in February, and American Airlines, which has
a major presence like United Continental at O’Hare, announced the addition of 7 flights there as
of July 5th
in response. American’s competitive response to United’s decision, as well as additional
news that Alaska Airlines, which recently acquired Virgin Pacific, is aggressively adding flights
into the California market, specifically in San Diego and the Bay Area, sparked fears that 2017
was going to another year of excessive capacity growth in the U.S. domestic air travel market.

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Some sell-side analysts have increased their assumptions for industry-wide capacity
growth and downgraded the sector. Others have argued that these decisions reflect local fights and
will not bleed out to the broader industry. They continue to expect industry-wide capacity
constraint in 2017. Separately, there are also growing concerns about the potential negative impact
on U.S. tourism resulting from a number of Trump administration travel policies.
We do not have an opinion on whose view is correct. What we have learned about the
sector is that the short-term data points can change quickly and materially. Capacity guidance does
change frequently and will continue to do so. United Continental’s recent announcement is proof
of that. The noise-to-signal ratio is just too high quarter to quarter to make it effective to connect
such short-term dots to determine whether the long-term outlook has changed.
We also know that January and February sector-wide revenue performance were weaker
than expected, and estimates for the first quarter may be too high. Share prices already fell in
response to those data points, so it is unclear what the impact of the quarterly results will be on
share prices going forward.
If the positive thesis for the long-term prognosis for the U.S. airline sector is correct, and
if exposure to international markets and oil price fluctuations are not overly negative factors, then
it seems like one could invest in the shares today or in the near future, down 10-20% or up 10-20%
and, in both cases, do quite well over the long-term. Over such a longer period, the noise fades and
the signal dominates.

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• Raji Khabbaz graduated from Berkeley and joined the Mergers and Acquisitions
Department of Morgan Stanley & Co. When Eric Gleacher left to start Gleacher & Co. he
asked Raji to join him at the new firm. Following a successful tenure there and graduation
from Harvard Business School, Raji became a founding partner of Highline Capital
Management. Following that, he founded and ran Pierce Street Capital Management before
working as Portfolio Manager at Ivory Capital. He started Silver Arrow with Gary Brode
in January, 2012.
• Gary Brode graduated from the University of Michigan and joined the Mergers and
Acquisitions Department of Morgan Stanley & Co. Following that, he joined Doug Hirsch
at Smith New Court, and was asked by Doug to join him in starting Seneca Capital. He
spent 3 years doing long/short equity investing at Brahman Capital, and then moved to
John Levin & Co. where he had investment discretion. Gary was one of the founding
partners of Akita Capital Management. He started Silver Arrow with Raji Khabbaz in
January, 2012.