WEB EXCLUSIVE COLUMN: Airlines are commodity businesses

Tim Mak

As The Wall Street Journal reports, another two major airlines in the country filed for Chapter 11 recently.

With the latest turn of events, four of the nation’s seven largest commercial airlines are presently flying under federal bankruptcy protection. Perhaps more scary is the fact that three of them rank

among the top four largest airlines in terms of sales revenue.

From what’s happening in the airline industry, investors can truly learn some important lessons.

When the first two of the four filed for Chapter 11, the conventional wisdom was that decreased air travel post-9/11 was one of the major reasons for their trouble. And now, the conventional wisdom is that high fuel cost represents one of the factors that have contributed to Delta and Northwest’s financial problems.

And sure, other reasons cited, including and especially the so-called “legacy” costs (bloated labor and pension costs) are by no means minor. In fact, I would argue these are huge and sometimes fatal burdens the airlines (and their auto and many other industrial brethren) are shouldering.

But their root problems run much deeper than that. In the eyes of long-term investors, the commercial airline industry is just a “commodity” business.

What is a commodity business?

Commodity businesses are those whose market players find it hard to effectively differentiate themselves from their competitors even after having spent hundreds of millions of dollars on advertising. In fact, I would argue that their advertisements at best cancel each other out, and at worst make the whole industry burning hell for every player around. Think of banks’ and retailers’ ferociously aggressive advertising buys in the media.

As legendary investor Warren Buffett argues, many decades back commodity businesses meant just that: commodities like wheat, corn, steel, copper, textile and paper. But increasingly, even banking services, insurance products, autos, retail, commercial airlines, and a zillion other types of businesses, are nothing more than commodity businesses.

Commodity businesses do not necessarily have a strong emotional hold on their customers beyond that of value and price. They compete on price, or a variation of price, for example, value, or, better service, both of which of course come at a non-zero cost to the firm, so you can look at these as just two more forms of “price concessions” from the firm.

Now, when a firm competes on price, it’s in a pathetically weak position to generate any above-market return-on-equity (ROE) for its investors (and ROE, as we can’t emphasize enough, is what ultimately counts for the investor).

Because, if you can lower your price, and assume that the strategy works (for example bringing you increased sales and profits), rest assured that others will follow suit before you can even excitedly exclaim “Profits!” That’s just the nature of capitalism.

In society, we commonly observe monkey-see, monkey-do behaviors. In business, it’s monkey-see-profits, monkey-set-up-shop in your town or even right next to you or just across the street from you.

Safe to say, industrial companies and other commodity businesses are probably “good” to the final consumers, and many of them may also be “good” to their managers and workers. But to investors, they are nothing but lousy investments.

Tim Mak is a teaching fellow at the College of Business Administration and a columnist for the Daily Kent Stater. Contact him at [email protected].