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Common Stocks and Common Sense by Edgar Wachenheim III

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12 SOUTHWEST AIRLINES

August 2012. Josh was smiling broadly as he entered my office and said: “I have an idea that you will have a hard time liking. In fact, you will hate it. You might end up throwing me out of your office—forever. My idea is an airline. It is Southwest Airlines.”

Josh was correct. I knew that the airlines were a terrible business. Among the worst. When an airplane flies from one city to another, the labor, fuel, and other costs of operating the plane are almost the same whether the plane is 100 percent filled with paying passengers, or 50 percent filled, or empty. Therefore, airlines have particularly large financial incentives to fill as many seats as possible. Because many passengers will choose a flight solely based on the price of the ticket, airlines historically try to fill seats by offering the lowest prices. The result has been severe price competition between airlines—in fact, destructive price competition. So destructive that the aggregate profits of the airline industry since the days of the Wright Brothers have been almost nonexistent.

Furthermore, the airline business is highly capital intensive because airplanes are expensive to purchase or lease. With low or no profits, most airlines have needed to borrow heavily to purchase aircraft, and thus most have balance sheets that are highly leveraged with debt or lease obligations.

During periods of weakness, many airlines have been unable to service their high debt loads or lease obligations and ...

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