Why you should avoid Qantas

Since the Wright brothers took their maiden flight more than a hundred years ago, airlines have been losing billions of dollars of investor’s money.

Warren Buffett famously said in 2001, “If capitalists had been present at Kitty Hawk when the Wright brother’s plane first took off, they should have shot it down.” He was referring to the fact that airlines are terrible businesses – for a number of reasons.

Qantas Airways (ASX: QAN) said in 2011 that it was hoping to generate returns that are greater than its cost of capital within five years. In other words, the company is going to make less money over the next five years than it costs to fund the airline’s operations. Planes are hugely expensive, costing hundreds of millions to buy, maintain and operate, making Qantas a highly capital intensive business. It’s no wonder then that the company has been forced to take on massive amounts of debt to allow it to continue operating.

Airline seats these days are virtually a commodity. If Virgin Australia (ASX: VAH) wants to charge $50 for a ticket from Sydney to Melbourne, Qantas virtually has to follow suit, or risk losing customers. And Virgin is aggressively targeting Qantas’ estimated 65% share of the domestic market, on several levels, going after Qantas’ corporate customers, its frequent flyers, and with its 60% ownership of TigerAir, is pitting that airline directly against Jetstar’s budget fares. Even regionally, Virgin took over SkyWest Airlines last year, to give it a lever to compete against QantasLink.

While CEO Alan Joyce has done a fantastic job in taking several steps to turn around the international operations, it may still be sometime before that division makes a profit. And if that profit is less than it costs the company to fund its operation, it still means the business is going backwards.

And management don’t just face internal risks that they may have some control over. There are many external risks that can affect the performance of an airline, including oil prices, exchange rates, economic cycles, aircraft prices, insurance costs, not to mention some competitors who are sovereign-backed, including Air New Zealand (ASX: AIZ), meaning they have less incentive to turn a profit.

As an example, Qantas’ fuel bill alone costs more than $4 billion each year, so a small change in oil prices or exchange rates can see costs skyrocket. To be fair, Qantas does hedge some of its exposure to oil prices and exchange rates.

Foolish takeaway

With high levels of debt, low returns on capital and a large number of risks to its business outside of management’s control, all the while selling a commodity product, Qantas is one stock Foolish investors would do well to avoid. To use another of Warren Buffett’s famous quotes, “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

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Motley Fool writer/analyst Mike King doesn’t own shares in any companies mentioned. You can follow Mike on Twitter @TMFKinga

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