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What Makes the Airline Industry a Tough Investment

Recently, I wrote about the level of competitive rivalry within the airline industry.

Competitive rivalry happens to be one of the elements in Porter’s Five Forces, a framework which is used to assess a business’s competitive strengths and weaknesses.

It was developed by Michael Porter, a Harvard Business School professor, and is widely taught in business schools and commonly used by analysts.

Besides competitive rivalry, I have also previously dug into two other elements: the threat of new entrants; and the bargaining power of customers.

I would like to take another step today. The next element to consider in Porter’s Five Forces framework is the bargaining power of suppliers. And, it appears to be a particularly acute problem in the airline industry as well.

Between a rock and a hard place

Prior to this, we learnt that airlines often find themselves in an intensely competitive pricing environment. This limits the top-line of the airlines.

Unfortunately, when we look at the cost side, the situation isn’t much better. It would seem that suppliers to the airlines also have unusually strong bargaining power.

This could be due to the fact that the aircraft fleets used by the industry are typically supplied by either Boeing or Airbus, making the market an effective duopoly. To add salt to the wound, the supply of engines is also dominated by a few players only like General Electric, Pratt and Whitney, and Rolls Royce.

Let’s use Singapore-based low-cost carrier Tiger Airways Holding Ltd (SGX: J7X) as an example.

The graph below shows the operating cash flows and capital expenditures of the company over the past few years.

We can use the level of capital expenditure as a proxy for the amount of cash outlay (to suppliers) needed in order for Tiger Airways to sustain its business.

Tiger FCF

Source: Morningstar

As you can see, Tiger Airways’ annual capital expenditure was consistently above operating cash flow since FY2009 (financial year ended 31 March 2009). This has resulted in the airline producing negative free cash flow over the six year period shown above.

Tiger Airways is not alone in this predicament.

Here’s the historical operating cash flows and capital expenditures for Singapore Airlines Ltd  (SGX: C6L):

image (1)

Source: Morningstar

As you can see, Singapore Airlines hasn’t done a whole lot better either.

The difficulty in earning a decent level of free cash flow may hinder the growth in share prices for both Singapore Airlines and Tiger Airways over the long-term. That’s especially so when the duo seems to have been caught between a rock (competitive rivalry) and a hard place (bargaining power of suppliers).

Foolish take away

This is not to say that investors are not able to profit from the airlines industry.

However, if the desire is to earn a profit from the industry, Foolish investors would have to be highly aware of the challenges that airlines face in their business and invest accordingly with the risks in mind.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chin Hui Leong doesn’t own shares in any companies mentioned.