Warren Buffett underlines that the airline industry has an unenviable relationship between risk and return

In an excellent article in the Age this morning, Dr Raymond da Silva Rosa, Director of the WA centre for Capital Markets Research at the University of Western Australia Business School quotes Warren Buffett who famously quipped that if he had been at Kitty Hawk in 1903, the best thing he could have done for future investors would have been to shoot down Orville Wright, since the airline industry had, at least up to 1990, lost more money than it earned for equity investors.

Dr da Silva Rose goes on to say in this article reproduced from the Age that Buffett’s remarks underline that the airline industry has an unenviable relationship between risk and return. The reasons are straightforward: airlines have high fixed costs, and when demand falls below break even, it is difficult to lower those costs by selling surplus aeroplanes because of the low demand.

High fixed costs are characteristic of several industries but the airline industry is more prone to overcapacity because its air of glamour attracts more capital than justified by pure spreadsheet-based calculations.

Given these widely known facts, and that Qantas is widely acknowledged as one of the most efficiently run airlines, it is not surprising that suspicions have been aroused that the only way the private equity interests behind the current offer for the airline could justify their 33% premium is by effecting some sort of wealth transfer to themselves at the expense of the taxpayer and other stakeholders in the company — such as employees and passengers who have frequent flyer points.

A substantial part of the financial logic driving the deal almost certainly rests on wresting some benefits from taxpayers and employee groups.

The problem with citing tax breaks as a reason for objecting to the deal is that the grounds on which we could reasonably deny investment bankers access to the wonders of negative gearing while allowing them to investors in real estate are far from obvious. Similarly, if one believes that maximising shareholder value is the sine qua non of management, it is difficult to see how one can validly object to Qantas wringing even more efficiencies from its workforce.

In short, the generally accepted economic framework used to analyse financial transactions provides no basis for treating the Qantas takeover offer any differently from the many other private equity deals.

However, such are the passions excited by the airline industry that a leading national paper felt sufficiently moved by the deal to qualify its otherwise staunch support for the principle of private ownership and minimal government interference in markets by firmly proclaiming in an editorial that “we also believe markets do not exist in a moral or financial vacuum”.

Qantas CEO Geoff Dixon, having just announced one of the most selfless gestures in Australian corporate history by declaring that he would place his gains from the offer, potentially worth up to $60 million, in a charitable trust must privately despair of his chances of measuring up to the exacting ethical standards of some commentators.

Notwithstanding his fine public spiritedness, Dixon has missed the point when lashing out against those who have called for an open skies policy in the wake of the takeover offer by noting that Qantas is one of the least protected airlines in the world.

It’s probably true but there’s no sensible economic reason for Qantas to have any subsidy at all. If taxpayers in other countries feel some obscure satisfaction in underwriting international air travel, the appropriate and decent response — as Milton Friedman might have counselled — is for our tourism authorities to send them a polite “thank you” note rather than petulantly throwing up barriers to entry.

Citing other countries’ airline subsidies as a reason to restrict those airlines’ access to Australia is akin to reducing Santa’s annual flights over Australia because he’s giving out free presents. It makes no sense.

I’ve heard rumours that Santa is fictional but the gains that the hundreds of thousands employed in the tourism industry would derive from cheaper air travel to Australia brought about by an open skies policy are most certainly not.

It’s time Australia took full advantage of the peculiar economics of the airline industry and truly reaped all the promise implicit in Orville Wright’s first flight by allowing open skies.

Report by The Mole reproduced from The Age