Today’s businesses with different economic models cannot be necessarily assessed on the same level as yesterday’s business with yesterday’s economic models.
Approximately a 100 years ago KLM begun the first commercial aviation service for the transportation of passengers, by the 1950s the transatlantic route had become the world’s most travelled route (Burns & McDonnell, 2014).Despite multiple successes there has been many bankruptcies due to many factors with the key one being low profitability or the lack there off. (Burns & McDonnell, 2014).
In 2012 the Federal Aviation Administration (FAA) predicted the Commercial Space tourism will be worth $1 billion over the next 10 years. Since the 1980s the industry has moved from sole government operations to commercial operations starting with the launch of satellites. The industry continuous to advance and grow.
The Aviation Industry Profitability.
Buffet’s view on the value destruction by airlines over the years is correct. This has largely been driven by a number of macro and micro economic challenges that the industry has faced.
From a macro view, there are some key forces that the airlines can do very little to protect against, such as geopolitical force and oil price movement which is affected by economic growth and more importantly the Organisation of Oil Exporting Countries (OPEC).
Geopolitical risks comes in various forms and over the years we have witnessed some key examples such as the 9/11 terror attacks on the United States and the Asian swine flu pandemic.
With oil accounting for about 30% of operating cost according to the International Air Transport Association (IATA), airlines are vulnerable to oil price volatility irrespective of the hedges the industry creates to counteract sudden oil price drops.
Instability in the Middle East continuous to add to this volatility.
The micro view in the aviation industry can be summarised by the key actors determining profitability in the industry as typically framed by Porter’s five forces.
Figure 1: Porter’s Five Forces.
The fragmented nature of the industry has over time contributed to the lack of pricing power and a reduction in profitability. This lack of pricing power and differentiation in service has made it difficult to maintain sustained profitability.
Even though the industry may seem to have a high cost in capital assets, the barriers to entry has not been significant enough to discourage new entrants from entering which further fragments the industry.
The key suppliers in the industry that is the gate operators, aircraft and engine manufactures have bargained away profitability due to their strength within the industry.
Customers remain fickle and price sensitive and will not necessarily maintain brand loyalty, although in recent history airlines have tried to grow brand loyalty with frequent flier programs, loyalty has still remained a challenge. As shown in figure 2, taking a perspective from 1970, after adjusting for price inflation, airlines services have also more than halved the prices charged to customers and in the process reducing profitability (International Air Transport Association (IATA), 2013).
Figure 2: The Real Price of Air Transport (US$/RTK IN 2009$). IATA
Customers have alternatives such as using rail, road or sea. This provides an extra layer of competition for the airlines and further reduces profitability.
These macro and micro factors have made the industry one of the most vulnerable and least profitable. The industry has one of the lowest net margins with a historic average of 2.33%. According to IATA’s 2013 report the Return on Invested Capital (ROIC) has been below the Weighted Average of Cost of Capital (WACC) since 1993 showing a consistent loss of value for investors as shown in figure 3.
Figure 3: Return on Invested Capital in Airlines and their WACC. IATA
For every dollar that has been invested in airlines between 1965 and 2007 it generated 5 cents in income on average making it hardly the best choice for an investor in the long term. The question then is will the space industry be subjected to similar forces?
The Commercial Space launch Industry
Until the 1980s all space flight were done by governments. Launch using commercial companies begun to develop during this time, as there were more launches required by geostationary communication satellite operators (Sunyer, 2014). There are a hand full of countries with the capability to do this as shown below.
Figure 4: Number of successful space launches for selected actors, 1997-2013. Source OECD.
After years of development this industry has still remained small. In 2013 the revenue generated was about $2 billion. As shown in appendix 5, in 2014 there were six companies capable of launching satellites into geo stationary orbit (Organisation for Economic Co-operation and Development , 2014).
Figure 5: Launch industry revenues estimates. Source OECD
Launch demand in the next 10 years is expected to remain robust, with stable or increasing demand from governments and commercial customers driven primarily by growth in emerging economies (Organisation for Economic Co-operation and Development , 2014).
The decision by National Space and Aeronautics Administration (NASA) to retire its shuttle program has provided an opportunity for commercial launch companies to provide NASA with the service of manned launches.
NASA currently pays the Russian Federation $72 million per seat to send astronauts to the International Space Station. The current political situation has further emboldened NASA to speed up the development of the industry.
On September 16, 2014 NASA awarded contracts to The Boeing Company, $4.2 billion and Space Exploration Technologies Corp (SpaceX), $2.6 billion to transport U.S. crews to and from the space station with a goal of ending the nation’s sole reliance on Russia by 2017 (NASA, 2014).
The decision by NASA to use private companies for human and cargo transportation is going to help further develop an eco-system of suppliers within the industry.
Apart from servicing NASA and the commercial satellite industry, another segment of the market is developing in the form of space tourism which is led by Virgin Galactic and other players. Virgin has already taken down payments of $200,000 each from over 500 customers. As the companies evolve and cost reduces there will be more people interested in space tourism helping the companies to increase margins and improving profitability. In 2012 the Federal Aviation Administration (FAA) predicted this part of the industry will be worth $1 billion over the next 10 years.
By combining satellite launches, manned mission for NASA and other governments, Payload delivery to the International Space Station (ISS) and space tourism the companies in the industry can create a business model that is different from that the airlines, with different economics and better profitability.
As reported this month both Virgin Galactic and SpaceX have already started moving towards to this model. Virgin is adding satellite launch to their business in conjunction with OneWeb with 2500 satellite slots booked. Google and fidelity invested $1 billion in SpaceX to help in expanding its satellite launch business (Gapper, 2015).
A Porter’s Five Forces Analysis of the Space Industry
A comparison of the two industries using Porter’s five forces helps to establish some of the reasons the two industries are different.
The market currently has six players indicating a highly concentrated market. The size of the market at the moment appears to be adequate to accommodate these players. This will allow them to maintain pricing power which is key to profitability as opposed to the airline business which is highly fragmented.
The development and operational cost coupled with the high safety bar makes the barriers to entry high, limiting the amount of new entrants into the market, this in turn keeps the market concentrated enough to ensure profitability is not eroded.
Unlike the aircraft and engine manufactures where there are two and three dominant players respectively, there are about seventeen launch vehicle manufactures, thereby eliminating an oligopolistic situation that can bargain away profitability.
The current customer base is not as price sensitive as can be seen in the airline business. This implies pricing power can be maintained for longer. The volume of customers in the tourism business can be expected to grow as more successful flights are accomplished, because people looking for a new and unique experience are likely to pay the asking price.
At the moment the only other alternative for space travel are governments. This does not pose a threat to the industry as most government are seeking to nurture and develop the industry globally.
In reviewing both industries there are differences in the business model that may create a different outcome for the commercial space industry.
In the case of the airline industry the five forces are very strong and worked against the airlines but in the case of the space industry these forces do not appear to be strong.
In the short term development costs and lack of regular cash flow will pose a huge challenge to the industry and its profitability. But in the long run when development costs drop, launches become more regular with a reduced operational cost, the pricing power in the industry could lead to high margins and profitability.
Therefore I do not believe the industry will destroy value but rather it has the potential to generate an adequate return for investors above the industry’s WACC as the market grows. Buffet is right about the airlines but I do not believe his scepticism should carry over into space flight as there is money to be made in the industry.
Burns & McDonnell, 2014. Burns & McDonnell. [Online]
Available at: http://www.burnsmcd.com/Aviation-Special-Report/Article/Timeline-of-Comm...
[Accessed 31 December 2014].
Foy, H., 2014. Elon Musk plans next stage of space travel with reusable rockets. [Online]
Available at: http://www.ft.com/cms/s/0/918ab6d2-e7c9-11e3-9af8-00144feabdc0.html#axzz...
[Accessed 29 December 2014].
Gapper, J., 2014. Showmanship and business collide in Virgin’s space venture. [Online]
Available at: http://www.ft.com/cms/s/0/2efcfa04-6279-11e4-9838-00144feabdc0.html?site...
[Accessed 29 December 2014].
Gapper, J., 2015. Davos 2015: Richard Branson to press on with space tourism. [Online]
Available at: http://www.ft.com/cms/s/0/00c19e6e-a2df-11e4-ac1c-00144feab7de.html?site...
[Accessed 23 January 2015].
IATA, 2014. ECONOMIC PERFORMANCE OF THE AIRLINE INDUSTRY, Montreal: IATA.
International Air Transport Association (IATA), 2013. Profitability and the air transport value chain, Montreal: IATA.
Logsdon, J. M., 2014. Encyclopedia Britannica. [Online]
Available at: http://www.britannica.com/EBchecked/topic/332323/launch-vehicle/272750/C...
[Accessed 20 January 2015].
Margolis, J., 2014. Spaceports are unlikely to get off the ground. [Online]
Available at: http://www.ft.com/cms/s/0/7bccdae4-2a29-11e4-8139-00144feabdc0.html#axzz...
[Accessed 29 December 2014].
NASA, 2014. RELEASE 14-256. [Online]
Available at: http://www.nasa.gov/press/2014/september/nasa-chooses-american-companies...
[Accessed 3 January 2015].
Organisation for Economic Co-operation and Development , 2014. The Space Economy at a Glance 2014, Paris: OECD.
Sunyer, J., 2014. The new market space: billionaire investors look beyond Earth. [Online]
Available at: http://www.ft.com/cms/s/2/a441d9bc-9d65-11e3-a599-00144feab7de.html#axzz...
[Accessed 29 December 2014].
Appendix 4: Companies capable of space Launch
European Arianespace Company (the current market leader, with the Ariane 5 launcher).
The Russian Federation’s International Launch Services (Proton launcher).
The United States’ Lockheed Martin (Atlas V) and Boeing (Delta launchers).
China Great Wall (Long March launchers)
Sea Launch, an international consortium (Norway, Russian Federation, Ukraine and United States).
Space Exploration Technologies Corp SpaceX (USA).
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