Why are some industries more profitable than others?
The figure to the right summarises the return on invested capital (ROIC) across numerous U.S. industries between 1992 and 2006. The average ROIC was 14.9% but there are huge variations across different industries. For example, airlines are at the bottom of the list with a ROIC of just 5.9% whilst pharmaceutical companies averaged 31.7%.
Before investing in a company it is essential that you understand the industry it is operating in and the rivalry between it and other existing competitors. The interaction of these forces plays a major hand in the profitability of each sector and could help you find companies with sustainable competitive advantages that can create market-beating returns long into the future.
A classic industry analysis article is Michael E. Porter's The Five Forces That Shape Strategy and is an essential read for all investors.
We can use these five forces to conduct a simplified analysis of the airline industry to show why it is one of the least profitable industries in existence.
1. Rivalry among existing competitors (High)
The competition between existing airlines is fierce and the margins are low.
Richard Branson once stated that "If you want to be a millionaire, start with a billion dollars and launch a new airline."
2. Threat of New Entrants (High)
New players enter, and exit, the airline industry constantly. The globalisation of airlines and the recent expansion of low cost carriers creates fierce competition.
3. Bargaining Power of Buyers (High)
The majority of airline customers will search for the cheapest fare regardless of the carrier.
4. The Threat of Substitute Products or Services (Medium)
Depending on the country, substitutes including trains and cars are readily available however many domestic and international trips will require air transportation.
5. Bargaining Power of Suppliers (High)
Boeing and Airbus supply the majority of commercial aircraft to the airline industry. Although the competition between these two giants is fierce, with no other substitutes available they achieve healthy margins and have bargaining power over the industry.
This framework can be applied in more detail to any company and industry you are considering investing in. The analysis will help you identify potential strengths and weaknesses of the company and provide additional confidence in your investment decision.
Conclusion
After analysing Porter's five forces it is easy to understand why Qantas Airways Limited (ASX: QAN) has an average return on capital of just 5.8% over the past ten years. Qantas, along with most other airlines, has almost no competitive advantages that will increase its profitability and ensure its survival in the future. To make matters worse, it operates in a cut-throat industry where the rivalry among existing competitors is fierce and customers exhibit minimal loyalty, usually taking the cheapest fare available.
In the long term Qantas looks unlikely to provide investors market-beating returns, as evidenced by the average total shareholder return of just 2.3% over the past ten years.
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