Following the Morningstar approach to evaluating a company's durable competitive advantage, the airline sector is arguably one of the worst industries within the business realm. Low barriers to entry and intense competition have benefited consumers immensely, pushing down inflation-adjusted yields (ticket prices) 2% per year during the last 71 years compared with a 4% annual increase in overall inflation, according to the Air Transportation Association. As a result, the industry has experienced an astonishing number of failures, and investors have been burned often. In fact, even value investor Warren Buffett denounced the airline industry in 1999, quipping:

"I like to think that if I'd been at Kitty Hawk in 1903 when Orville Wright took off, I would have been farsighted enough, and public-spirited enough--I owed this to future capitalists--to shoot him down. I mean, Karl Marx couldn't have done as much damage to capitalists as Orville did."

Despite this negativity--admittedly supported by the recent bankruptcies of industry behemoths US Airways (NYSE:LCC - News), Delta (NYSE:DAL - News), Northwest, and United (NasdaqGS:UAUA - News)--we note that there have been a few prolonged outperformance exceptions, both in invested capital and investor returns. In this report, we will explore this outperformance, investigate what would make the airline industry (mainly legacy carriers) more profitable, and highlight a few companies that could be considered for an investor's portfolio.

Surprising Outperformance for Some Players
The airline industry is an integral part of economic activity. Based on 2006 data, the Federal Aviation Administration calculated that commercial aviation, which includes airlines and manufacturers, annually contributes approximately 5.2% ($700 billion) to the United States' gross domestic product. Furthermore, in 2008, commercial airlines' operating revenues alone accounted for 1% of GDP ($156 billion) based on data from the Bureau of Transportation Statistics. Considering this sizeable economic impact, it is clear that the airline industry is essential, and we think that the potential for respectable profitability should exist.

However, given the plethora of airline bankruptcies since deregulation in 1978, one can see that airlines as a whole have experienced suboptimal performance from a market-return and a return-on-invested-capital basis. This is evident especially in the abysmal performance in the AMEX Airline Index (Toronto:XAL.TO - News), as a $100 investment in 1992--the index's inception--would be worth a paltry $60 as of this writing compared with $249 for the same investment in the S&P 500.

That said, we've compiled the list of airlines that have actually outperformed the S&P 500 Index since their inception, measured on an annualized total return basis, which is displayed below.

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Each of these airlines is unique in its own right: Southwest (NYSE:LUV - News) perfected the low-cost business model in the United States while Ryanair has done the same in Europe. SkyWest (NasdaqGS:SKYW - News) capitalized on lucrative regional carrier contracts, where the firm receives a cost-plus reimbursement from its legacy carrier partners for connecting passengers to their hubs. Gol (NYSE:GOL - News) is akin to Southwest in Brazil with its low-cost model, but it also has benefited greatly from the massive economic expansion in South America (the Brazilian economy grew almost 2.5 times faster than the U.S. economy from 2006 through 2008 according to Central Intelligence Agency figures). Copa (NYSE:CPA - News) and Lan (NYSE:LFL - News) benefited both from the impressive growth in South America and operating efficient hub-and-spoke models in less competitive markets.

In addition to this equity outperformance--which is noteworthy considering the holding period for some of these firms includes the 2008 market collapse--we also compared the returns on invested capital delivered by these companies versus a handful of wide-moat firms within the Morningstar coverage universe. Our comparison group includes Wal-Mart (NYSE:WMT - News), Fastenal (NasdaqGS:FAST - News), FedEx (NYSE:FDX - News), CH Robinson (NasdaqGS:CHRW - News), Home Depot (NYSE:HD - News), and Caterpillar (NYSE:CAT - News), which we selected from a subset of Morningstar analysts top picks from our coverage universe.

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Surprisingly, the airline group reported higher average and median ROICs during this time span versus the comparison group. However, the higher variance for the airlines suggests that in some years the airlines earned a return that was actually below their cost of capital, while the wide-moat firms on average almost always produced results in excess of their capital costs. Even excluding outliers such as Gol (because it only has a few years of data) and CH Robinson (it is an asset-light carrier), the numbers still favor the airline sample. Nevertheless, we note that these airlines represent the industry's best operators, and that our results would look markedly worse if we included a sample of all airlines.

For instance, our airline group avoids United, Delta, US Airways, Continental (NYSE:CAL - News), and AMR (NYSE:AMR - News). Collectively, this group is referred to as legacy carriers because of their pre-1978 incorporation, but they decided to switch to the hub-and spoke business model after deregulation rather than continuing to fly point-to-point as a way to expand their networks and bolster profitability. Instead, the horrendous historical operating results and numerous bankruptcies suggest that the U.S. hub-and-spoke business model is a failed one. Including the paralyzing effects of 9/11, the legacy carriers lost $33 billion from 2001 through 2005, while point-to-point airline Southwest earned $2.5 billion during this period according to the Bureau of Transportation Statistics, illustrating the models' disparate profitability. Given this discrepancy, we've concocted methods that could improve the financial performance of the legacy carriers.

How to Improve the Legacy Carriers
In order to improve the future profitability for the airline industry, we must first dissect the root causes. We have concluded that the industry's structure is mostly responsible for its disorder, especially for the legacy carriers. Specifically, the airlines have limited buying power over the airplane manufacturers, as suppliers Boeing (NYSE:BA - News) and Airbus dominate the industry, and because there are no substitutes for a plane today, carriers are forced to accept almost any price. Additionally, airlines are subject to market-driven premiums on the price of oil, which proved to be very costly in 2008. Although research and development is increasing the potential for synthetic biofuel, it appears it is still years away from acceptance, and there is no guarantee it will become a legitimate substitute for oil.

Creating Barriers to Entry
Beyond substantial supplier power, another problem plaguing the industry is a lack of strong barriers to entry. Armed with a licensed pilot, a Boeing or Airbus plane, and a wealthy investor, the creation of a new airline can happen in short order. If the airlines were able to own the airport, however, we believe it could thwart a new entrant by either rejecting the startup's request or by raising the rental rates to a level that makes it uneconomical for new competition. Although this approach would greatly improve the supply environment for the airlines, the public domain would likely not allow this ownership structure to occur because it could create a significant monopoly. Effectively, this is the main reason that governments still have substantial control in most airports today, even in countries like Mexico and Europe that have privatized their airports.

Strengthening Ancillary Revenue Streams
Faced with rapidly ascending fuel prices and a significant reduction in premium-paying business travelers during 2008, airlines were desperate to find new ways to boost revenue while minimizing the amount of demand destruction. Thus, the industry began implementing an a la carte pricing scheme that charged passengers extra for amenities such as checking bags, food and beverage service, and pillows. Although it is too early to discern how viable this strategy will be for the long term, we believe it was paramount in staving off major airline bankruptcies. Going forward, we estimate that the checked-bag fees could deliver $2 billion in annual proceeds for the industry depending on the number of passengers that check bags. However, the impact could be mute if the new fees are coupled with lower ticket prices. Although the checked bag fees is a start, the initial fees charged (on average approximately $20 per bag) is still significantly below the rates FedEx or UPS (NYSE:UPS - News) charge for similar service. Thus, we think airlines could increase the fees even more, as the substitute method for transporting a bag is more expensive.

Restricting Food and Beverage Access on Planes
Once free, airlines have begun charging passengers for food and drinks to help expand additional revenue avenues. Still, though some restrictions apply depending on the destination, passengers are currently allowed to bring food onto the plane. If airlines could prohibit passengers via regulation to carry food on flights, it should improve the ancillary revenue stream opportunities considerably. Assuming the majority of passengers decided against eating prior to departure, the industry would benefit from a potentially larger audience--the five-year average number of annual enplanements (defined as one fare-paying passenger) was approximately 746 million according to the Bureau of Transportation. In addition, these other revenue streams would enhance profitability tremendously because the markups on these products would likely remain excessive. Although the public would negatively react to this change, this structure is analogous to the setup at every major sporting event venue or concert hall.

Consolidation
The last, and likely the most plausible, option for the legacy carriers to improve profitability is through continued consolidation. To the airlines credit, there have been a considerable number of mergers and acquisitions during the last 70 years. For example, the 2008 Northwest-Delta union is likely to have the most significant financial impact with an estimated $1 billion-$2 billion in annual synergies by 2012. The continued combination of carriers would remove duplicative costs (mostly overhead but also direct labor) while the incumbents should enjoy a greater percentage of industry revenue, which would ultimately translate into higher returns.

In the chart below, we analyzed the BTS data for general administration expenses (which we refer to as overhead) per available seat mile (ASM) for the entire airline industry versus that of the legacy carriers: Delta, United, America West (which merged with US Airways in 2007), US Airways, Northwest (which merged with Delta in 2008), Continental, and AMR.

To see the related chart, click here:

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It appears that the legacy carriers are already more inefficient than the entire industry on an ASM basis and that improving this disadvantage could bolster profitability. We calculated the cost savings by assuming that consolidation would enable the legacy carriers to achieve parity with the industry's metric, and we then multiplied this difference by the number of seat miles flown. As a result, we estimate that consolidation would have saved the legacy carries a cumulative $14 billion during the last two decades in reported overhead costs. In addition, we suspect that consolidation would be even more accretive because it would also reduce capital investment, employee training, and payroll requirements. Although regional carrier Republic Airways (NasdaqGS:RJET - News) recently acquired both Frontier and Midwest Airlines, these purchases were mostly insignificant, and we contend that large-scale consolidation needs to occur in this mature industry if it ever intends on earning its cost of capital.

Outlook for Airline Shares
Overall, until a fundamental shift occurs, we still expect that the airline industry will continue to destroy capital. Excluding the few airlines we consider to be outperformers, we believe that investing in an airline will prove unprofitable for investors. Furthermore, conviction in the long-term expectation for airlines is a courageous challenge, as daily changes in the operating environment can often have lasting effects on the long-term value of these firms because of their massive operating and financial leverage. That said, we think there are a few firms worth keeping on investors' radars, as short-term stock fluctuations could offer a decent entry point.

Republic Airways
Based on our estimates, we think Republic Airways is one of the cheapest airline stocks in our coverage universe. Although the firm is acquiring Frontier Airlines, Republic trades at roughly its premerger book value ($302 million). We think it is also attractive on a historical average P/E ratio basis, especially if Frontier continues to generate similar profitability as it has during the last nine months.

SkyWest
SkyWest has been one of the better performers in the airline industry during the last 20 years. The firm has consistently paid a quarterly dividend since 1990, and that dividend has increased at an impressive 15% annualized rate during that period. In addition, the firm has roughly $13 per share in gross cash, and the firm has been free cash-flow positive for the last 14 quarters, which convinces us that its annual dividend of $0.16 per share--roughly $9.5 million per year--should be safe.

United Airlines
Although we believe United is one of the financially weakest airlines, we think it is the most likely takeover candidate among the legacy carriers, with Continental as the possible acquirer. We think the two firms create a natural link between their networks, with each carrier strengthening the geographic reach where the other is weak. For example, United would give Continental its much-needed exposure in the western United States (via Denver and San Francisco) and Continental's Newark, N.J., hub gives United an important East Coast exposure. On the international front, United's strong Chinese presence would round out the global network between the firms, making the firm a strong global player.