Wednesday, December 15, 2004


My "OLD MERRILL PAL" responded with skepticism to my Delta Air (DAL) blog. I understand. The airline business is at a very low point in its history. I can't think of another product where people must accept a body search to buy the product. In my response on the blog I used a case history from USAir to show that 10 baggers are made on airline stocks if they are bought and sold at the right times.

Mr. Herring used to say that no one was going to ring a bell to tell you that a stock has hit bottom. However, us old guys know that sometimes we hear a bell near the bottom. Last night on the CNBC show Bullseye, one knowledgeable "guru" stated that the Airline business is a lousy business and it will never change! DING DONG!

Do any of us believe that the airline business is going to go away? No! Will all current airlines be profitable in 5 years? No! Will several that survive be sitting in the cat bird seat when demand exceeds supply? Yes! Which will survive? LUV will probably survive but it currently sells for as much as all the bigger airlines combined. It does not have the revenues but the stock has the price. Recheck the numbers in an earlier blog and you can see that LUV is valued at about $9 Billion more than the three bigger lines of CAL, DAL and NWAC.

I am sure my "OLD MERRILL PAL" remembers the story I've oft repeated about the time when the prime rate was at 21% and I said it was on the way to 6%. One fellow heard my statement and said I had lost my gourd. He said the prime would never fall to 6% again. I bet him $1,000 to his $10 that it would and he agreed. What a beautiful bet! I was never ever forever going to have to pay $1,000 but I visited his house the first day prime hit 6%. Anyone want to bet me that prime will never again reach 21%?

The airline business is a wonderful business. But, when a 400 seat plane flies with 100 passengers who paid $99 per seat, the revenues of $9,900 will not even pay for the fuel. On the other hand, when a 400 seat plane is sold out at an average of $399 per seat, the revenues are $159,600 per flight!

The big trouble is that the supply and demand curves shift sharply and no algorithm is good enough to maximize the utilization of assets. Sophisticated software is used but the best in the business cannot anticipate future demand or what actions the competition will take. You may remember from college economics that the problem is similar to the one farmers face. When farmers over or under produce the profits or losses swing sharply. I rotten basket of tomatoes is worth even less than an empty airline seat. The graph of several years of supply demand curves looks like a spider weaving a web to try and catch an elephant.

We are currently at one of the extremes of the pattern. Cost are being slashed, routes are being slashed, planes are parked in the desert and capital is scarce. US Air cannot even find financing while under the protection of the bankruptcy court!

Several years from now, we will have zoomed to the other extreme. The break even point will be much lower because of reduced costs and revenues will be out the roof with demand chasing supply. Regular passengers will not be searched or slowed. It will be in style to fly.

Who knows how long it will take? I may be early. I believe DAL and CAL will survive. I believe the survivors will be slow to over expand in the next up cycle. I believe the survivors will enjoy many years of good large profits but even now one should plant a seed in his mind that the time to sell the airlines is when they are making record profits.


Jack's Old Merrill Pal said...

Ok I'll buy their is blood in the street regarding the airline industry. Here is my problem.

The industry, according to far smarter people than I, has never made money. Having said that some carriers will survive and make money. The 10 bagger question is, "which one?".

I doubt any existing airline will receive a "Chyrsler Bailout" (although I was far too young to realize the details)

So now we are left with the decision process of which one.

Now I with limited resources would actually rather choose an industry with superior outlook rather than disseminate from the previously overly analyzed macro and micro data of a historically floundering industry.

Regarding Delta, it seems the bet here is the rising economy will increase seat sales faster than their debt service and fuel costs rise.

I will add one last positive bit of info; I have been looking for a quick and easy way to cash in my Delta miles before...who knows.

Jack Miller said...

My comment about USAir, posted in response to the earlier comment still says it all. A broker, my Old MERRILL PAL knows, first name Sam, told me when I bought USAir at $7 that I was crazy. He knew that Warren Buffet had recently taken a tax loss on his USAir preferred as did I. Sam would not accept the point that Buffet still owned the preferred and only wrote it down for tax purposes. Indeed, Buffett cashed out when the stock hit about $60.

Continental has been one of the best run airlines for the past decade. However, when the crazy venture capitalist gave lots of money to start ups, the legacy carriers had no choice but match prices. One new carrier received $200 million in start up capital quickly lost half. Again, the market has changed. USAir is having trouble getting financing under the protection of the bankruptcy court. GE has refinanced a lot of planes to save carriers but even this interested party has its limits. Without financing available the airlines must cut cost. Continental has asked for $500 million per year in labor savings.