Friday, September 14, 2007


For the first time I can remember in a long while, an airline announced a share buy back today. Alaska Air will buy back $100 million worth of stock and will use cash on hand to make the purchase. A lot of pundits rail against share buy backs. One thought is that companies should pay dividends instead. The counter argument is that the effect for the company is the same but the buy backs give the share owners the option of collecting taxable income now or deferring the gains to a later time. The frustration about buy backs is in regard to employee stock options. Company managements are tempted to "spend" stock options like drunken sailors. As we all know, a few company CEOs now make millions of dollars per year off of company issued stock options.

Another major positive thing about company buy backs is that they show the wisdom of "holding back on capital spending". The age old problem that has created the boom and bust of the business cycle has been excessive expansion during the "good times". If the individual companies in an industry are disciplined enough to avoid cut-throat expansions, all the companies earn higher profits and the "bust phase" is muted.

The airline industry has been showing much restraint in recent years. The biggest carriers, including UAUA, AMR, DAL and NWA have all reduced capacity. Old fuel guzzling planes have been sold to fuel rich countries such as Russia.

CAL has gotten into this act and recently sold 5 planes to Russia and has reportedly been negotiating the sale of at least 10 more. CAL was the first domestic carrier to order the new, fuel efficient 787. It has also lead the way in taking other steps to reduce fuel consumption, such as installing winglets on the tips of their fleet. These winglets are similar to the air foils installed on trucks some years ago to reduce wind drag. CAL has bucked the growth trend to some extent. It has reduced its US presence but it has been expanding rapidly in the international market. The strategy of adding direct flights from US hubs to international locations has provided CAL with niche flights with no direct competition. Many a passenger would rather fly direct rather than land in a hub to connect for the second leg. The cost to CAL is lower and yet margins are higher.

With the New York area saturated with as much traffic as it can stand, CAL has added another major hub at Cincinnati, OH. The city agreed to pay $16,000,000 of the cost to upgrade facilities. CAL will grow this hub by 40% over the next several years. With new plane deliveries to begin next year and with steady world wide demand growth, CAL will add several more direct international flights. The second CAL direct flight to India will commence in October and the company is lobbying hard to start another direct flight to China.


Because CAL's earnings have been sheltered by depreciating assets and by Net Loss Carry Forwards, the company has been collecting cash, cash and more cash. To "dispose" of some of the extra cash, the company has made extra large contributions to its employee pension plan. The company just announced yet another $50,000,000 deposit. The good news for the company is that if it gets into a pinch, it will be able to stop making contributions because it is well ahead of the level of contributions required by law. Even so, the company has announce that it expects to end the quarter with over $3 billion of unrestricted cash.

With $9 billion of new planes on order, $3 billion does not seem like a lot of money but airlines often lease planes with little or no money down. It is entirely possible that Alaska Airlines has started a new trend; the share buy back may be the first of many to be announced in the industry.

Merger Mania

Time and again, merging two carriers has proven to be a difficult and unproductive task. Midwest Air was recently successful in fending off its determined suitors. NWA will own a minority stake but Midwest will remain an independent carrier. The merger of US Airways and US West is still a work in progress. Each of these carriers know how to "do things right"; it takes a lot of effort to over come the cultural biases built up over the years. Airline mergers are tough. Still, many believe consolidation is needed; perhaps not. By buying back shares with excess cash, all carriers might enjoy higher profit margins, stronger balance sheets and niche markets. It is pointless to continuously do battle to try to take over another carriers prime market. CAL is one of the carriers that defends its hubs at all cost. No matter how low a discount carrier goes, CAL is willing to match prices and still offer bonus amenities such as bonus frequent flier miles through out its extensive net work. In addition, frequent fliers can visit CAL lounges and those of its partners.

It took a few years for the "big boys" to learn how to compete with the low cost carriers. Now a days, the big boys fund small companies which can go toe to toe with the discounters. A company like Republic gets the fuel buying power of CAL, discounted costs to buy planes and yet it hires lower cost employees to operate the lines. The company signs contracts to fill the feeder flights that land just in time for connections to the major hub flights. As a result of this well planned and executed competitive strategy, companies like LUV are left to admit that they cannot grow at the same rate as they have in the past and they continue to offer employee buyouts.


Companies like LUV need the same type of "link ups" that have been made by CAL. CAL has over 250 "partnerships" with other carriers. Russians can buy one ticket all the way from the depths of Siberia through Moscow, New York (Liberty New Jersey), and to whatever final destination in the US they might choose. The various carriers share the revenues. CAL has the most sophisticated ticketing system. The most recent change permits customers to go online to make changes from one flight to the next. Depending on the circumstance, there may be an extra charge for making the change. Customers can even select seats online.


In 1995, the dollar was hitting all time record lows against other currencies. The airlines were having a tough time. Indeed the entire US economy was under pressure from a Fed Funds Rate that had been pushed to high levels. Then the FOMC cut rates. The dollar turned and climbed for the next 5 years. The airlines saw dramatic traffic growth while their fuel costs fell.

The recent free fall of the dollar combined with hints that Iran will be embargoed have sent oil prices out the roof at the same time that supplies are more than adequate to meet our needs. We are in the "shoulder season" when less and less gasoline is demanded and when refineries must make the switch to produce double the amount of heating fuel and half the amount of gasoline. The reason refineries are not buying as much raw fuel right now is because they perceive that pending slower economic growth is going to reduce demand for oil. China, which has seen its industrial production soar partly due to the rapid fall in the dollar, is about to begin a steady slow down. Substitution effects are starting to take hold. New supplies are coming on line. OPEC did not increase production out of the kindness of their hearts. Saudi Arabia spent $6 billion over the past 4 years developing a new field. Having spent the money, it made sense to sell the oil.

Ironically, both of the leading Democratic candidates for the Presidency have supported liquid coal fuel for most of their careers. John Edwards has tried to use the issue to gain support. He says that CTL technology should not be used because liquid coal throws off more hydrocarbons than does other fuels. I am starting to have fun observing the gyrations of the environmentalists. They have come to realize that bio-fuels are not nearly as environmentally friendly as they first believed and they have come to realize that sugar cane grown in Brazil is a much better source of fuel than is corn, rape seed, palm oil, soy or other northern hemisphere crops. Their actions to support bio-fuels has lead to the destruction of ever more hectares of rain forest. Clear cutting in Brazil is producing bamboo and sugar cane plantations which indeed do absorb about twice as much carbon as do rain forest but this is not "worth the price".

Eventually, CTL technology will be improved to the point that liquid coal will become a growth industry. Probably not in this cycle because the price per barrel is about to fall and because the Democratic Congress has put fear in the hearts of anyone who would consider such production. Should the Democrats pass one of their tax and spend schemes (both a carbon tax and a cap and trade system are "tax one to give to another programs", congressmen can raise lots of campaign contributions by being for or against either one of these systems), the added cost of the tax could sink otherwise profitable ventures. Ironically the drive to reach energy independence is being held back by those who express the desire to achieve this goal.

I am not fond of tax increases, but if we want to tax "pollution externalities" a straight forward carbon tax would be the best solution to the energy problem. Under this method, the fuels that pollute the most would pay the highest tax and the market would quickly figure out which fuel works the best.

Windmills, which are very resource expensive (requiring tons of concrete and steel per unit of production) might make a little more sense if they were deemed to be a low source of pollution. Of course, the problem is that some agency would have to rate them as a pollution source and the citizens of North Carolina have declared that we do not want windmills sticking up from our mountain tops. Location, location, location would be a key determinant of a windmill's pollution rating. You can see that a carbon tax would put a lot of power in the hands of some agency but again, this would be better than seeing billions spent to lobby congress.

If the tax on CTL were fixed in the law the lobbying would not surface except before the next expiration date of the "fix". In any event, the USA has enough coal to supply our energy needs for 200 years. We also have enough natural gas off our coast to supply our needs for the next 200 years. We also have enough shale oil in Colorado, Wyoming and Utah to supply our needs for the next 200 years. Canada has enough tar sand oil to supply our needs for the next 200 years. There is no shortage of energy. There is an unwillingness of Congress to legislate!

The purpose of reviewing the energy situation is to provide support for my market stance. Those who understand that the price of oil will not go up and up and up can have faith in the idea that the price of airline stocks will go up and up and up. The turn is near!