Wednesday, February 13, 2008


Three stocks, three directions: Delta Airlines, Coke and Exxon.

The management at Delta Airlines went to the board of directors and volunteered to waive all "merger compensation". While the talks between the NWA and DAL unions are grinding along, it appears that the managements of the two airlines are ready to go. Having a deal in place with the unions is a brilliant move. The upcoming merger could be the smoothest ever between major air carriers.

In the mean time, Coke and Exxon have been pumping out the profits. Both of these companies are profit making machines. Indeed, the number one performing Dow stock for the past 30 years or so is Exxon. When making the comparison to other companies, it is assumed that one has plowed ones dividends back into the stock.


The stocks are going in three directions in regard to PE ratio. Investors often forget that the increase or decrease in the price of a stock is determined largely by the change in what the market is willing to pay for $1 worth of earnings. The current numbers are 25 per dollar for Coke, 11.5 times per dollar for Exxon and 3.2 per dollar for DAL. Now this does sound just a little bit crazy does it not. Why are investors willing to invest $25 in Coke to earn a $1 and only $11.50 in Exxon to earn a dollar when over the long haul Exxon has been the better stock to own? In the case of DAL, the company was able to shed most of its debt and dramatically reduce its operating expenses by going through the bankruptcy process last year. It is now a "lean and mean machine" so why does it only cost $3.20 to buy $1 worth of earnings?

Are the future prospects for Coke 2 times as good as the future prospects for Exxon and 8 times as good as the prospects for DAL? During the past two years, the PE ratio for KO has risen sharply, the ratio for Exxon has fallen a little and the ratio for DAL has dropped from infinity to a very low level.


The irony is that investors have been running to the "safety" of KO. For two years, there has been a constant drone among TV pundits of a pending recession. The pundits in cooperation with the actions of Bush administration and the actions of investment bankers have pushed the economy to the brink of recession. The more ominous the view of the potential recession, the more investors have crowded into the Coke shares. These crowd includes includes a ton of mutual fund managers who must stay invested in stocks of one kind or another.

Investors know that oil shares are sensitive to economic down turns and they know that airlines are super sensitive. Again, this is well reflected in the prices of the shares.


As you know, I do not believe the current slow down had to happen. It is largely the result of phony or exaggerated write downs of assets and an FOMC committee that cooperated with the profit needs of investment bankers and the political needs of politicians. The politicians continue to make moves to "solve the crisis". So, I missed the degree of down turn. Does that mean it is time to buy Coke now?

The bottom line is that the prospects for increased profits are higher for DAL than for Exxon and the prospects for increased profits by Exxon are higher than the prospects for Coke. In other words the PE's will at least be mean reverting. The current market PE is somewhere in the 14 times range. If these three companies were to maintain their current level of earnings over the next couple of years, it would be rational for the price of Coke to be cut by the ratio of 25 to 14, for Exxon's price to be increased by the ratio of 14 to 11.5 and for the price of DAL shares to be increased by the ratio of 14 to 3.2.

The neat trick is that should it become clear that the down turn is over, the PE ratios should see a flip flop. In an obviously strong economy, the most economically sensitive stock would take on the highest PE. Indeed, it is not unusual for airline PE's to soar to double the market PE during boom times.

The PE of DAL could easily move from 3.2 to 28 while the PE of Coke could easily fall from 25 to 12. In this scenario, with no change in earnings, the relative price movement would be a gain of 875% for DAL and and a loss of 52% for Coke. In my opinion, the gain of 875% for DAL is more likely than the decline of 52% for Coke.


The big difference in prospects between DAL and Exxon is the difference in demand growth. In the case of Exxon, high price of products has started to bite in two directions. Democrats like to talk about how they will create millions of new "green jobs". These jobs are coming hard and fast, no matter what the democrats do. The jobs are coming from all kinds of directions. One technology that is getting a lot of play is called pyrolysis. This is where man mimics what happened to create coal and crude oil. Big chambers are filled with the waste products of forest harvesting and "cooked at high temperatures without access to oxygen ". Several companies have improved on the process in recent years. One of the innovations is to place the "cooker" near logging sites so that the only transportation is of the bio-crude to the refinery.

Investments in competing technologies are also coming from every direction. Companies such as GM and Dupont have invested in competing methods of using bacteria to eat fibers while excreting petroleum type products. At the same time, companies such as GM and Johnson Controls have invested heavily in new battery technology. The cost to weight and power to weight ratios are falling sharply. In an amazing development, geneticist are inserting various plant DNA into E. coli bacterium to find out which is the most productive at converting fibers to natural gases. So far, one team has increased the natural rate of production of hydrogen by 147%. It is anticipated that methane production might be increased by factors greater than 10,000 percent.

The bottom line is that a demand and supply shift is in the works for Exxon. Over at DAL the supply demand shift is going the other way. International demand for air travel is growing by leaps and bounds during the economic slowdown. Once the slowdown is over, airline seats will have to be rationed in the only way the market knows how to ration. If you plan to visit China for the Olympic Games, you should buy your tickets now!