Sunday, April 27, 2008


The management at CAL has long expressed its preference to remain independent. Management has often reported that airline mergers are difficult. Still, the announcement of a deal between DAL and NWA seemed to have pushed CAL into a corner, perhaps not.

Over the weekend, the management reported to the board its findings in regard to the "new airline landscape". Management recommended to remain independent and the board voted to follow the recommendation. CAL will ground 15 more of its older and less fuel efficient aircraft. The company is determined to fly only profitable routes. At the same time, smaller carries are falling like dominoes. Another "business only" carrier filed for bankruptcy this weekend. Each time a competitor falls, the higher the future bounce for the remaining carriers. Like my Great Grandpa said, the time to get into the chicken business is when others are getting out. He noted that the price of chicken feed would go down at the same time that the price of eggs would go up. Bankrupted carriers lower the amount of fuel being used while eliminating the availability of the deeply discounted alternative seat. The price of the "last seat" is the one that makes a huge difference in the profit or loss of an airline.

Perhaps, CAL is only waiting for a better deal or for a bid from UAUA. UAUA has been bleeding heavily since the last big run up in fuel costs. Analysts now estimate that UAUA will lose over $7 per share in 2008. The loss at AMR is expected to be $5.15 per share. The projected loss of $2.04 at CAL looks great relative to the others. First quarter numbers are even more lopsided, CAL lost 86 cents compared to more than $4 each for the other two. CAL is still producing positive cash flow, the airline is getting stronger while the public reads about losses. My expectation is that the loss will not be nearly so high because ticket prices have already been raised.


David Sarnoff, of NBC fame, postulated that the value of a network was proportional to the number of viewers. This broadcasting network law works for airlines as well. For example, Southwest Airlines has been the largest airline in the USA for a number of years when looked at from a market capitalization point of view. It has also been the largest in terms of passengers. The problem that LUV has is that its growth potential is close to maxing out as it is a point to point carrier. LUV really does not benefit as much from the network effect as described below. LUV is not an attractive merger candidate. The merger of DAL - NWA will dramatically increase the size of the DAL network.


Robert Metcalf, of Ethernet fame, took the Sarnoff law to a whole new level. He noted that there is a network effect in broadcasting information. The fact that a person who watches NBC TV in his home town is more likely to watch NBC while visiting another town is just a fraction of the network benefit. The value can be seen easily by considering the fax machine. One fax machine as a zero net worth. It is only when a fax machine can communicate with another that it has value and it is very valuable if it can communicate cheaply with businesses all around the world. As the number of fax machines increase, Metcalf postulated that the value of the network grows at an exponential rate. He said the value of the network is the square of the number of "nodes".


In February of 2001, David Reed posted an article in the Harvard Business Review that pointed out how great the number of new pair connections increases as a network grows. His formula for pair connections is N(N-1) divided by 2. As you can see, after N has grown to a large number, the addition of one more "node" creates a very large number of new connected pairs.

Friday, I wrote that the merger of DAL and NWA is a powerful event because of the very large number of new city pairs. The merger opens the door to 6,000 new combined routes. Assuming these two carriers can smoothly integrate numerous components (which is no easy trick), the new DAL will be a very powerful airline. This result or even the fear of it is putting all the more pressure on the weakest of its competitors. CAL is currently the strongest of the majors in several ways. It has the youngest fleet, the best relations with employees, the most extensive code sharing system and the most advanced computer technology. CAL is going to survive and then prosper. It remains to be seen if it is waiting for a better deal to be had in regard to UAUA or another carrier. My Dad was famous for walking away from a deal if he could not get his terms. It was often the case that there was a lot of movement toward his terms after he walked away.

When the DAL - NWA was announced, the CAL share price went down. The market ran from the risk that CAL would pay too much for UAUA and from the fact that oil prices hit another peak about that time. Tomorrow, there very well might be a relief rally in CAL shares. Besides, investors should remember the "mass transit effect" of higher fuel prices. In the short run, high fuel prices hurt airlines, railroads and bus lines. In the long run, the higher the price of fuel, the more sense it makes to load a truck onto a railroad flat car and for travelers to leave their cars parked.

The public has been sold a lot of upside down thinking. The public is constantly told by the media that an increase in interest rates will make bond interest rates go up. The truth is that an increase in the short term interest rate is the same as applying the brakes to the economy and a slower economy will generally lead to higher bond prices and lower long term mortgage rates. The same is true in relation to the value of the US dollar. The public is told that higher short term interest rates will strengthen the dollar but, once again, it is a question of short term or long term. In the long run, the dollar is strengthen when the economy becomes strong and the economy becomes strong after short rates act as a stimulus. It is easy to get the cart before the horse. A strong economy will result in higher short rates and a higher dollar but it is the strong economy that is pushing the rates up not the higher rates pushing up the economy. Over the past couple of weeks or so, market based short term interest rates have started to rise as has the US dollar and the price of oil. The indication is that the economy is stronger than most people think. In a strong economy the demand for air travel is going to be strong.

Folks, it is very rare for a public company to sell at an almost 50% discount to its cash in the bank when the company is producing positive cash flow quarter after quarter. You can buy CAL today at a tiny fraction of its long term value. My trust in the management has never been higher.