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The Wealth-Destroying Nature of the Airline Industry
Vaughn Cordle, CFA / January 23, 2008
Big airline Investors like the potential returns of airline stocks given lower oil prices and the possibility
of asset spins and/or consolidation. However, share prices may be above intrinsic values of a status
quo scenario. In other words, market prices reflect a certain probability that mergers or asset sales
will happen. No mergers or asset spins, airline shares could continue to fall.
Our top pick in 2007, and the most profitable North American airline, Canada’s WestJet airlines, is
firing on all cylinders. The stock increased in value 50% over the last year even as the AMEX airline
index fell by 50% and the broader market was flat. A spike up if fuel costs and the prospects of a
recession has resulted in a flight to quality. Cyclical airline stocks are not a safe place to be right
before the economy tanks.
The US airline industry is weak and unfit for long term investment because there is too much
competition. The intensity of the US airline rivalry is high and yields too low for it to earn the cost of
capital. Canada’s Westjet Airline, on the other hand, only has one real competitor, Air Canada. This is
why, in large measure, Westjet is so successful. It should be noted that Air Canada’s cost per seat
mile is 35% higher than WestJet’s.
Even the best U.S. airline management team will not earn capital costs in this type of hyper-
competitive environment. Airlines in high oil price and weak economic environment typically do not
earn adequate profits, have the balance sheet strength, or the workforce culture to fire on all cylinders.
Southwest’s market value has fallen from $16 billion in 2000 to $8.7 billion today. It has to buy back
shares to prop up a share price that would otherwise continue to fall. Moreover, the bulk of its
profitability is from fuel hedge benefits, not from operations. JetBlue’s share price has fallen over 70%
and it took a 19% equity investment by Germany’s Lufthansa to stabilize the company with needed
capital.
We have made the valuation case for mergers, but this is much different than saying mergers will
succeed, or are the best solution over the longer term. If done right, mergers can reduce capacity,
enhance profitability, and increase share prices. This potential is what drives current investments in
airlines and any post-merger value must be measured against the status quo [lower than current
prices] value. Labor costs will gap up at some point after any big merger and this is why post-merger
market values will not hold up over time. Hence, the short-term opportunity enables investors to exit
the investment before the share price falls. However, mergers must be viewed against the
alternatives, and some airlines are running out of options. Asset spins becomes the next best option
if oil prices stay high and the economy remains weak. This becomes a key strategic initiative to prop
up the share prices of the big network airlines before labor takes more than the airlines can afford.
Consultants, investment bankers, and airline CEO wannabes will always be able to convince dumb
money to invest in airlines. Why? Because most simply don’t understand how the industry works and
become blinded by the potential riches of a successful Initial Public Offering. MaxJet and Indy Air
provide painful lessons of dumb money buying into rosy scenario projections. However, risk takers
have to get up to bat if they are to hit a home run and capitalism is all about taking risk and reaping the
rewards of success.
Bottom Line: Until industry fundamentals change, and this will require a reduction in the number of
competitors, no U.S. airline, regardless of management or quality of the service, is fit for long term
investment. Hence, the need for consolidation, a merger or two, asset spins, or better yet, a couple of
liquidations.
Vaughn Cordle, CFA / January 23, 2008
Big airline Investors like the potential returns of airline stocks given lower oil prices and the possibility
of asset spins and/or consolidation. However, share prices may be above intrinsic values of a status
quo scenario. In other words, market prices reflect a certain probability that mergers or asset sales
will happen. No mergers or asset spins, airline shares could continue to fall.
Our top pick in 2007, and the most profitable North American airline, Canada’s WestJet airlines, is
firing on all cylinders. The stock increased in value 50% over the last year even as the AMEX airline
index fell by 50% and the broader market was flat. A spike up if fuel costs and the prospects of a
recession has resulted in a flight to quality. Cyclical airline stocks are not a safe place to be right
before the economy tanks.
The US airline industry is weak and unfit for long term investment because there is too much
competition. The intensity of the US airline rivalry is high and yields too low for it to earn the cost of
capital. Canada’s Westjet Airline, on the other hand, only has one real competitor, Air Canada. This is
why, in large measure, Westjet is so successful. It should be noted that Air Canada’s cost per seat
mile is 35% higher than WestJet’s.
Even the best U.S. airline management team will not earn capital costs in this type of hyper-
competitive environment. Airlines in high oil price and weak economic environment typically do not
earn adequate profits, have the balance sheet strength, or the workforce culture to fire on all cylinders.
Southwest’s market value has fallen from $16 billion in 2000 to $8.7 billion today. It has to buy back
shares to prop up a share price that would otherwise continue to fall. Moreover, the bulk of its
profitability is from fuel hedge benefits, not from operations. JetBlue’s share price has fallen over 70%
and it took a 19% equity investment by Germany’s Lufthansa to stabilize the company with needed
capital.
We have made the valuation case for mergers, but this is much different than saying mergers will
succeed, or are the best solution over the longer term. If done right, mergers can reduce capacity,
enhance profitability, and increase share prices. This potential is what drives current investments in
airlines and any post-merger value must be measured against the status quo [lower than current
prices] value. Labor costs will gap up at some point after any big merger and this is why post-merger
market values will not hold up over time. Hence, the short-term opportunity enables investors to exit
the investment before the share price falls. However, mergers must be viewed against the
alternatives, and some airlines are running out of options. Asset spins becomes the next best option
if oil prices stay high and the economy remains weak. This becomes a key strategic initiative to prop
up the share prices of the big network airlines before labor takes more than the airlines can afford.
Consultants, investment bankers, and airline CEO wannabes will always be able to convince dumb
money to invest in airlines. Why? Because most simply don’t understand how the industry works and
become blinded by the potential riches of a successful Initial Public Offering. MaxJet and Indy Air
provide painful lessons of dumb money buying into rosy scenario projections. However, risk takers
have to get up to bat if they are to hit a home run and capitalism is all about taking risk and reaping the
rewards of success.
Bottom Line: Until industry fundamentals change, and this will require a reduction in the number of
competitors, no U.S. airline, regardless of management or quality of the service, is fit for long term
investment. Hence, the need for consolidation, a merger or two, asset spins, or better yet, a couple of
liquidations.
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