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Dumb Money in the Airline industry
By Vaughn Cordle, CFA / October 2, 2005
Bob Crandall is fond of saying that there is lots of dumb money in the airline industry.
Why are money managers considered shrewd investors when they constantly lose more money
than they make in the airline industry. Are they shrewd because they have money to invest? The vast
majority of money managers under perform a simple index like the S&P500. There are smart money
managers with good track records, but not in the airline industry, at least over the longer term.
The trading that takes place in the airline industry -- especially when the airlines are close to filing
bankruptcy –is an option play, and the return distribution BI-modal.
As long as there is time left (i.e., time value), before the company wipes out equity and emerges from
bankruptcy, there is plenty of exaggerated volatility to make a quick in-and-out trade.
As I've said before, the hedge fund managers know that in some rare cases bankruptcy can be
avoided -- recall AMR - and it makes sense from their perspective to speculate on a beaten down
bankruptcy-valued stock. In these cases, the return distribution is BI-modal. In other words, either
the stock will explode up in price if the bankruptcy is avoided, or it gets wiped out. There is a low
probability of success, but the potential returns are exaggerated enough to justify the risk, at least
from a hedge fund manager's perspective.
The reason there is too much capital (capacity) in the system is because the many risks are MIS
specified in the industry. The lower the perceived risk, the lower the cost of capital and the greater
the capital available to invest.
Airline managers are not going to tell the world how to value those risks and neither are the big Wall
Street firms that sell financial services to and underwrite securities for the airlines.
On a related subject, there are 3 new business-class airlines that plan to offer service to Stansted
London. FlyFirst wants to fly from Newark and EOS and MaxJet from Kennedy. I'm quite sure that the
business plans are beautifully written with attractive projections of traffic, yields, revenue, and
cashflows. I'm also quite sure that the risk section is as underdeveloped as the projections are
overstated, and, that the discount rate used to capitalize those future cashflows is too low.
The objective for all three of these startups is to do a public IPO. This is the exit strategy where the
initial investors cash out, hopefully at inflated prices driven by the marketing promotion of the
securities underwritten by the Wall Street firms that they employ.
The Atlantic market is going to heat up competitively speaking. The 39 or so competitors in the
market are not going to roll over and allow some upstarts to skim off the cream business travelers.
And as everyone and their mother moves more capacity into the higher yielding Atlantic market,
yields will fall because it takes greater fare promotions to generate traffic. Within a year or so there
will be excess capacity in the Atlantic market and there goes the attractive yields and rosy revenue
projections.
Sorry to be so cynical. I have seen too many pie-in-the-sky airline business plans and examined too
many airlines that have failed. Everyone is attracted to the business because they think they can do
a better job. Well, they can do a better job with young and cheap employees and cheap aircraft. What
they can't control is the many forces and factors that can overwhelm even a good airline product with
low costs. Management is critical, but it cannot overcome too many competitors, high fuel costs, and
bad industry fundamentals. One other thing, as soon as the big network emerge from the debt and
cost reducing restructuring, the first thing they will do is announce exciting new growth opportunities.
Lower costs get passed on to the consumer and we are back to the races again for another cycle of
the industry growing too fast for its own good.
The managers and financiers of these upstarts are going for the brass ring -- the IPO. It's a very long
shot for most if not all of these airlines. However, if they don't get up to bat, they'll never hit a home
run. And this is what capitalism and America is all about. Who knows, perhaps luck will be on their
side.
By Vaughn Cordle, CFA / October 2, 2005
Bob Crandall is fond of saying that there is lots of dumb money in the airline industry.
Why are money managers considered shrewd investors when they constantly lose more money
than they make in the airline industry. Are they shrewd because they have money to invest? The vast
majority of money managers under perform a simple index like the S&P500. There are smart money
managers with good track records, but not in the airline industry, at least over the longer term.
The trading that takes place in the airline industry -- especially when the airlines are close to filing
bankruptcy –is an option play, and the return distribution BI-modal.
As long as there is time left (i.e., time value), before the company wipes out equity and emerges from
bankruptcy, there is plenty of exaggerated volatility to make a quick in-and-out trade.
As I've said before, the hedge fund managers know that in some rare cases bankruptcy can be
avoided -- recall AMR - and it makes sense from their perspective to speculate on a beaten down
bankruptcy-valued stock. In these cases, the return distribution is BI-modal. In other words, either
the stock will explode up in price if the bankruptcy is avoided, or it gets wiped out. There is a low
probability of success, but the potential returns are exaggerated enough to justify the risk, at least
from a hedge fund manager's perspective.
The reason there is too much capital (capacity) in the system is because the many risks are MIS
specified in the industry. The lower the perceived risk, the lower the cost of capital and the greater
the capital available to invest.
Airline managers are not going to tell the world how to value those risks and neither are the big Wall
Street firms that sell financial services to and underwrite securities for the airlines.
On a related subject, there are 3 new business-class airlines that plan to offer service to Stansted
London. FlyFirst wants to fly from Newark and EOS and MaxJet from Kennedy. I'm quite sure that the
business plans are beautifully written with attractive projections of traffic, yields, revenue, and
cashflows. I'm also quite sure that the risk section is as underdeveloped as the projections are
overstated, and, that the discount rate used to capitalize those future cashflows is too low.
The objective for all three of these startups is to do a public IPO. This is the exit strategy where the
initial investors cash out, hopefully at inflated prices driven by the marketing promotion of the
securities underwritten by the Wall Street firms that they employ.
The Atlantic market is going to heat up competitively speaking. The 39 or so competitors in the
market are not going to roll over and allow some upstarts to skim off the cream business travelers.
And as everyone and their mother moves more capacity into the higher yielding Atlantic market,
yields will fall because it takes greater fare promotions to generate traffic. Within a year or so there
will be excess capacity in the Atlantic market and there goes the attractive yields and rosy revenue
projections.
Sorry to be so cynical. I have seen too many pie-in-the-sky airline business plans and examined too
many airlines that have failed. Everyone is attracted to the business because they think they can do
a better job. Well, they can do a better job with young and cheap employees and cheap aircraft. What
they can't control is the many forces and factors that can overwhelm even a good airline product with
low costs. Management is critical, but it cannot overcome too many competitors, high fuel costs, and
bad industry fundamentals. One other thing, as soon as the big network emerge from the debt and
cost reducing restructuring, the first thing they will do is announce exciting new growth opportunities.
Lower costs get passed on to the consumer and we are back to the races again for another cycle of
the industry growing too fast for its own good.
The managers and financiers of these upstarts are going for the brass ring -- the IPO. It's a very long
shot for most if not all of these airlines. However, if they don't get up to bat, they'll never hit a home
run. And this is what capitalism and America is all about. Who knows, perhaps luck will be on their
side.
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