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Excess Capacity Destroys Shareholder Wealth
By Vaughn Cordle, CFA / May 2006
It is interesting to note that the "excess capacity" concern is now been expressed by the CEO of the
largest lessor in the world, GECAS. In fact, he recently said he expects a "disconnect" between
capacity and traffic growth over the next five years, and that this could lead to an airline recession in
2008 or 2009. One might naturally ask: what happened to the recovery?
Shareholders have been churned and burned in the airline industry. Institutional investors are
starting to learn their lesson: to avoid the sector, which in turn drives up the cost of capital for the
airlines. This has the positive effect of putting a lid on capacity growth. Passenger airlines, of
course, are different from freight operators, which have significantly less competition. Many of the
hedge funds that we work with are increasingly negative about investing in airlines, and tend to look
for short opportunities or short term trades.
Poor stock returns are forcing the airlines to reduce capacity. Exhibit A: JetBlue's recent capacity
growth reduction from 30 to 20 percent. The stock price has plunged over the last three years
because of what the market perceives as "excess" growth. And let's not forget about the massive
capacity reduction that has taken place at United, US Airways, Delta, American, Northwest, and
others in the domestic market. Negative returns are forcing the reductions, and there is an inverse
correlation between unit revenue, earnings, and industry capacity.
Excess capacity is good for the consumer, but bad for the investor and labor. This will naturally lead
to a higher required rate of return for shareholders, and less equity capital to those that continue to
underperform—which, as it turns out, is the entire airline industry.
In the long run, the shareholder is the most important stakeholder and the airline industry will be
starved for this type of capital if it cannot provide the proper return. In other words, airlines must
increasingly rely on retained earnings, which must produce the appropriate risk-adjusted rate of
return. This appropriate return is a function of capital structure, and when there is not enough equity
on the balance sheet, the airline cannot grow.
Excess capacity is the primary problem for the airline industry. Moreover, the industry is too
fragmented and the entire system is inefficient.
In my view, three things could help the industry: 1) reregulation; 2) capital market discipline; and/or 3)
consolidation.
Reregulation is not going to happen, and should not happen, and the capital markets have too much
capital to invest. Consolidation makes the most sense and it has to be on a global basis if the
industry is to be properly rationalized in a way that makes investment sense.
By Vaughn Cordle, CFA / May 2006
It is interesting to note that the "excess capacity" concern is now been expressed by the CEO of the
largest lessor in the world, GECAS. In fact, he recently said he expects a "disconnect" between
capacity and traffic growth over the next five years, and that this could lead to an airline recession in
2008 or 2009. One might naturally ask: what happened to the recovery?
Shareholders have been churned and burned in the airline industry. Institutional investors are
starting to learn their lesson: to avoid the sector, which in turn drives up the cost of capital for the
airlines. This has the positive effect of putting a lid on capacity growth. Passenger airlines, of
course, are different from freight operators, which have significantly less competition. Many of the
hedge funds that we work with are increasingly negative about investing in airlines, and tend to look
for short opportunities or short term trades.
Poor stock returns are forcing the airlines to reduce capacity. Exhibit A: JetBlue's recent capacity
growth reduction from 30 to 20 percent. The stock price has plunged over the last three years
because of what the market perceives as "excess" growth. And let's not forget about the massive
capacity reduction that has taken place at United, US Airways, Delta, American, Northwest, and
others in the domestic market. Negative returns are forcing the reductions, and there is an inverse
correlation between unit revenue, earnings, and industry capacity.
Excess capacity is good for the consumer, but bad for the investor and labor. This will naturally lead
to a higher required rate of return for shareholders, and less equity capital to those that continue to
underperform—which, as it turns out, is the entire airline industry.
In the long run, the shareholder is the most important stakeholder and the airline industry will be
starved for this type of capital if it cannot provide the proper return. In other words, airlines must
increasingly rely on retained earnings, which must produce the appropriate risk-adjusted rate of
return. This appropriate return is a function of capital structure, and when there is not enough equity
on the balance sheet, the airline cannot grow.
Excess capacity is the primary problem for the airline industry. Moreover, the industry is too
fragmented and the entire system is inefficient.
In my view, three things could help the industry: 1) reregulation; 2) capital market discipline; and/or 3)
consolidation.
Reregulation is not going to happen, and should not happen, and the capital markets have too much
capital to invest. Consolidation makes the most sense and it has to be on a global basis if the
industry is to be properly rationalized in a way that makes investment sense.
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