Winging It?

Richard Branson, founder of Britain's Virgin Atlantic Airways, was once asked the best way to become a millionaire. “There's really nothing to it,” he joked. “Start as a billionaire and then buy an airline.”

Branson's joke must seem like gallows humor to many current airline shareholders. “The entire industry is a mess, and it's hurting carriers and shareholders alike,” says Vaughn Cordle, chief analyst for AirlineForecasts, an independent airline consulting firm in Washington, D.C. “Plunging ticket prices and skyrocketing costs are wreaking havoc among the already-troubled airlines.”

How bad are things? Industry giant United Airlines filed for bankruptcy in 2002, and rival US Airways followed suit this summer — for the second time in two years. And Delta Airlines may not be far behind.

In fact, Cordle warns of a domino effect in which all the legacy carriers, the longstanding major domestic airlines like United, Delta and American, successively file for bankruptcy to reorganize their operations and avoid further losses.

Flying Low

The damage isn't just limited to the legacy carriers, though. Low-cost airlines like JetBlue and Southwest — noted for its strong balance sheets and innovative business models — are also having trouble making ends meet. “This is the worst downturn in the industry's history,” explains Cordle, “and although it's particularly hard on the legacy airlines, it's also painful for the low-cost carriers.”

High labor costs top the list of industry problems. Employee salaries make up about 40 percent of overall airline costs. “And since these salaries are generally fixed under collective bargaining agreements, they cannot be easily reduced to offset falling revenues,” says Holly Hegeman, airline analyst and founder of PlaneBusiness Banter, a newsletter based in Covington, La.

But salaries are only the tip of the labor iceberg. Inflexible regulations and massively underfunded pension liabilities — to an industrywide tune of over $20 billion — also hamper airline operations. In fact, the pension problem is so dire United is trying to cancel its current pension plan altogether. “The legacy carriers need to fix their labor and pension problems,” says Cordle, “but they've dug themselves into such a deep hole the only way out is through bankruptcy.”

Skyrocketing fuel prices are another problem. Next to labor costs, jet fuel is the second largest airline expense, and it's almost doubled in price in the past two years. With oil prices having topped $50 per barrel, many experts doubt even a significant price decline will be enough to return the struggling legacy carriers to profitability.

While soaring fuel prices also hurt low-cost and regional airlines, several of them have used derivatives to lock in lower prices. For example, Southwest has hedged 80 percent of its fuel needs at around $25 per barrel until the end of 2005. “In contrast, since most legacy carriers are in such deep financial trouble, they can't afford to significantly hedge against higher fuel prices,” says Hegeman.

Many airlines are also buried under mountains of debt and long-term aircraft leases. American, for example, has over $22 billion in debt, while rival Delta has over $20 billion. As a result, these carriers end up with a huge chunk of operating profits going to interest expenses. This is another competitive advantage for low-cost carriers like Southwest. Since they usually have newer fleets and stronger balance sheets, they can often expand operations without incurring much new debt.

Fare Thee Well

Finally, revenues are declining sharply across the sector. “Traffic has come back from its post Sept. 11 lows,” says Cordle, “but revenues are falling because fares have plunged.” And, according to a recent Raymond James industry report, these low fares are here to stay. The report cites many reasons for this continued weakness, including Internet bargain shopping, price sensitivity among business travelers and oversupply, especially among low-cost carriers who increased capacity by 44 percent between 2000 and 2003.

So, given all this bad news, are there any bargains among the wreckage? After all, haven't many of the carriers' problems already been factored into their deflated stock prices? Not according to Cordle. He cautions the pain is far from over, especially among legacy carriers. “There's more downside ahead,” he warns, “and several more carriers will file for bankruptcy before it's over.”

Hegeman agrees. “We need to see what happens with United's bankruptcy reorganization,” she says. “If they can emerge leaner and more competitive, it will force the remaining legacy carriers to follow United's lead and seek bankruptcy protection themselves. Until that plays out, it will be hard for the airline sector to gain any traction.”

Against the Wind

While there's more airline turbulence ahead, contrarian investors — truly intrepid bottom feeders with some fun money to wager — have some options. Hegeman sees at least one airline worth owning now: Washington-based Independence Air. Independence, formerly known as Atlantic Coast Airlines, previously operated regional jets for United and Delta.

“Independence has cash in the bank, a strong balance sheet and is perfectly positioned to pick up east coast routes from US Airways if, as many expect, they never emerge from bankruptcy,” says Hegeman. “Independence is a perfect high-risk/high-reward play.”

Arne Alsin, president of Alsin Capital Management, also sees some current values among the low-cost carriers, particularly JetBlue. “JetBlue and Southwest are the two best discount carriers around,” he says, “both have strong balance sheets, low debt and sound business strategies. The difference is JetBlue is just starting to grow, while Southwest is a much more mature story.” In fact, Alsin recently added a small JetBlue position to the Turnaround Fund based on his valuation analysis.

And for those investors who are brave enough to jump into the sector despite its many problems, a quick word of advice. Fasten your seat belts, make sure to locate the nearest exit and hold on tight: It may be a very bumpy ride.

Grounded