Aeroholics Beware

Warren Buffett, the world’s second-richest man and perhaps its most successful investor, offered some advice to gifted management: “When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is usually the reputation of the business that remains intact.”

Make no mistake, Geoff Dixon and his team at Qantas are exceptional. It is, however, frightening to imagine what they might have achieved over the past five years had they been running a business with economics far superior to an airline. It is these economics that is the subject of this note.

About a year ago, in August 2005, when market commentators were reporting to their readers the frequency of better-than-expected profit results being released, they included in their list of businesses to be lauded and perhaps by implication, shares to be purchased, Qantas '” an airline.

I would guess that you may hesitate at owning an airline outright, if one were offered to you, so I cannot understand why there is little, if any, trepidation when it comes to buying a small piece of an airline on the stockmarket. After the aforementioned lauding and subsequent strong results, Qantas shares rallied from $3.29 to $4.29, reflecting enthusiasm for the business and its management.

Perhaps the buying was more accurately a reflection of irrational exuberance. At the time of writing, the share price is again $3 '” where it was in December 1998 '” although we do concede there are now more shares on issue!

This note argues that there may be inescapable economics driving the long-term share prices of airlines and sharemarket investors should be aware of them.

Qantas’s full-year results for 2005 were exceptional compared to its peers, but their peers are nothing to write home about and, as we will demonstrate, for a 100% owner, the 2005 result was only marginally superior to cash in the bank earning interest of 5.75%.

Geoff Dixon was appointed chief executive of Qantas in March 2001. That financial year, the company reported a profit of $419 million (let’s ignore, for now, the fact that the adoption of historical cost depreciation may be understating the cost of owning and maintaining aircraft and other equipment and machinery and so the reported accounting profit could be overstating the true economic profit. We’ll explain later).

Fast forward to 2005. Qantas reported an after-tax profit of $760 million. Qantas management has a done a sterling job of increasing profits by about $340 million in four years and increasing profits by $110 in the last year. But, while management had been working hard and succeeding, they may have been flogging a dead horse: a business with poor economics and prospects that are unlikely to change those economics.

Although profits rose, the company has also had the benefit, between 2001 and 2004, of an additional $1.8 billion of share capital: funds raised from shareholders, an additional $2.6 billion in borrowings over the same period and $750 million in retained profits. All up, the company has had the benefit of $5.5 billion in additional invested capital. Give any company an extra $5.5 billion and their profits had better go up! Management has been described as exceptional, and I would agree with that, but the economics of the business are difficult to overcome and despite all of management’s hard work, the company really has not done anything remarkable.

Suppose you personally scrape together $5.5 billion ($2.6 billion of it borrowed) between 2001 and 2004 and deposit it in the bank at 5.75% on July 1, 2004. Today you could report interest earned of $316 million '” earnings before interest and tax (EBIT) for the year ended July 30, 2005, and after deducting interest on the borrowings (at say 7%) and tax (at 30%), report $94 million after tax. To compare, give an additional $5.5 billion to Qantas '” an airline '” at July 1, 2004, and the business produced additional earnings of $110 million. Not significantly higher than cash in the bank. And according to the commentators, this is supposed to be a great investment? Cash deposited in a bank account last year generated a similar return with, arguably, significantly less risk.

That's why Warren Buffett's views are so strong on the subject of airline investments. Given the risks and hard work involved "investors" can easily come up with better investment metrics than this. As Buffett explains: “You’ve got huge fixed costs, you’ve got strong labour unions and you’ve got commodity pricing. That is not a great recipe for success. I have an 800 (free call) number now that I call if I get the urge to buy an airline stock. I call at two in the morning and I say: 'My name is Warren and I’m an aeroholic’. And then they talk me down.”

An aircraft purchased today and maintained or modified with services and parts at present prices costs considerably more than an aircraft purchased two decades ago and maintained and serviced since.

Yet accounting standards allow historical cost depreciation to provide for the expense. In 2005 Qantas reported $705 million in depreciation of aircraft, engines and spare parts. Its aircraft are depreciated over 20 years on a straight-line historical cost basis with a 0–20% residual.

The resultant profit, after inadequate expenses (historical cost depreciation) have been deducted, is therefore an accounting construct and bears little resemblance to the true economics of owning and running the business.

In the airline industry if debt and leasing arrangements have already been stretched to acceptable limits, creditors will be unlikely to keep the business on life support, as United Airlines shareholders discovered in 2004.

An alternative is to ask existing shareholders to return some of their dividends (also known as a rights issue, share purchase plan or placement) or to ask new shareholders to tip in funds through a capital raising of some description.

The shareholders will now be required to keep the company afloat by injecting further capital. It is no coincidence that airlines are monotonous in their efforts to raise fresh capital for "growth". Such growth, however, is arguably illusory and not of the profitable variety.

Airlines are a tough business: capital and labour-intensive, fiercely competitive and from which legislated protection is required and even holidays from debt repayment for some competitors as well as ultimately selling a commodity '” a product where for many, the buying decision is based on price alone. But it is not the ingredients of a sound long-term investment.

Investors, however, will not change until their advisers and market commentators start to explain the relevant facts and they will continue to buy shares in airlines, trying to pick the highs and lows in the share price (speculation) as the airlines, in turn, jockey for market share and report illusory benefits from restructures, merger synergies, staff reductions and route cancellations and embargoes, while paying dividends from borrowed funds and new capital.

• Roger Montgomery is the director of Clime Asset Management.