Soaring Airline Stocks: a Leveraged Way to Fly
Airline stocks, limping along like geese with broken wings for most of the 1980s, now soar like hypersonic jets. Much of the recent stock market surge has been driven by takeover speculation in airline stocks, pulling up the transportation sector generally. Transportation stocks are heavily weighted in the Dow-Jones Industrial Average, the most closely tracked broad indicator of stock market performance.
California investor Marvin Davis’ aggressive bid for UAL, the parent company of United Airlines, hard on the heels of the Los Angeles-based Alfred A. Checchi’s takeover of NWA Inc., parent of Northwest Airlines, has been like a slug of high-test fuel in a market already turning bullish.
Last Thursday, the U.S. Transportation Department announced an investigation of airlines’ “fitness,” linking massive debt to questions of air safety.
UAL shares were coasting along in the low 100s before Davis’ $275-per-share offer. By the end of the week, reports of additional bids, by UAL pilots and British Airways at about $300 a share, had some analysts projecting prices as high as $400 before the party is over.
Most analysts expect takeover action for other airlines to heat up as well. Both USAir and American Airlines have just shored up takeover defenses in anticipation of hostile bids.
There are both good reasons and bad reasons for the surge in airlines. The good reasons--good for investors, not necessarily for travelers--relate to the airlines’ return to financial health after 10 years of frantic scrambling for position in the new era of transportation deregulation.
The bad reasons have to do with the game of financial chicken being played by the major leveraged buyout, or LBO, firms. When the big LBO game started 10 years ago, the stocks of most major corporations were grossly undervalued. LBOs woke the markets to bullish possibilities in the 1980s. With the stock market now fully priced by anybody’s measure, there are few real bargains left. But the early successes of LBOs have drawn so much money into the game that major LBO firms have to keep bidding to protect their market share and keep the fees flowing.
After the competitive free-for-all of the early 1980s, the airline industry has so sorted itself out that 90% of domestic air traffic is controlled by eight major carriers--American, United, Delta, Northwest, Continental, TWA, Pan Am and USAir. And after years of heavy losses, the industry as a whole is moving strongly into the black, although a few, like Texas Air--the owner of Continental and Eastern--and Pan Am are still ringing up losses. The healthier lines, like American and United, have managed to amass substantial cash along the way.
Airlines have reinforced their competitive positions by “hub and spoke” route alignment. Most major airports serve as “hubs” for just one or two airlines that control most of the airport’s gates. American dominates Dallas-Forth Worth, for instance, USAir has Pittsburgh and TWA is the major carrier in St. Louis. Dominating a hub allows the airline to control the routes that link up to it, dampening the competition to more “manageable” levels.
A side effect, as many critics have pointed out, is that the average passenger now has to fly much farther than used to be necessary because so many once-direct routes are now channeled through the hub. At the same time, there has been a not-so-subtle upward creep in industry fares, particularly to cities that have only single-carrier service.
The icing on the cake for takeover speculators, is, paradoxically enough, the shortage of planes. During the lean years of the early 1980s, carriers could not afford to replace their fleets and most now have hangars-full of aircraft 15 to 20 years old.
A huge rush of replacement orders have been filed over the past few years, far beyond what the airframe manufacturers can produce. Boeing, the dominant supplier, now has an $80-billion backlog in orders, stretching well into the next decade.
The pressing shortage of equipment has pumped up the resale value of older planes and the pools of capital that would ordinarily have financed new fleets are flowing into lease-backs or other refinancings of the old ones. Airlines like United--owning 80% of its $3 billion fleet outright--offer a juicy takeover target because of the opportunity to pay off buyout debt by refinancing or selling off part of the fleet.
Throw in a few other “hidden assets” like computerized reservation systems--that in theory could be sold off to specialized service companies--and you have the rosy scenario driving stock market speculation.
It is a pretty picture, and there’s a good argument that earlier in the summer, the stock price of the average airline was too heavily influenced by the lean years just past. But the question remains: How high is up? The lofty prices the buyout firms are tossing around leave no margin for error.
It’s easy to make a short list of possible horribles. Before the recent Eastern debacle, airline unions had been remarkably docile for some seven years. Unions can read financial statements as well as buyout artists. Over the next year or so, almost every airline faces major contract negotiations. The bankruptcy at Eastern, precipitated by the pilot’s strike, has probably left the unions more irritated than cowed. The lesson the unions have drawn is that they should challenge healthy airlines, not those on the verge of folding their wings.
Then there is the ever-present possibility of fuel price hikes. The oil market has been remarkably tame for an extended period. Even if supplies are assured over the long term, it’s easy to envision sharp spikes in price lasting for a year or two--creating havoc with the careful calculations of the speculators.
And finally, the fleet refinancing scenario is nine parts hope and one part experience. The fact is, no one has done it on a large enough scale to be sure there is the kind of appetite for deals that an industrywide round of LBOs will require.
The lack of breathing room built into the airline LBO offers has become characteristic of the LBO market over the past couple of years. Not surprisingly, there has been a spate of recent reports that a number of major LBOs are in trouble. LBOs were a terrific idea whose time had come--and now has gone. The high-flying prices in the airline industry are just one more sign of a cycle in the financial markets that is drawing to a close.
TAKING STOCK OF THE AIRLINES Stock prices for the first day of trading, 1989: United: 106 5/8 Closing Prices as of Sept. 1, 1989: United: 287 Stock prices for the first day of trading, 1989: American: 52 1/2 Closing Prices as of Sept. 1, 1989: American: 89 3/4 Stock prices for the first day of trading, 1989: Delta: 49 3/8 Closing Prices as of Sept. 1, 1989: Delta: 80 Stock prices for the first day of trading, 1989: Texas Air (Continental): 12 1/8 Closing Prices as of Sept. 1, 1989: Texas Air (Continental): 20 3/4 Stock prices for the first day of trading, 1989: Pan Am: 2 1/2 Closing Prices as of Sept. 1, 1989: Pan Am: 4 1/8
