FOOL ON THE HILL
Beware of Steel and Airlines

Having invested in both the steel and airline industries, Whitney Tilson highlights their similarities, cautions investors, and argues against government intervention to save large, failing players.

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By Whitney Tilson
September 18, 2002

I currently own a stock in the steel industry, Universal Stainless & Alloy Products (Nasdaq: USAP), and used to own one in the airline industry, Mesaba Holdings (Nasdaq: MAIR), so I have developed enough familiarity with both industries to discover remarkable similarities. In short, they're both dreadful to begin with, a situation made worse by bad management and labor decisions over many decades (such that many of the major companies are in bankruptcy, or on the verge of it).

Not surprisingly, they are appealing for government intervention to save them, which should be denied. The best solution, however painful in the short term, is to let the failed giants fade away, to be replaced by newcomers like Universal Stainless, Southwest Airlines (NYSE: LUV), and JetBlue Airways (Nasdaq: JBLU).

Investors beware, however. While the newcomers may appear to be good investments, formidable industry characteristics and irrational competitive behavior by large, desperate, failing companies can undermine even the most promising business plan. It's not a coincidence that Universal Stainless and Mesaba have been two of my worst investments ever.

Industry structure
Roger Lowenstein neatly summarized the awful characteristics of the airline industry in a brilliant New York Times Magazine article in February:

Airlines... use huge amounts of fixed capital -- wide-body jets go for $100 million each and can't be readily liquidated. They also depend on a skilled labor force. The two problems exacerbate each other. Since airlines cannot afford to let planes sit idle, they can ill suffer strikes. That makes their unions unusually powerful... Stringent safety codes strengthen the unions further by introducing a stickiness into the rules that govern hiring and firing. Any other industry would compensate by raising fares, but air travel is a commodity, so the temptation is always to cut fares to fill seats.

It's not surprising, therefore, that according to Lowenstein, "From 1995 to 1999, the industry's best half-decade ever, airlines earned only 3 1/2 cents on every dollar of sales, whereas American industry typically earns 6 cents. And through the full cycle -- that is, for all of the 1990s -- airlines made less than a pitiable penny for every dollar of sales."

The steel industry has similarly terrible economic characteristics. While industry structure is not as onerous as in the airline industry -- unions are not as powerful, and costs can be cut a bit more easily -- this advantage is offset by significant foreign competition, much of it subsidized in one form or another by national governments (the subject of never-ending trade disputes).

Legacy costs
Both industries are saddled with huge legacy costs. In the case of steel, a Wall Street Journal article (subscription required) last week noted, "The beleaguered industry isn't likely to see much consolidation until it resolves the issue of 'legacy costs' -- the $13 billion promised to retirees by union contracts in the past. Big steel companies resist taking over a weak player because doing so means absorbing its legacy costs, too."

Another major legacy cost, which also stands in the way of consolidation, is environmental remediation. Mac McAninch, CEO of Universal Stainless, argued, "there's no way a company can survive with legacy costs from 40 years ago."

Though not as crippling, the airline industry also faces significant legacy costs, mainly in the form of absurdly high wage scales that are nearly impossible to reduce (this was bias No. 11 in Charlie Munger's speech on the psychology of human misjudgment, which I wrote about last month). Lowenstein noted, "Today, thanks to generous vacations, sick-leave provisions, and clauses that fix minimums for days worked and trips flown, United Airlines (NYSE: UAL) pilots get paid for 81 hours a month but actually fly, on average, only 50 hours."

It's therefore not surprising that, according to Lowenstein, "Through the '90s, airline wages rose 43%, just slightly above inflation. Not bad until you consider that air fares rose only 6%. This was, significantly, a time when other industries were holding the line on every conceivable employee benefit. Only the airline industry, shackled by 40-year traditions, continued to kneel to its unions."

Management strategies
The problems endemic to the steel and airline industries were aggravated by misguided management strategies. The key for any company, especially one in a commodity business, is to develop a distinct strategy. In "What Is Strategy?" (Harvard Business Review; download it for $7 by clicking here), Harvard Business School professor Michael Porter argues that, in general, sustainable competitive advantage is derived from the following:

  • A unique competitive position.
  • Clear tradeoffs and choices vis-�-vis competitors.
  • Activities tailored to the company's strategy.
  • A high degree of fit across activities (it is the activity system, not the parts, that ensure sustainability).
  • A high degree of operational effectiveness.

Yet instead of pursuing unique competitive positions and profitable niche markets, nearly all of the major players in both the steel and airline industries tried to get bigger and bigger, without regard to margins, returns on capital, or debt levels. What madness! 

Name one major airline with a distinctive strategy. Now name one that has been consistently profitable. The only answer to both questions: Southwest.

Management complacency
The steel and airline industries were at one time dominant and highly profitable, which led to complacent management behavior that proved difficult to change, even when the environment did. Universal Steel's McAninch told me that at his company, "There are no shiny-asses in executive offices. Management gets out into the mill and knows what's going on and where we're spending money. This is not the mentality in the steel industry, where the CEO might spend two days a year in a plant."

Labor-management relations
McAninch also made observations about labor-management relations in the steel industry:

Workers were treated like mushrooms: keep 'em in the dark and feed 'em horseshit. [In contrast] we pride ourselves on pushing decision-making down in the organization. We encourage people to spend money as if it's their own and let them assume ownership. People don't get their ass chewed for making a bad decision.

In the airline industry, Lowenstein captured perhaps an extreme case, but one I nevertheless believe is representative, when he described the fallout from a strike that United Airlines broke in 1985:

The strike was over, but permanent damage had been done. A certain culture, an implacable Arab-Israeli-like hatred, took hold at the airline, and nobody has been able to dislodge it since. More significant, United's experience helped spread fear through the industry. Airlines began to leapfrog one another, granting successively better terms at each negotiation -- anything to avoid a strike.

Public policy implications
Yes, subsidized foreign imports hurt the U.S. steel industry, and, yes, 9/11 hurt the airline industry. However, I'm convinced the root causes of their problems lie in the industries' fundamental characteristics, combined with the misguided, even reckless, behavior by both management and labor.

As hard as it may be on certain individuals and communities, I say let these companies and their unions reap what they have sown. Fundamental restructuring is needed, and this won't happen if the U.S. government steps in -- as it is doing now -- to bail out the weakest players, who should be allowed to go bankrupt or be bought by stronger companies.

Lessons for investors
Warren Buffett, himself a victim of an investment in the airline industry (which, due to blind luck, he'll admit, turned out profitably), once said, "With few exceptions, when management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact."

Words I should have kept in mind before investing in these industries, and words to always keep in mind when considering investing in unattractive industries.

Guest columnist Whitney Tilson is managing partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He owned shares of Universal Stainless & Alloy Products at the time of publication. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com. The Motley Fool is investors writing for investors.