POST OF THE DAY
Berkshire Hathaway
Southwest Airlines

Format for Printing

Format for printing

Request Reprints

Reuse/Reprint

By FoolSchool101
March 28, 2001

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

Well, I have mostly been a lurker on this board. However, here we go...

First, great insights, Lleweilun. Operating leases are a HUGE part of what makes up an airline. It is debt... however, it is simply off-balance sheet debt -- an accounting principal that allows a company to make it appear that leverage is lower than it actually is. The biggest difference is the fact that a capital lease is basically a pseudo-term note (similar maturity, recordation on the balance sheet, etc.), whereas an operating lease is similar to leasing a building (paying rents).  However, these rents are generally irrevocable commitments to pay X dollars over a number of years. The term is generally shorter than a capital lease and offers a cancellation feature, which is why I believe that they get to be classified off-balance sheet. The $2.9 billion of operating leases represent a commitment to be paid in the corresponding years. A great example of the use of these leases is US Airways. They had a little over $2 billion in total long-term debt listed in the FY99 10K and over $9 billion in operating leases in the notes.

Secondly, I will not argue about whether the Company is run well or not -- it obviously is -- however, I think that Buffet does say something to the effect that when you have a great management team in a horrible industry, in the long run the industry wins. I think that the airline industry is one that should have the slogan "Past Performance Is Not Indicative of Future Results." I mean this in both a good and bad sense, as the airline industry is TOTALLY unpredictable due to factors that are beyond a company's control. You have a company that does well for many years, and then has several horrible years.

It looks like UAL could be a prime example of this. UAL was on a roll operationally, and had increasing earnings from 1996 through 1999. That trend came to an abrupt halt in 2000 due to union troubles. Ahhhh, good old unions. What America was built on! (Please do not take this as a UAL or union bash, as I am just stating some facts mixed with some opinions.) UAL has the best unions in the airline industry, or at least the wealthiest.

Some time ago (1994) UAL was having operational problems. At the same time its big union contracts came due. What was the outcome? The unions gave UAL salary concessions and other amenities, in exchange for about 50% of UAL distributed in some fashion through 2000. Was this a win? I am not going to even open that can of worms. Did this improve operations from 1995 through 1999? I would have to say yep. Is this going to bite current shareholders of UAL in the rear? It did in 2000, and probably will in 2001 as the unions have a huge hand in on the US Airways merger, and almost certainly will bite again in the future.

The point of this ramble? I don't believe LUV has had any significant union troubles -- how long do you believe this will last? A couple of the big ones (Mechanics in 2001, Flight Attendants in 2002, and Pilots in 2004) are coming due over the next several years, and I wouldn't be surprised if the result were operational problems. These people, although happy with the company culture, are almost certainly underpaid in comparison to the other major airline employees, especially with the recent increases given by these other airlines. They may not even have any troubles with the renewal of these contracts, but to believe that they will never have union troubles is highly na�ve in my opinion.

Another area of concern is fuel. Although it appears that LUV is an average hedger, this is a practice that will hopefully (for shareholders) remain. Although hedging can sometimes cost, it provides consistency. The recent surge in oil prices affected many airline income statements; however, some were affected more than others were. US Airways gambled in 1998 and 1999, and was minimally rewarded with lower fuel costs. Toward the end of 1999 and 2000, US Airways gambled again, but this time the surge basically wiped out all operating earnings. Another example of several good/improving years in the airline industry followed by disaster. Nonetheless, this is an area that LUV can partially control with proper management. The problem has been that when prices are good, management can sometimes get greedy and not hedge as much on the belief that prices will continue to fall.

The last major "uncontrollable" thing that I'll blabber about is capital expenditures. Although management can control CapEx by simply not buying more planes, it is obvious that LUV wants to expand, and will continue to add to its fleet. They do save some via buying the same planes from the same company -- but what about the maintenance CapEx? As the fleet grows, so will the nut that cash flow will have to cover.

In addition, (1) planes do not live forever and (2) people like to fly on newer planes. LUV's base is newer, but later down the line the Company will have to start to rationalize its fleet. At that point the fleet will be much larger, causing a bigger "nut," which will put more pressure on the cash flow needed to support the new planes. It would be hard to argue that the CapEx will decrease significantly in the future due to the aforementioned arguments.

In regards to the comparison, I do not believe that Wal-Mart and Southwest are even close to being similar, with the exception that they operate in highly competitive industries and focus on rural areas. Wal-Mart has pricing power over their suppliers. If one supplier doesn't give Wal-Mart a good price, don't you think that another will? Do you think that LUV has this kind of purchasing leverage with Boeing?

Secondly, once Wal-Mart builds a store, that's it. A little paint and other general maintenance for CapEx, but barring a disaster, that store is there for a long time. The plane? Well, as discussed above, they require significant maintenance and need to be replaced every decade or so. Unions? The response is obvious. There are other factors, including the glaringly obvious regulation that airlines face, but they just add to the case that LUV should not be compared to Wal-Mart.

In regards to profitability, both for UAL and LUV, the longer routes are the key. UAL makes its money on the European travel (can't really stop on the way), as well as on the coast-to-coast flights... it has hubs/major gateways in Chicago, Los Angeles, New York, D.C., and others. The merger with US Airways is attractive, as it gives UAL the entire east coast to exploit. A minor problem for LUV is that many airlines, including UAL, have adopted the regional jets. Regional jets allow the big guys to compete on price in a cost-effective manner. This will come into play more and more in the future.

Will LUV continue to defy odds going forward and become the only airline to ever consistently perform? Only time will tell. I am too conservative of an investor to believe that will occur, and not na�ve enough to believe that the share price is undervalued.

Thanks to all that endured this in its entirety.

- FS101
...a little out of breath