Airlines discussion
GEOFF COLVIN: Things are looking up for the U.S. airline industry -- it should lose only $2.2 billion this year, much better than the $5.9 billion it lost last year. But within those awful numbers lurk some surprisingly upbeat stories. For example, the stock of AMR, parent of American Airlines, has quadrupled in the past year.
And the industry's hottest story is JetBlue, just ranked number one in the 2004 Airline Quality Rating. In a business everyone loves to hate, JetBlue has been winning fans -- imagine that -- and earning big profits. To see how, I questioned Gareth Edmondson-Jones, a JetBlue executive, aboard a plane at the company's base, John F. Kennedy Airport in New York.
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COLVIN: So, Gareth Jet Blue is doing well in this industry that historically has been very, very hard to make any money in. You've got some jets, big A320s like this one we're on. You've got a lot of gates here at JFK. So does everybody else. What's the difference? What is the explanation?
GARETH JONES: People love a cheap ticket, and in the early days that was enough. It's not anymore, so low fare carriers really
reinvented the product. So starting with the things the customers see, two thirds of the seats here have 34 inches of seat pitch so there's plenty of leg room. Obviously the TVs. We're still the only carrier that has it every seat, and it's free. We don't serve meals, so we save some money there. We figured we'd rather give people TV than a crappy airline meal. We figured bring your own meal, we'll provide the entertainment
COLVIN: Another difference is you've got no carts in the aisles here.
JONES: When we looked at the airline, we said, well, what do we hate? And passengers hate being stuck in the aisle, so you won't see carts going up and down. We've go three lavatories for this size plane, perfect, so there's fewer waiting. It's reinventing. You sit down and you think, well, what didn't I like about the airline industry and how do we fix that? JetBlue has the lowest cost in the industry. Our flight crew and our pilots and our customer service help clean the plane. Everyone does three or four tasks, it's a commitment across from A to Z.
GEOFF: So you really do have a different business model here, and it's working. What would stop a big old established airline from going the same way?
JONES: What's often being copied is things that are obvious, the leg room and the TVs, for example. What they haven't been able to copy are the people. Our people look after our customers, and it's a much harder deal to copy that.
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COLVIN: Is JetBlue -- or any other airline -- a stock you should consider buying now? And what innovations are in store for this industry that financially always seems to have at least one engine out? Glenn Engel is a top-ranked airline industry analyst with Goldman Sachs; he joins us from New York. Hedge fund manager Whitney Tilson runs the Tilson Growth Fund . Whitney, you like JetBlue. It's fun as a passenger, it's a great story. Is it a stock you want to buy at today's price?
WHITNEY TILSON: No, it's not, as much as I admire the company. I've spent a lot of time getting to know it and I really think the executive we just heard from nailed it right on the head: JetBlue has a very motivated workforce, and it translates into wonderful customer service. JetBlue's culture is perhaps its least tangible but most powerful competitive advantage -- and the most difficult thing for the big jumbo carriers it competes against to replicate. That being said, with this morning's earnings announcement, the stock was up significantly today. It now trades at approximately 35 times this year's earnings estimates.
COLVIN: That's awfully rich.
TILSON: And that's a steep price to pay for any stock, and especially one in such a difficult industry.
COLVIN: For sure. Glenn, I don't believe you're recommending JetBlue, but you are recommending some of the big, old carriers. What are they and how come?
GLENN ENGEL: Right now the big airlines are flying their planes about 10 percent fewer hours a day than normal, or were in 2003. As they bring these seats back, the cost of these seats is incredibly low. And what you're finding is, is the big airlines' costs are falling much faster than people expected. As they put these seats in the market, they're putting a lot of pressure on the low fare carriers.
And so the margin gap between the big uglies, I call them, and the low fare carriers has been cut in half by about 10 points. The big airlines are still losing money, but they do seem to have better momentum and the stocks have significantly underperformed. They also have a lot more leverage to international business, which is improving, and if the business travel ever does come back, again they have a bit more leverage there. So sometimes always the best companies aren't the best stocks. Clearly JetBlue is a better company than let's say an American. I think right now American though will be a better stock. And I like Alaska as well.
COLVIN: And Alaska. Are we talking about long-term investments, or are these things you're going to want to get out of at a certain point in the near term?
ENGEL: You know, the answer is, only Southwest has proven itself to be a long-term investment, and I guess JetBlue is going on its way to do that. But, no, you are correct. I would consider these trades. I would just point out that if you can't buy airlines when they're losing money, when business is depressed, when oil prices are high, and those things are likely to move the other way, I don't know when you can trade them.
COLVIN: So this is the moment if ever there's a moment.
ENGEL: That's correct. And you are seeing signs. Really it seemed like somebody turned on a switch in mid-March where business all of a sudden started to pick back up again. As you know, March was the first month that the economy created some jobs. Airline business travel is correlated to that. We're waiting for oil.
COLVIN: Whitney, a point you raised earlier having to do with the cultures of these businesses, I also am a great believer that the culture actually makes a big, big difference. Now the established carriers may be able to duplicate much of what the low cost carriers have, but an essential feature to the success of the low cost ones is this collegial culture that they have, and labor relations at the big carriers, especially at United and American, is poisonous. I mean they hate each other. Can they ever hope therefore to match the model of the low cost carriers?
TILSON: I don't think so, and that's why I ultimately think U.S. Air is going to go Chapter 22 -- they'll go back into Chapter 11.
COLVIN: That's Chapter 11 twice.
TILSON: Twice. And should be liquidated at that point. And while I think United will in fact get out...
COLVIN: They are currently in Chapter 11.
TILSON: They're in Chapter 11. I think they will come out, probably not as soon as they're projecting -- probably not even this year would be my expectation -- but they probably shouldn't. That airline has the worst labor-management relations, probably tied with US Air, of any company in America that I've ever seen. And it's sort of like the Middle East: There's been so much, so many bad deeds on both sides for so many years, the atmosphere is so poisonous. In the same way I think JetBlue's biggest competitive advantage is a very positive culture that feeds on itself over time and is very difficult to replicate and change, a very negative culture that feeds on itself over time is almost impossible to turn around as well, and that's why bankruptcy exists.
ENGEL: Whitney brings up a good point, which is, one of the biggest problems in the airline industry is the barriers to exit. It's very hard to kill companies.
COLVIN: Well, it's a very interesting concept. Explain it further.
ENGEL: You know, TWA lost over $100 million a year for 12 years before they finally disappeared, and the planes didn't disappear. They became called American. The problem is, is that labor has a vested interest to keep airlines alive, so the big, ugly airlines will see big labor cuts when times are tough, not enough to make them healthy, but enough to make them survive. Leasors constantly come in and offer discounts to carriers who are bankrupt. Suppliers step in. I think GE's financed all the carriers in bankruptcy. And of course the government has stepped in. So the barriers to exit this business make it hard for the successful airlines to do better.
COLVIN: Well, what you're saying is that a lot of people and entities have an interest in keeping the airlines alive just barely.
ENGEL: That's right.
COLVIN: We've talked a lot about the airlines that you like or don't like, but there are other businesses that touch the airline industry that can be interesting investments as well. Glenn, I think you've looked into some of those.
ENGEL: You know, I'm a big believer the aftermarket is a great investment opportunity in 2004 and 2005.
COLVIN: Meaning?
ENGEL: That the airlines' maintenance costs have dropped about 30 or 40 percent over the last several years. They've been retiring a lot of planes, and that as those retirements are over, as planes come off warranty, as capacity picks back up again, as inventories get restocked, maintenance is going to be picking back up again much faster than people expected. And carriers who make engines like Rolls and UTX: United Technologies should benefit. Goodrich, who makes wheels and brakes, or Honeywell or AAR (AAR Corp) who makes, who's into logistics inventory business, all these guys should benefit because maintenance costs I think are going to be picking up substantially over the next several years.
TILSON: I actually would go outside the passenger industry, and look at air cargo. There's one very interesting, tiny little stock called ABX Air. When Airborne Express was purchased by DHL, owned by Deutsche Post -- that's a foreign company, foreign companies cannot own U.S. airlines -- they were forced to spin out about six or eight months ago ABX stock to the old Airborne shareholders. It's an independent billion-dollar company. They have 18 percent of the U.S. air cargo market, serving exclusively Airborne, so they have basically a guaranteed profit contract that has various incentive clauses for on time delivery and so forth.
You know, as a spinoff there was no analyst coverage, (and) all the ABX shareholders dumped it, (so) it was under $1. The stock's now approaching $6, so it's had a heck of a run. But it's a very stable, profitable business. It doesn't have any of the risk factors of a typical airline, and they could do $1 a share (in earnings) in a couple of years, so it's very interesting.
COLVIN: The company with perhaps the biggest stake in the airline industry's future is Boeing, in the news lately because a former employee pleaded guilty to violating some conflict of interest laws, and also because the company is now forecasting higher than expected profits. So I sat down recently with Boeing CEO Harry Stonecipher, at company headquarters in Chicago, to get his views on the airlines' future, and Boeing's.
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COLVIN: Well, you're facing an interesting situation here on a number of fronts. First off, it has to be said last year was the first year Airbus sold more planes than Boeing, commercial planes.
HARRY STONECIPHER: Yes.
COLVIN: How do you respond to that?
STONECIPHER: Well, they did it, all right? And they've been building a product line for 30 years, something like that. And we continue to focus on running a good business. We're not happy about it, but we're not going to write bad business. I described to someone the other day and said, the celebration of a new contract lasts for a day or two, a bad deal lasts for an eternity.
COLVIN: You and Airbus have chosen to go different routes in what you're developing for the future. They are developing this mammoth plane, the A380. Boeing studied developing a mammoth plane and decided against it. How come?
STONECIPHER: Well, we see a different market. We see the market developing in a different way. We think there is a market for the big airplane that Airbus is building, and our 747 as well. But we think it's about 400 airplanes over 20 years, and so that's a market; it's just not a big enough market to be attractive to us. And we look at it in terms of how you think about it when you're going to take a trip. Do you want to go from New York to Chicago in order to get to Little Rock? Or do you want to go from New York to Little Rock? Do you want to get on an airplane with 500 or 600 of your closest friends or 200 of your closest friends? And I'm sure we could argue that all the way down.
COLVIN: So what's your forecast?
STONECIPHER: The forecast is traffic is coming back. It's looking right now like it was looking like the year 2000. 2000 was the record year.
COLVIN: The greatest year.
STONECIPHER: The greatest year. We think buying will move along from now into '05 and then deliveries will pick up in '06.
COLVIN: From the passenger's point of view. Either on the 7E7 or on any other airplane you are designing, what's going to be new and exciting and good from their point of view?
STONECIPHER: In the case of the 7E7, you know, we've put an awful lot into the esthetics. You've got bigger windows so you can see out of them in any direction without moving around or ducking down or stretching up or whatever the case may be. And when you walk into the cabin and you look at the spaciousness, as we're trying to give everyone, you know, a more spacious feel. But so that environment will be great. And we're talking about commercial business, you know, there's still one thing about it. It is still the safest, least expensive, fastest way to go anywhere. That's got to have a future.
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COLVIN: Well, it has a future, one way or another, but Whitney, Boeing stock has actually had a pretty good run the past year. Is it a buy today?
TILSON: Well, I don't own it. I think it's very difficult to predict what the future's going to look like for Boeing a couple years out, and unless I really have that degree of comfort, I'm not going to own anything. That being said, I like the fact that Boeing and Airbus are pursuing different strategies. Airbus may well succeed with that jumbo jet, and Boeing is essentially saying go right ahead, and we'll succeed with a slightly different strategy. So I think both companies can be winners.
Generally I like the idea of being a supplier of arms to both sides in a war without end, so they're supplying the arms to all these airlines that are in turn bashing each other's brains in, but Boeing and Airbus -- and for example a regional jet manufacturer like Embraer based out of Brazil -- they can all make an awful lot of money as that happens.
ENGEL: Now I think that any pick up in aircraft deliveries is farther out than Boeing is expecting. If you just look at how decimated the airline industry is, he's said to lose $2 billion in the U.S. this year. Worldwide they're not going to make any money. You have to have your customers profitable before they can start buying planes. Balance sheets are decimated. I think you're several years away before you're going to see orders pick back up again, and the stock seems to be discounting a recovery quicker than I think will happen.
COLVIN: They have, Boeing and Airbus have made different bets on what the future is. If Boeing turns out to be right with this smaller jet, the 7E7, more point-to-point efficient flying on the part of the airlines, could that change the whole hub-and-spoke system that the big airlines are using now?
ENGEL: You know what? The answer is, is that the reason why smaller planes are in vogue is because of the hub-and-spoke system. That when you fly from Pittsburgh to London or Cincinnati to London or Memphis to Amsterdam, that's not because there's any point-to-point traffic in those cities. It's because there's a hub supporting it. But clearly, I would say that the 7E7 market to me seems much bigger than the A380.
TILSON: I just want to add two points to Boeing's story. First off, the very high fuel prices, while it's killing their customers, may in fact encourage their customers to buy new planes rather than take the 20-year-old planes that are very fuel-inefficient out of mothballs, so in some ways that could help Boeing. Secondly, most people think of Boeing as a commercial aircraft company, but in fact that's now a minority of their revenues. Fifty-six percent of their revenues last year were in the military space, and that area, for better or for worse, is booming these days.
COLVIN: Which makes it part of this extremely interesting, always fascinating industry. Glenn Engel and Whitney Tilson, thanks so much.
TILSON: Thank you.
ENGEL: Thank you.
Market roundtable
KAREN GIBBS: A roar was heard on Wall Street this week, but it wasn't the sound of a jet engine. It was Federal Reserve Chairman Alan Greenspan expounding on the economy, making it crystal clear interest rates will rise, he just wouldn't say when. The blue chips were rattled on Tuesday when Greenspan spoke, losing 123 points, but then reversed those losses on Thursday with a 144-point rally. By the end of the week, the Dow had digested the news and closed up slightly. The Nasdaq defied conventional wisdom and rallied, while the S&P was virtually flat.
Maybe it's time to Greenspan proof your portfolio -- something market maven Bernie Schaeffer, CEO of Schaeffer's Investment Research, and John Waterman, chief investment officer for Rittenhouse Asset Management, have been doing for months. Well, John, there's no consensus in the markets right now. They're all going their own way. What do you make of it?
JOHN WATERMAN: Well, we think now is a buying opportunity. What we try to do is really step back, look out 12 to 18 months. And what we're focused on is what the economy is doing and what corporate earnings are doing, and we expect this economy to grow this year, probably grow faster than people expect. And we're looking for strong corporate earnings growth, and in fact we think corporate earnings may surprise on the upside. So if you focus on the right stocks and focus on those fundamentals, we think that will lead people to the right place.
GIBBS: Bernie, are you as optimistic as John?
BERNIE SCHAEFFER: Well, Karen, I think it's important to focus on what we know and what we don't know with regard to the interest rate situation. I mean it's absolutely perfectly clear, as you alluded at the beginning of the segment, that rates are going up. It's just a question of when and I guess by how much. What we don't know is how the market is going to react to that. I'm going to go back a few years now to early 2001 when the Fed started to aggressively cut rates. It was considered to be a slam-dunk, particularly after the third rate cut in February of '01, that this was going to be extremely bullish for the market, and the market was going to, the stock market was going to react positively. I don't know if that's going to be the case this time, and I think we have to recognize that we are in a very, very uncertain environment and invest accordingly.
GIBBS: Well, Bernie, with that uncertain environment, obviously you don't construct a portfolio simply in response to interest rates, but you certainly try to Greenspan proof your investments. You focus a lot on smaller stocks like the I Shares Russell 2000 Index, companies such as Red Hat, Midway Games.
Mr. Greenspan also has you looking at energy and gold, stocks like Smith International and Hecla Mining. But most intriguing, you've got 25 percent of your portfolio hidden under the mattress in cash. Explain.
SCHAEFFER: Well, cash obviously is generating nothing in the way of return here, but I think it's important to have an aggressive level of cash here because I think there is a reasonable chance that the market is in peaking mode here. Let's recall now that we've had for the first quarter of this year huge inflows into equity mutual funds. According to strategic insight, $135 billion flowed into equity mutual funds in the first quarter. That's a billion dollars more than flowed into equity mutual funds in the first quarter of 2000.
Well, of course that was the market peak, and also the market was very strong in the first quarter of 2000. We've essentially gone nowhere in the first quarter of 2004, and it kind of concerns me, more than a little bit, that with all that money coming into the market, with all these rosy corporate earnings forecasts out there, that the market essentially has not been able to get out of its own way. So I think aggressive cash is called for because of the uncertainty out there.
On the other hand, I don't want to miss opportunities, and I feel the similar names that have brought us here so far in the small-cap arena, in the mid-cap Nasdaq arena, names that have doubled or more since the market bottom in October of '02 are going to continue to lead the way, are not going to be as negatively impacted by the interest rate environment turning from positive to negative.
So I want to stick with those names that have been very good to me, but at the same time inflation proof, well, gold stocks, energy services stocks, stocks that are going to react positively to a continuation of high energy prices, perhaps a surge in inflation and increasing interest rates.
GIBBS: John, Bernie raises a good point. All of this money flowing into equity mutual funds, and we're basically treading water. What is that telling you?
WATERMAN: Well, I think this has actually been a good period of consolidation for stocks. And we still go back to where is the economy headed. We think the economy is going to grow.
When we look at interest rates, we do believe rates are headed higher. We expect the 10-year Treasury will probably be around 5 percent by year end, maybe actually push above that level before year end and then pull back. But we really don't see that as a threat to stocks, because you have to step back and say, how are stocks priced today? And we think the market is already built in at 17 times forward earnings, that type of rate increase. And the real risk to stocks starts only if rates start to go above 5.5 or to 6 percent.
And so the question really is, Karen, where are rates headed? And longer term we think that's about inflation. We don't see inflation as an issue, at least for the next one to two years, because we think what will really drive inflation will be labor costs.
GIBBS: John, you've always been a rather conservative investor with a big-picture outlook, and of course your response to Greenspan is having such holdings as GE, AIG, Pepsi, Pfizer and Microsoft. Tell me why.
WATERMAN: Well, those stocks all share certain common characteristics, which we think particularly now, given the outlook for the economy, that investors should be looking for. What we like about them is, one, they've been the laggards of this market.
They really haven't participated. Many of those stocks we've just mentioned are selling at relative P/Es that are at 10-year lows for those stocks, but we're looking at earnings that will growth this year 12 percent. We're looking at strong balance sheets, strong cash flows, in many cases really healthy dividends.
General Electric's dividend is 2.6 percent, and we're going to see that grow. Pfizer's dividend is at 1.9 percent.
We will see that grow 10 percent plus going forward. So we see those stocks as really where investors ought to be looking in the next 12 to 18 months. Important to that is this concept that they will sustain their earnings growth into 2005, because we do see corporate earning overall peaking this year and starting to decelerate. So investors need to tilt toward stocks where the earnings growth will continue through 2005.
GIBBS: Bernie, I know you like small-caps, but what about John's position on the blue chips?
SCHAEFFER: Well, I agree that they've lagged, and I generally don't like to buy into lagging stocks or sectors unless I have a good reason. Actually I don't believe they're lagging for lack of commitment to those stocks on the part of large fund managers and individual investors. I think that so-called quality trade, which I would characterize the names that John is talking about, has really been in the forefront of investors' minds for the past year and a half.
And as a matter of fact, one of the problems John Q. Public has had with this market rally is they've been in the wrong area of the market. They've been in the big blue chips. They missed the big rally in tech. And the major inflows of course have come in the first quarter of this year where the market has kind of gone nowhere.
I guess I have a problem with regard also to the theory behind low interest rates were good for the market, and now higher interest rates are going to be good for the market. And also maybe a little bit of a corollary, weak job growth is good because it's going to, it means that inflation isn't going to be a problem, but then again I would submit that weak job growth is going to be the bane of this economy if it continues. So you can't have it both ways.
My point is, again, there's a lot of uncertainty in the environment here, and I don't know that past ways of looking at things is going to be the approach that's going to be the winning approach here.
WATERMAN: Bernie, the first thing we'd say is that we've actually seen a lot of the money flowing into the market flowing into value and small stocks, and if anything we have a concern about that group because we've really seen investors chasing performance there, and we know long term that hasn't worked either.
With the large blue chip stocks, if you look at mutual funds, for example, the money hasn't been going in the large blue chip names recently on behalf of individual investors. With respect to job growth, I don't think anyone sitting here is saying job growth will roar ahead. What we're expecting is that we'll start to see payroll growth in the 150,000 to 200,000 job range going forward
GIBBS: Well, let me ask you one final question, because you did mention about the information flows. People are really just flooded with types of information. What should investors do when they hear it? Should they just tune it out?
WATERMAN: We also think that investors shouldn't really react to daily information in the market. We think they'll tend to honestly go in circles if they do that. What they need to do is really step back and put together a diversified portfolio that does include some small stocks, that does include bonds, that does include blue chips.
What we don't think investors should be doing now is pulling money out of blue chips because they've lagged and moving them to small stocks, that if anything if they're thinking about rebalancing, they should be doing some rebalancing away from what has worked, from what has outperformed, to what hasn't worked, and that would be our recommendation to investors at this stage.
GIBBS: Well, John Waterman, Bernie Schaeffer, thanks so much for joining us.
Next week
COLVIN: That's it for this week. Next week we're going to stir things up in the soda industry: Can Pepsi really reinvent itself as a health food company? Will Coke ever find a CEO investors can love?
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