Japan Airlines Bankruptcy Should Come As A Surprise To No One

Yesterday, it was announced that shareholders in Japan Airlines (JAL) would be wiped out, as the company would undergo a restructuring that would see creditors and the Japanese government own the beleaguered airline. Obviously, the immediate problem was that the billions of dollars of the company's losses prevented the company from paying back the billions of dollars of the company's debt. But more fundamental than this is the plague that afflicts the entire airline industry, and always has.

Warren Buffett is quoted as saying that the airline business in the US “has made no money.” Thanks to a forgettable investment Buffett had made in US Air, he even went so far as to suggest a capitalist should have shot down the Wright brothers during their historic "first in flight" moment.

Is there something particular about the airline industry that causes these companies to have been such bad investments? Why is it that every recession takes a few airlines down with it? The answer lies in the supply and demand characteristics specific to this industry.

Let's start on the demand side. When incomes fall (e.g. during recessions), airlines get hit particularly hard. This is measured by income demand elasticity, which determines the impact changes in incomes have on demand for particular products or industries. According to a study by Houthakker and Taylor, here are some U.S. income elasticities of demand:



Basically the chart is telling us that for every one percent drop in income, we see a drop in demand for each of these items corresponding to it's chart entry. For example, at the bottom of the list, we see that for every 1% drop in income, food demand drops by just .14%. On the other hand, at the top of the list, we see that airlines are disproproportionately affected, with demand dropping by 6% despite only a 1% fall in income!

But the converse is also true, meaning that for each 1% rise in income, airline demand increases 6%! So shouldn't this cancel out the drop that occurs every now and then? To see what happens when times are good, let's look at the supply side.

When demand increases (and we see it increases disproportionately with incomes), airlines add to their capacity. This results in fixed costs for airlines, either in the form of lease payments or debt taken out to buy expensive increases in capacity. However, as all airlines do this, the one that increases too much or too fast ends up with overcapacity. Since customers generally choose their airline based on price (though there are exceptions), an airline with too much capacity will simply cut its price to fill its seats. Competitors are forced to follow suit, or carry overcapacity themselves, resulting in an erosion to profits despite strong economic times!

This effect prevents airlines from benefiting from their high income demand elasticity. To make matters worse, when the economy turns down, the airlines are left with large fixed cost obligations (aircraft lease or debt payments) that are tough to pay off, and especially tough considering the disproportionate drop in demand as compared to incomes, resulting in the annihilation of the weakest airlines.

The evidence? Consider that this is the fourth government bailout of JAL since 2001! Moreover, consider this list of bankrupt US airlines since 1979. In most industries, a list of the companies that have gone bankrupt will contain a lot of fringe companies with the occasional fallen angel. In the case of this industry, however, the list reads as a who's who of airlines!

Of course, there are the low-cost innovators of the field that manage to stay above the pack. Companies like Southwest Airlines (LUV) and Canada's WestJet Airlines (WJA) have consistently generated returns that beat the competition. Unfortunately, the odds are stacked against them. Consider what happens when the competition goes under. The competition's debt gets wiped out, and it returns to the market as a leaner enterprise, better positioned to compete with the industry leaders. Because of this constantly re-occurring industry dynamic, well-performing companies must constantly innovate to stay ahead of the curve, lest they become the next entries on the list of shame.

Shareholders beware! Airlines are not the place to look for long-term investments. Investors are better off investing in companies that will first and foremost protect their capital from erosion.

Disclosure: None

Largest Bankruptcies By...

The Lehman Brothers bankruptcy of 2008 is often trumpeted as the largest bankruptcy ever recorded. When measuring bankruptcies by assets, indeed Lehman Brothers is far and away the largest, as shown by the following chart:

But financial companies use leverage to increase assets and thereby increase returns. As such, the number of employees actually working at these companies is not necessarily proportionate with the number of assets. Here's a look at the same bankrupt companies as above but listed by employees instead of by assets:

Interestingly enough, when it comes to employees, the Lehman Brothers bankruptcy is not the runaway bankruptcy by historical standards that it appears to be if only judged by assets. The largest bankruptcy by employee is actually K-Mart at 250,000, but it doesn't even make the top 10 list by assets so it doesn't show up in the chart above. The most recent large bankruptcy is that of Circuit City, at around 35,000 employees; this represents more employees than Lehman Brothers, but Circuit City will go down with far less fanfare.

So which measure is the one on which bankruptcies should be judged? The answer is both. When companies with large numbers of employees go down, it has a large direct effect on employment. When companies with large amounts of assets are wiped out, it results in large amounts of capital being wiped out, which affects the workers of stakeholders indirectly.

Could You Have Seen Circuit City's Bankruptcy Coming?

A few months ago, Circuit City announced that it would seek bankruptcy protection, causing its share price to drop by over 75% in value. It was clearly getting beaten by Best Buy in most operational categories, and carried a more dangerous debt load. But on the other hand, it still had a very positive book value and its current assets appeared to more than meet its current liabilities. So how could one have seen this bankruptcy coming?

Unfortunately, determining whether a company is likely to go bankrupt is not an easy task. Research analysts spend weeks pouring over industry reports and considering macroeconomic, industry and company factors such as financial ratios and management capabilities.

Since the mid 1980s, a quantitative method that has gained acceptance in determining whether a firm will go bankrupt is the Z-Score, developed by a professor at NYU's business school. The Z-Score is found by weighing and then summing the following five factors:

1. Working Capital / Total Assets
2. Retained Earnings / Total Assets
3. EBIT / Total Assets
4. Market Value / Liabilities
5. Sales / Total Assets
   

A score above 3 implies the company is fairly safe, while a score below 1.8 suggests big trouble ahead.

So how did Circuit City do on this scale prior to its bankruptcy announcement? It scored a healthy 3.86! While academic research has shown the Z-Score to be accurate about 70% of the time, it's obviously not perfect. While debt rating agencies also come up with formulas that help them determine the probability of default, qualitative information is also incorporated in these analyses, as the numbers by themselves are generally not considered enough to properly judge the probability of default.

Also, the Z-Score was meant to apply to public manufacturing companies. It has since been adapted in numerous ways in order to better fit data for other types of enterprises. Nevertheless, determining an impending bankruptcy is far from a perfect science: note that since Circuit City's stock dropped by such a large amount following the bankruptcy announcement, it did catch the market off-guard.

Interested in determining a company's Z-Score? You can use this site to input the data and it will complete the calculations for you.

Bankruptcies In Prior Recessions

The recession of 2001-02 is considered a relatively mild economic contraction. In a previous post, we saw evidence of why that might be by comparing unemployment data across several recessions. Another interesting way to compare recessions is by looking at bankruptcy data. Here's a look at business bankruptcies each year (year end: June) for the last quarter century:

Once again we see that while there was a slight uptick in business bankruptcies in 2002, it was nowhere near levels of previous recessions.

While the current bankruptcy level seems low, recall that the year end for this data is June, and things took a dramatic turn for the worse after that. It will be interesting to see quarterly data as it comes out, and it should not be surprising to see 2009 levels reach those not seen since the early 1990s.

This data doesn't tell the full story, however. The magnitude of the bankruptcies are not shown; for example, a Lehman Brothers bankruptcy has far more impact than that of a small business, but this data does not account for this. Furthermore, changes to bankruptcy laws over time have change incentives for businesses to file, and therefore makes the data more difficult to interpret. Finally, this only includes business bankruptcies, and excludes consumers bankruptcies, which we will look at in a future post.

Event-Driven Hedge Funds

Hedge funds can be broadly classified into three categories:

1) Relative Value
2) Event-Driven
3) Directional

In event-driven hedge funds, managers look for stocks trading at discounts due to unusual circumstances. Such circumstances can include merger arbitrage, distressed securities, and private placements.

Here's an example of merger arbitrage. Let's say Blockbuster and Circuit City agree on a buyout whereby each share of Circuit City would receive 1 Blockbuster share. But Circuit City's price only jumps to $9, while Blockbuster's shares trade for $10. A merger arbitrageur might buy Circuit City shares, and short Blockbuster shares, hoping to profit from the eventual convergence of these values.

We've discussed action on distressed securities here.

Private placements are allow securities to be sold through private buyers rather than public offerings. In this way, companies can receive funding or help their owners get paid out, while avoiding the costs and rigour of having to go public. As such, these companies are sold at a discount to what they would sell on the public market.

Bankruptcy Pays for Michael Price

Most of the value investors you hear about are super old. This is mainly because, to have proven yourself successful as a value investor, you've had to put in years of patience and shown that you can beat the market over long periods of time. Michael Price was fortunate enough to be recognized as a great value investor by the time he was 40.

After graduating from college, Price worked for 13 years for Heine Securities. When Max Heine died in 1988, Price assumed direction. A few years later, he sold the company to Franklin Resources, and soon started his own smaller company. He has kept his fund private, so as not to succumb to the quarterly pressures inherent in public companies.

One area where price has made a killing is on bankruptcies. For those diligent enough to study a company in or entering bankruptcy, an investment does not correspond to a random spin of a wheel.

As outlined by Bruce Greenwald, there are four main stages to most bankruptcies:

1. Before filing for bankruptcy: Here, the company may be desperate for cash to keep afloat, and thus may be willing to grant equity or debt at attractive prices. If an investor is confident the company will eventually return to normal, there are large gains to be made here.
2. The filing itself: Many funds are forbidden to own securities in companies that involved in such reorganization, and thus many of these securities can be acquired at fire-sale prices
3. A reorganization plan: Two-thirds of each class of security holders must approve the plan for it to go through, so controlling one-third of the votes of any class garners some control, which can result in payoffs if used well.
4. Liquidation or re-emergence of the firm: Either liquidation, whereby stakeholders are paid with senior debt holders first in line, or re-emergence, where debt is substantially reduced, and the company is now in a position to be more profitable than it was before.

A lot of people invest in bankruptcies looking for dead-cat bounces or other random movements in prices. But there is value to be found for those willing to put the effort into doing the work!