Real Wealth Society

Wednesday, January 18, 2006

A tale Of Two Strategies; Or How The Airline Industry Blew it By Wayne N. Krautkramer

There were some changes in the airline markets over the last few years. Each airline was subjected to the same environment. The first change occurred in passenger bookings, and all airlines had to deal with that change. The change in energy costs is a different story. Some businesses used the correct strategy, and the rest did nothing, as the results show!

The First Strategy. Do Nothing!

This has a been a terrible two years for most of the US airlines. The unforeseen happened, and the poor airlines were mauled by the evil free market in energy!
Let’s look at the last two years to see how well the industry has managed its resources.

Delta Airlines Bankrupt Flyi Inc. Bankrupt
Northwest Airline Bankrupt
United Airlines Bankrupt
US Air Professional Bankrupts?
Bankrupt for the 2nd time

AMR Not bankrupt but still bleeding (Management by Hemophiliacs?)
Many other US air carriers are in serious trouble.

Before we indulge in the obligatory wailing and gnashing of teeth, let’s look at the 2nd strategy!

The Second Strategy. Hedge Your Uncontrollable Expenses!

Southwest Airlines and Alaska Airlines knew that they could not afford a major increase in their costs. These management teams found the old "we’ll just raise the price" argument to be uncertain!

Exhibiting true management skills, they hedged their fuel costs by buying options and futures contracts through 2007. By this tactic, they were freed from the uncertainty of their fuel costs, and focused their efforts on running their businesses. Southwest and Alaska had no intention of speculating about things that are out of their area of expertise!

Let’s see the results of this hedging strategy!

"Southwest Airlines Co. and the parent of Alaska Airlines turned in strong third-quarter results on Thursday, cashing in winning bets they made on the direction of fuel prices.

US airlines are seeing strong demand for travel, and they have even had a bit of success in pushing up ticket prices, but high fuel prices have kept giants like American Airlines in the red.

Not so at Southwest and Alaska Air Group Inc., which were more aggressive than their rivals in taking options to buy fuel far into the future at set prices, a practice known as hedging.

Southwest said Thursday it earned $227 million, or 28 cents per share, in the third quarter, including an $87 million gain from its hedging. Analysts had expected 18 cents per share, according to a survey by Thomson Financial, and the results beat Southwest's year-ago profit of $119 million, or 15 cents per share"

"Seattle-based Alaska Air Group, which operates Alaska Airlines and Horizon Air, used hedging to save on half the fuel it bought. Its profit rose to $90.2 million, or $2.71 per share. Excluding the impact of special items, net income would have been $71.5 million, or $2.16 per share, still enough to beat Wall Street's forecast of $2.12 per share.

JetBlue Airways Corp. reported a profit of $2.7 million, or 2 cents per share, when analysts were forecasting a penny per share loss. But JetBlue was not as insulated from fuel prices as Southwest and Alaska, and it fell short of a year-ago profit of $8.1 million, or 7 cents a share.

New York-based JetBlue also said high fuel costs would push it to a loss for the fourth quarter and the year as a whole.

"Southwest, however, said it will pay the equivalent of $26 a barrel of oil -- less than half the current price -- for 85 percent of the fuel it will need in the fourth quarter. Alaska locked in 50 percent of its fuel for this year at about $30 a barrel of oil.

Hedging let Dallas-based Southwest cut its average cost of fuel to 95 cents per gallon in the third quarter -- far less than the other carriers who have released results for the July-to-September period. Alaska Airlines paid $1.56 a gallon, and JetBlue paid $1.70 -- and expects $2 a gallon the rest of the year. Continental Airlines Inc. paid $1.88 a gallon, and AMR Corp.'s American Airlines paid nearly $1.89.

JetBlue hedged against only about 20 percent of its fourth-quarter fuel at about $30 a barrel, and American Airlines only 8 percent at $48 a barrel, leaving them at the mercy of open market prices.

Fuel was 19.6 percent of Southwest's operating expenses, compared with 23.7 percent at Continental, 27 percent at Alaska and Horizon, 29 percent at American and 31.4 percent at JetBlue, according to figures provided by the companies.
Southwest is poised to continue reaping this advantage, with deals to buy more than half its fuel through 2007 at prices far below current levels."

Independence Air ceased operations on Thursday night, 18 months after launching service as a low-cost carrier.

The airline's last scheduled flights trickled into Independence's hub at Washington Dulles Airport late Thursday. The company shut down its web reservations and flight information system earlier in the evening.

Roughly 2,700 employees will lose their jobs.

Independence, a unit of FLYi, sought Chapter 11 bankruptcy protection in November but failed to attract investors to keep flying into 2006. The carrier was squeezed by low-fare competition and record-high fuel prices."

And the carnage continues into 2006. Most of the carnage is due to these airlines failure to hedge their fuel costs!

This article shows that Southwest Airlines, Alaska Air, and Jet Blue are not begging for the taxpayers to bail them out of their mistakes!
They had to deal with the drop in revenue when people were avoiding flying, but they hedged their fuel costs, and they are prospering!
This is a wake up call to realize that not hedging the major costs that you can hedge is tantamount to rank speculation!
Remember, you might lose your bet, and your business, if you’re wrong!
The markets offer many ways to transfer some of your risk to others. Use them, or wind up like the US airlines!

Wayne N. Krautkramer
Everybody has accepted by now that change is unavoidable. But that still implies that change is like death and taxes it should be postponed as long as possible and no change would be vastly preferable. But in a period of upheaval, such as the one we are living in, change is the norm. Peter F. Drucker


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