From 1926 through 1991, a company called Eastern Airlines flew an unofficial monopoly over the northeasterly American skies. Headquartered in Miami, it was one of the “Big Four” airlines and featured hubs in Chicago, Orlando, and Tampa Bay. During the 1960s and 1970s, it had an extended period of delivering shareholders very good returns at a rate of 15.2% annually. That was because the company was reporting earnings per share growth of 13% and paid a small dividend, and investors were enamored with the stock. Around the mid-1980s, the stock started trading in the valuation range of 10-13x earnings, leading many people to think that the stock was cheap and worthy of purchase for the value investor.
If Yahoo Finance had existed back then, it would have shown steady growth and a low P/E ratio and a superficial look at the company may have induced you to buy the stock. That would have been a terrible mistake, as the company went bankrupt in 1991.
What could someone that reads balance sheets have noticed and done differently? They would have observed the financial engineering conducted by Eastern Air President Phil Bakes after he laid off 4,000 workers over the course of the late 1980s and announced that Eastern Air would discontinue its expansion into Western U.S. territory. Why did this event matter? Because Eastern Air’s management and board found it wise to engage in something called hell-or-high water finance leases to support their aircraft expansion. It is just what it sounds like—it is a promise to keep making payments on money borrowed irrespective of financial difficulties, and a failure to make these payments gives the banking creditor the right to seize your assets and this often serves as a prelude to bankruptcy.
That is exactly what happened to Eastern Airlines in March 1989, when shareholders got virtually wiped out by bankruptcy declaration (the actual amount of loss was somewhere in the low 90% range). Two years later, Eastern Air stopped flying. That is why financial statements matter-you need to know if a company is giving up secured claims on its assets and cash flow that could threaten its solvency and set you up for wipeout risk.
Fast forward to today, and you will see an example of history rhyming—maybe even repeating. Someone studying Delta Airlines may see $4 in profits, a $44 share price, and think the stock looks cheap at 11x earnings. Profits at Delta have grown every year since 2010. The price of the stock has gone from a low of $7, to the teens, the $20s, and now over $40 when you track its year-by-year changes. There is even a dividend now, with the $0.12 payment in 2013 growing to $0.30 in 2014, and at $0.36 now. A superficial glance at Delta—growing dividend, growing profits, great stock price growth, seemingly reasonable P/E valuation could induce you into buying the stock based on Yahoo Finance characteristics.
But if you dig into the statement at Delta, you will see this is Eastern Air all over again. Delta has $21.9 billion in pension commitments that it is on the hook to buy. The pension fund at Delta only contains $9.1 billion. That is a problem. The company has $6.5 billion in uncapitalized leases. That rhymes with what happened at Eastern Air. It has a balance sheet where the debt-to-capital ratio is 97%. That is a huge problem. Delta has $9.7 billion in total debt, with interest payments of $650 million, and $7.7 billion due within the next five years. If interest rates spike, if we see a repeat of the 2008-2009 recession, if fuel prices spike, Delta shareholders will be in an awful lot of trouble if there is any prolonged period of bad news.
In terms of style, this is where Charlie Munger’s commentary on George Soros at the 2000 Berkshire Hathaway shareholder meeting comes into play—as a long-term investor, you have to get comfortable with the fact that other people will be making money at a faster pace than you. Since 2009, Delta has compounded at 42% annually. Someone with $100,000 to invest in Delta six years ago would have over $760,000 now.
“Missing out” doesn’t bother me one bit. Delta went bankrupt in 2005. It is leveraging itself so that it will eventually repeat Eastern’s folly—heck, its own folly from less than a decade ago—when a prolonged set of poor economic conditions reveal themselves. You don’t want to get on your knees at night and pray for low fuel prices, lack of labor strife, and accommodating bankers during credit freezes. It is an inferior way to live because you are treating investing like a game of betting on black in roulette—you either win real quickly or lose real quickly. Given that there are literally almost one hundred companies that will deliver 5% growth in most bad case scenarios, it is foolish to spend your time playing with anything else.
Originally posted 2015-03-04 18:40:24.
