Phil Ordway of Anabatic Investment Partners discussed the dynamics of a U.S.-based industry and highlighted selected companies, including Alaska Air (NYSE: ALK), at Best Ideas 2018.

The U.S. airline industry has changed but old biases still rule the day. Airlines made more money in 2015-2017 than in the prior thirty years combined and have posted eight consecutive years of profitability. Four major (and often troubled, loss-making) carriers disappeared in the last decade, and four carriers now control 80+% of capacity – American, Delta, Southwest, and United. New entrants have a hard time, as it is not possible to fly new routes in many of the best markets: JFK, LGA, and DCA are “slot constrained”; EWR, ORD, SFO, and LAX are effectively slot constrained; and many airports (ATL/Delta, MDW/Southwest, DFW/American) are so dominated by one carrier that competitors face severe challenges. Industry balance sheets are strong, and leverage and fixed-cost coverage have never been better. Airlines used to get very little of the interchange fees reaped by banks from valuable airline-branded credit cards. Airlines command a large share of the economics: billions of dollars per year at very high margins. Over the past four to five years, American, Delta, United, Southwest, and Alaska have reduced their share counts by 35%, 16%, 24%, 21%, and 15%, respectively.

Alaska Air has a good culture and happy customers. It reaps advantages from costs/margins, customer loyalty, and attractive routes. Alaska has industry-leading operating margins (≥15-20%) and ROIC (≥15%). The shares recently traded at a ~10% earnings yield (at a market cap of less than $9 billion), with profitable growth ahead. Alaska has a cost advantage versus Delta (and American and United) and a revenue advantage versus Southwest (and the other U/LCCs).

Phil asks, “What would you pay to own the following companies?”

Writes Phil, “We’ll be talking about Company A and Company C, as well as their respective industries and peers. Despite a persistent reputation for poor economics, there is reason to believe that the odds have shifted significantly and are now in favor of future prosperity. Even in “the bad old days,” we’ll walk through three companies (Company A included) that have seen stock price increases of 10-20x over the last 20 years. The presentation will also cover the industries’ history and offer some explanation for the current investor (mis)perceptions. The presentation will conclude with a look at why Company A and a few others have seen equity market price declines of 20-30% in 2017. What are the real risks, and what is just noise? Where are the best odds for profitable investment? What are the mistakes to be avoided?”

For further background, see this excerpt of a letter of Anabatic Investment Partners.

Listen to a replay of this LIVE session:

printable transcript slide presentation audio recording

The following transcript has been edited for space and clarity.

A quick review of what I have talked about at prior MOI Global conferences.

  • We did the bond insurance industry about four years ago. Assured Guaranty has worked out well. Ambac has been a total frustration, but there is a lot coming to fruition there in 2018.
  • Verisign and internet domain registration companies was a fascinating industry, and that has worked out well.
  • Two years ago, we did building products and, specifically, the “exciting” world of ceilings. Armstrong finally turned the corner in some areas and posted strong results last year.
  • Last year at this conference, we talked about community banks, specifically (i) Wells Fargo and the ongoing issues they had, and (ii) OceanFirst, which has done quite well, even though the price has declined over the past year, so that could be interesting going forward.

Let’s move to “A Rorschach Test for Investors”. I hope everyone will do their own work and not rely on anything in here. All the errors are mine and unintentional.

I like to play this game with people to open their minds about different companies and compare Company A to Company B without knowing exactly who the companies are. This, of course, was Ben Graham’s famous favorite game form his teaching days. This first company to consider is a travel-related business with a rewards program. It’s tied to credit card issuers, it’s similar to hotel points. You can even think back to Blue Chip Stamps if you like the historical analogy. It has high market share in the Pacific Northwest. One of every three credit card swipes in Seattle is on their co-branded credit card. It gets paid in advance, so the working capital is float. Margins are off the charts, 40-50% net. It takes no incremental capital to run this business, so the vast majority falls as pure free cash flow and it’s growing double-digits a year and there are the numbers at the bottom, so a billion dollars topline. Somewhere in the neighborhood of $500 million pure free cash flow. Keep that number in mind as to what you might pay for a business.

Next, consider a business that is even more familiar to most people. It is a consumer-facing company with which we are all familiar. The industry is quite consolidated as you can see. There is little or no brand loyalty and no individual brand-based pricing power per se. It is cyclical and tied to GDP, but it has been growing better than GDP for quite a period of time. It is reasonable to expect it to continue. The balance sheet’s quite good. There’s no risk of financial distress and there you can see some of the recent financials. In the topline, it’s had a long history of growing in the high single-digits. It’s likely to continue. A mid-teens or high teens operating margin. Good returns on capital. Keep in mind what you might pay for that business compared to some others. This is where it gets interesting.

Company C has some peer companies on both sides of it. What stands out, topline growth goes up across the board but margins vary quite a bit. Returns on capital vary quite a bit. They are all cyclical. They all have decent balance sheets with the exception of Company E on the right, but look at the valuations down at the bottom. Our company stacks up as quite attractive and stands out relative to the rest of those companies and some of them look downright expensive. If you have pen and paper in front of you, it’s fun to guess.

CSX, before the tragic passing of the legendary “outsider” CEO Hunter Harrison was a well-run railroad, but it is, in fact, a railroad. It is not going to grow a lot more than 2-4% a year. The margins are quite good, but it’s capital-intensive and it is cyclical and look at the price you’re paying. It’s maybe fairly priced, but hard to argue it is a bargain or cheap. I cheated with Company B because that is the S&P 500 with three zeroes missing.

Most interesting is to compare that to Alaska, Company C. On any metric, Alaska is superior to the aggregate of the S&P 500 or even the median S&P 500 company. I picked Company D because, at the time when I started this several months ago, NVidia was the best performing S&P 500 stock. It finished at #9 or #10 or something like that and it’s a legitimately wonderful business, no doubt, but it’s got a pretty fancy price on it, too. Company E is Tesla, because I do not think you can go five minutes without talking about Tesla these days and we will come back to Tesla toward the end.

The airline industry, because it sucked for so long, may be prone to more psychological bias than any industry. It is a perfect laboratory for behavioral biases in investors. It is fascinating to look at this industry through the lens of Danny Kahneman’s work or any psychological analysis. Everyone has an opinion about the airlines. Everyone listening to this presentation will have an opinion about the airlines and the vast majority of those opinions are going to be driven by an emotional, System-1 style response. It probably hinges almost purely on availability. Even the people who do real analysis in thinking about the industry tend to revert right back to System-1 almost all the time and it is fascinating. The industry categorically has changed, but all of the old frameworks and biases are still ruling the day if you ask me.

There is a funny Family Guy episode, and there are airline jokes all over the internet. Everyone loves to hate the airlines, and everyone groans as soon as I say the word “airline”. We have to consider what they are worth and what the price is — here are two questions I always consider: What is the industry structure? (While there are counter examples, a bad industry or a bad company can swamp the best-intentioned executives.) What are the individual cost structures? (In a competitive world, low costs usually win. That remains the case almost everywhere and especially in the airline industry.)

Is the airline industry like the Chicago Cubs, i.e., a horrible century that is now in the past, with lots of talent and a bright future; or are we one recession or one bad strategic decision away from the battle days? I would argue the past is the past. The seeds of the turnaround in the industry were laid over ten years ago with some of the early consolidation moves that stem from some of the smaller companies, namely at America West and US Airways. 2008 was a buzz saw, but 2009 was a watershed moment for the industry. The latter has been enormously profitable for eight years.

Everybody reverts back to this quote from Gordon Bethune, the former CEO of Continental Airlines: “You are only as good as your dumbest competitor.” That is probably the best quote of all time about industry structure. If you are in a competitive industry that is not dominated by a brand, this is exactly right.

The question is, who is the dumb competitor today? It was obvious who the dumb competitors were in 2003 or 2004. At almost no point in the airline industry’s history were there not at least two or three mortally wounded airlines swinging a bloody ax around trying to survive by pricing for cash. They wanted to price a ticket at anything to bring in cash to live to fight another day, and that was dumb competition. It seems impossible to argue there is a single dumb competitor today. The race to the bottom is over. It is still a competitive industry, but it is not the miserable slog it used to be.

The background on consolidation is important. You can see over time going back to the 1980s, we eliminated a large number of airlines over the years through consolidation and through a couple of bankruptcies and liquidations to the point now that we have gone to the four largest carriers that used to be quite ineffective controlling 60% of the market to the four largest today controlling more than 80% and being profitable, well-run businesses. This is another look at the path we have taken through consolidation to get here.

Market share today is heavily weighted to the big three network carriers — American, Delta, and United — along with Southwest, which is a different animal. Those four dominate the industry. It is arbitrary to lump Alaska in with the legacy network carriers, because its adjusted cost excluding fuel — fuel being something airlines cannot control — is lower than Southwest’s cost. They’re in line with Southwest and JetBlue, so it’d be a little more reasonable to maybe put Alaska in that group because they are a legacy and,, have never filed bankruptcy either, get grouped in that category. American, Delta, United all have similar business models and somewhat similar cost structures. The low cost guys, Southwest and JetBlue, are in a different spot today than they ever have been historically in this industry.

The most interesting group might be the ultra-low cost carriers, arbitrarily defined as having an adjusted unit cost excluding fuel of less than six U.S. cents per mile. Spirit and Frontier have common routes and some DNA overlap. Allegiant is its own animal but clearly follows a low-cost model.

An argument I hear is, there are no barriers to entry. Any idiot can start an airline and ruin it for everybody. That used to be true for decades, but the last major airline started in the U.S. was Virgin America. It’s gone, Alaska bought it. If you wanted to start an airline in the U.S. today, it would be literally impossible to fly from the most attractive cities in the country. You literally could not buy your way into JFK, LaGuardia, and Reagan Airport in Washington, D.C. You could not get access of any material size in New York, Boston, Washington, Chicago, San Francisco, and Los Angeles.

That makes it difficult, but perhaps even more importantly, you could not get any airplanes today. If you wanted to compete, you would have to be at least cost-competitive, even if you wanted to stomach some startup losses. You would need 50-100 airplanes and several billion dollars to get anywhere near the existing companies on a cost basis, and that is effectively impossible now as Boeing and Airbus work through a backlog.

We will have a slowdown at some point, but unless we start building many new airports in the big cities, it is not going to be possible to gain access to those route networks. You can have airlines flying between second- and third-tier cities. There is a tiny airline in Minnesota that does exactly that. They were sold to Apollo, but for all purposes, the threat of new entry is extremely low for the major U.S. carriers.

There are two ways to compete in this industry. Before deregulation in 1978, you had to compete on service because it was illegal to compete on price. A generation of people is still grumpy about the fact it grew up pampered. Of course, they paid irrationally high prices for it, but they got “great service” and loved it because the airlines had no choice but to compete on outlandish service, perks, and food and drinks.

They compete on service to a certain extent, but primarily on price. The reason they compete on price is because that is what consumers have proven time and time again — that is what they want. In today’s market, you can compete on revenue, which means you want to charge for having a great network, being able to get anywhere, from one point to another, any way you’d want to cut it. Thousands of different options. High frequencies, great schedules, good service, of course, desirable amenities, all that good stuff, but then the other side is you can compete on cost, which is the idea that I want to get from Point A to Point B as cheaply as possible and that has proven to be a profitable business model. The various companies lay out across that spectrum.

Unit costs are extremely important. Based on fiscal 2016 numbers, adjusting for flight length, you can see how the industry has got a couple of low cost guys in Spirit and Frontier that are extremely cost competitive and can make money at,, low prices. As low as $30-40 for a one-way ticket in many cases. You have some guys in the middle – JetBlue, Alaska, Southwest – and then you start getting up to the network guys on the far right side. Ironically, even though Delta has the highest unit cost, they more than earn it because they get a revenue premium. A final important factor — to steal Howard Marks’ line that everything is important among the twenty different factors that are “the most important thing” — you have to have load factors because, as you can see here going back to right after 9/11, load factors for a long, long time were in the 60s and 70s and that was a big problem because no one had enough consolidated capacity constraints, no one had enough discipline to be able to drive capacity tighter and drive pricing up and look at how much that has changed over the years.

The big, thick line in the middle there is all U.S. carriers. You can see how it went from $70 into the mid-$80s and the breakeven load factor for most carriers today would be in the low to mid 70s for an ultra-low cost carrier and maybe the high $70s to around $80 for a higher cost network carrier and above $80, all of these airlines print money. That is key. If load factors stay above 80%, these airlines will do extremely well. There again it comes back to demand. How likely are load factors to stay high? There’s only so many ways to add capacity in this market, so how likely is it demand for air travel will change over time and how will it change.

It has outstripped population growth by a significant factor over time. It’s outstripped GDP growth by at least a marginal amount over time and that is likely to continue. What might change people’s demand for air travel? It is clearly cyclical, but how likely is it air travel is flat or lower in three years or five years or ten years? Pricing has gotten far more favorable for the consumer than you often hear.

The final factor is balance sheet, which of course, is extremely important. Through bankruptcy legacy airlines, excluding Southwest and Alaska, have all gone through bankruptcy and have all cleaned up their balance sheets to an astounding degree., since they’ve all emerged in the last five to ten years, they’ve continued to de-lever massively. They used to have to price to marginal costs. Now capital and liquidity are more than sufficient. They can price rationally, and it makes a difference. The balance sheet is no longer a problem. Delta is investment grade, Alaska should be. Pensions are still somewhat of an issue. Alaska, for example, is almost fully funded, and Delta is less than 70% funded. Based on cash flow generation over the next few years, it is hard to argue a mortal danger awaits them.

Also interesting is how they fund themselves. You buy your air travel tickets in advance, so there is a negative working capital impact. It used to be a wash, but now that they can play more offense, they have more scale and can push vendors. Almost all airlines have gone from a marginal working capital balance to a massive negative working capital balance. If this were a different industry, people would talk about “float”, because they get paid in advance. They also get paid on their airline miles in advance. In 2017, Delta generated $3 billion of incremental negative working capital on a $53 billion balance sheet. It is astounding how much more efficiently funded all the airlines are today than they ever were in the past.

Fuel’s another hot topic, but it’s far less important than you think. It’s anywhere from 20-40% of operating expenses, but again when oil was over 100 in 2013 and 2014 before the crash, the airlines were all nicely profitable. What hurts is when it jumps around sporadically and is volatile on a short run basis because over a one to three quarter period, the airlines can’t adjust quickly enough. Over the longer periods, they’ve proven quite adept at adjusting their price to account for oil, but unless they can predict the price of oil and none of them can, hose short-term moves can help on the way down and hurt on the way up., some airlines like Alaska use call options to hedge, but a lot of the airlines, I should put this data together at some point, the industry has lost more money on hedges than they’ve ever made or protected. Delta went so far as to buy an entire oil refinery a couple of years ago. They paid something like a couple of million dollars and last year, it benefited the company by roughly $120 million. Fuel is important on a short-run basis, but less important in the long run.

This is probably my favorite topic in the industry because it is still poorly understood or at least it gets shrugged off and overlooked, so these airline loyalty programs, everybody’s probably familiar with them. They’ve existed. Advantage was started in the 1980s at American. Hugely valuable programs and it used to be because they were so desperate, the airlines would turn to the banks as an unsecured source of financing. Delta got bailed out American Express and staved off bankruptcy for a couple years because American Express pre-bought billions of dollars from Delta. When they do that, they do not give Delta any of the economics. They keep all the economics for themselves because they take all the risk. As balance sheets have improved, business models have matured, and profitability has improved, airlines can now go to the banks and say, “We are important where because our customers drive this business, so we want the money.”

Over the last two years or so, everybody has recut their pricing and their contracts. These deals generally come up on three- to five-year contracts, so they now make a ton of money. Delta, for example, makes $3+ billion a year. It’s something like a 40% or 50% margin. Little ol’ Alaska makes about a billion dollars at a 40% or 50% free cash flow margin. It is a truly incredible business — that was “Company X”. It was Alaska’s loyalty program.

If I describe a business that had one out of every three credit card swipes in Seattle, how likely is that business to decline next time we have a recession? It might decline 5%, 10%, but it’s not going down by half. They get paid every month in advance on that business based on customer spend on Alaska’s Visa card through B of A. It requires no incremental capital, it’s growing double-digits a year, so when I play that game with people, most people say, “For that business, I’d probably pay $10 billion, $12 billion, $15 billion.”

The market cap for the entire business has been in the $8-9 billion range lately, so you get the airline for nothing. It’s academic, it’s arbitrary because you’re never going to separate these two businesses nor should you, but the free cash flow is real, it’s attractive and in my opinion, it’s not going anywhere anytime soon. These are the various programs and the banks, the card issuers behind them. They have their relative strengths and weaknesses — the ultra-low cost guys are the least valuable in this matrix — Delta, American, Alaska, even JetBlue, Southwest, United, all have extremely valuable programs.

Moving on to the structure of the big three, they all have their strengths and weaknesses. They’re all roughly the same size, roughly the same business model and each one deserves consideration. There are some differences between them. The SkyMiles piece of this is stunning. The other interesting thing Delta has done is, it now has a multi-billion dollar asset via equity stakes in foreign airlines. Delta owns 10% of AirFrance/KLM and half of Aeromexico. It has extremely profitable JVs. It is an intelligent business. They also built out an in-house MRO operation that does maintenance work for other airlines and they placed an order with Airbus last month. Guaranteed contract work on those engines will generate hundreds of millions of dollars of profit for Delta over time, so they have improved the business in many ways.

American’s CEO, Doug Parker, is the former CEO of America West and US Airways. He used to work for Bill Franke. Doug merged his way up the food chain to CEO of the biggest airline in the world. He said at the last investor day, “I don’t think we’re ever going to lose money again.” Everybody laughed and mocked him, everybody snickered about this being the ultimate bull market top. Doug has been saying this for several years, so it is not exactly news.

I have yet to see someone put pen to paper and say, here is what demand did in the 1990-91 Gulf War crisis and recession; here is what it did in the global financial crisis in 2008-2009; here is what it did after 9/11. Take those three circumstances as the base rate for a downturn, apply the current industry structure to it, and tell me what is going to happen to demand and margins. I am not saying this is a perfect business, but it is not a crappy business. The down-cycle for an airline used to be bankruptcy. The next down-cycle is going to be low but positive profit for these airlines.

Assume that in 2018 or 2020 or 2022 the industry will have an issue, whether it is an inevitable recession, a terrorist attack, or a spike in oil. Put some simple numbers around that and show me how American is going to be unprofitable, because that is the key consideration. Management has stuck its neck out and said, “We are going to make $3 billion pretax in a bad year, $7 billion in a good year, and average $5 billion in the middle.” That is what they have done, and time will tell.

United stands out because it has the most upside if it can fix some of its problems. It does have some structural disadvantages, as it does not dominate a single hub, like Delta does in Atlanta or American in Dallas, because United splits Chicago with American, it also splits Houston, San Francisco, Newark, and other places.

While this industry was so miserable and horrible from 1997 (when Ryanair IPO’d) to 2007 or 2008, you could have made dramatic money in the low-cost companies. They did much better than either the S&P 500 index or other industrial transport companies. If you had bought Ryanair at the IPO, you would have made more than twenty times your money. If you had bought Alaska or Southwest about twenty years ago, you would have made about ten times your money. The returns were fantastic, and this was when the industry sucked and had not fixed itself. In the 1970s, ’80s and ’90s, Herb Kelleher and Rollin King at Southwest Airlines figured out customers care about price. They may whine about Southwest being a “cattle car” but customers vote with their wallet. There is one thing they are willing to pay for, a seat from Point A to B, and that is it. The rest is noise because people say one thing and do another.

It is clear from the economics of the business, polls, and specific consumer behavior that people care about price far more than anything else. If that is true, one thing you should do is pursue a low-cost strategy so you can have low prices. That is exactly what these ultra-low cost carriers (ULCC) have done over the last two or three decades. They have had great benefit from the demand growth of the middle class, anyone who wants a cheap seat from A to B, and demographics. Even Scott Kirby, who is regarded as one of the smarter strategists in the industry — he was president of American and now of United — saying the “Spirits” and the ultra-low cost airlines create a better model by giving more customers more choice. That is exactly right.

If you take the world’s most profitable airlines during the twelve months ended September 2017, i.e., capturing a difficult 2017 and the summer flying season of 2017, in a bad year they earned an operating margin of 16%. That is the new normal. Market valuations do not reflect it as the new normal. Every single one of the twelve most profitable airlines in the world flies narrow-body aircraft so, by definition, they all fly short-haul routes or transcontinental routes. They do not fly across the world.

The vast majority of them, eight of the twelve, are in North America, but there are some big differences there. Copa is in Panama, even Jazeera there is in Kuwait. AirAsia is the largest airline in Asia by passenger volume. Wizz Air is in Hungary and Ryanair, of course, is based in Ireland and dominates Europe, but every single one of those airlines flies narrow bodies and is an ultra-low cost or at least a legacy low cost airline with the exception of Hawaiian, which is a different animal because it only flies vacationers to Hawaii. The other interesting piece is two of the four are owned partially or outright by Indigo Partners. The other two, Spirit and Ryanair, have Indigo in their DNA.

Unbundling is the practice of charging customers for individual things other than the ticket to get on the plane and it boggles my mind how this is still so controversial and generates so much animus. Psychological deprival is the only answer for it because you used to get something you thought was free, even though it definitely was not free and it got ‘take away’ and so it make people angry, but to me I don’t understand how this is anything, but a good thing because when I fly a lot of the time, I’m not bringing luggage. Why do I want to pay for two checked bags? It makes no sense. When I go to the movies, I get a ticket to sit and watch the movies, I don’t get a free drink. I don’t get any of these ancillary things. Why wouldn’t you want to pay for what you want rather than just get a bunch of things bundled together? That is not how any other industry works. We are going in that direction because customers are voting with their wallets.

Ten years ago American Airlines started charging for bags, and everybody had a heart attack. It was a big deal. United thought they could eventually at some point maybe collect a billion dollars a year in revenue for ancillary fees. In 2016, it collected $6.2 billion. This has been the single biggest home run in the industry ever and it will continue heading in this direction. Of course, Southwest is the godfather of the low cost and ultra-low cost industry. They developed the model, it’s a fantastic company. It’s had brilliant leadership, it’s got a great culture. Today it has got a different landscape ahead of it than it’s ever had before because it competes on revenue instead of cost, its transparency campaign. They are the last holdout that does not charge for baggage, drinks, and reservation changes. They have flipped their business model from competing on cost to competing on revenue.

Ryanair is a dramatic success story and the largest airline in Europe, which has been fertile hunting ground for them. Margins and operational performance are off the charts. The load factor, despite some operational struggles in 2017, was in the mid- to high-90s, ten points higher than the best North American airlines. That is why they are lapping the field on operating margin. Since the IPO, Ryanair grown it revenues and a comp annual growth rate of 20%, operating profits at 22% and it hasn’t used a nickel or a euro of material net debt or issued any new shares over that time. It is astounding. Things are changing (e.g., Brexit). New unions, they’re recognizing unions for the first time ever. Growth is going to have to slow because they’ve saturated large parts of the market. Costs are going up, but I still think Ryanair is likely to perform extremely well.

The single best business person I didn’t know of two years ago is Bill Franke. He’s a lawyer by training who had turned around a forest products company in Arizona. He turned around Circle K as a convenience mart and then was called by the governor of Arizona in 1992 to help save America West Airlines because it was in bankruptcy. It was the largest employer at the time in the State of Arizona. The governor didn’t want to see it go into liquidation and said, “Can you help?” Less than a year later, Bill Franke is the chairman and CEO. He ran the airline for about a decade, turned it around, ended up hiring almost all of the industry’s current executives, including Doug Parker and Scott Curvey. He retired on September 1, 2001. We all know what happened, tragically, ten days later when he was on vacation. Starting the next year in 2002, he got some capital from David Bonderman at TPG and some others to start a private equity firm called Indigo Partners. Over the last 15 years, his compounded capital is something like 40% over a decade and a half. It has been one massive homerun after another.

Spirit was the first ultra-low cost airline in the U.S. and an enormous success. He then moved on to Frontier. He launched Wizz Air from scratch in Hungary. It is a great company. Volaris in Mexico is an interesting company to look at after what happened there in 2017. One of his next opportunities is JetSmart, based in Chile and launching in 2018.

Indigo came into Spirit in 2006. Bill Franke partnered with Howard Marks’ Oaktree. The latter and TPG had been distressed investors in the industry. Bill Franke came and said, “Let’s turn this into America’s first ULCC.” Franke is a pre-IPO investor in Ryanair. He watched what Southwestern did every day he was at America West. He grasped the power of the ultra-low-cost model and said, “Let’s do it at Spirit.”

Spirit had been around for decades, but it had been bungling from one mess to the next. As soon as the ultra-low cost model took hold, they sailed right through the financial crisis and since 2006, it posted a cumulative operating profit of $2.5 billion. Over the last decade, they’ve grown revenues at a compound growth rate of 16% a year. Operating profits at 31% a year and, likewise, using almost no net debt and posting a great return on capital to boot, so extremely impressive performance that they evoked a backlash from the network carriers who don’t want to see Spirit encroach on them like Ryanair encroached on its peers in Europe and so they occasionally they fought back. They’ve Basic Economy, which ironically is a good thing both for them and for Spirit. That is a sideshow. The biggest threat to Spirit is itself and maybe to a lesser extent Frontier because that is the business model and that is who they compete against. They will continue to prosper.

Frontier, Bill Franke was interested in repeating his enormous success at Spirit. Frontier came up for auction and a distressed seller, Republic, needed to unload it in 2013, so he resigned from the Spirit board and Indigo sold its stake in Spirit – it was public at that point – in order to buy Frontier for $147 million in 2013. Roll it forward about four-and-a-half years, and it’s worth about $3 billion. Similar overall business strategy as Spirit. The route networks don’t overlap much. Frontier’s focused mostly on the western half of the country, Spirit mostly on the east with some notable exceptions, but they are not going head-to-head on more than 15-25% of their individual routes.

Frontier was going to go public in 2017 (I recommend their S-1 filings in Q2). Bill Franke wants the best possible valuation for this. When the market for airline equities got choppy in 2017, after United started launching fare competition, he decided to put the IPO on hold. It will happen at some point, but the timing is going to be predicated on higher prices in the market. The obvious outcome here would be a merger of Frontier and Spirit. That has been an obvious speculation for years. Spirit will want to see the Frontier market price after Frontier comes public. They have a benchmark and allay the concerns it is selling itself too cheaply. Both of these companies have plenty of patience. It’s not likely to happen in the next few months, but it could happen in the next few years.

Most unique among these airlines is Alaska. It is a great airline with a great culture, a Southwest-like culture of empowering employees. It generally has had happy employees, engaged with the customers. They have generated customer loyalty. Alaska, like Delta, is the rare airline to generate a revenue premium. They have a attractive route network up and on the West Coast and increasingly across the country as well. They have a cost advantage vis-à-vis Delta., anybody but the low coast airlines and they’ve had some of the best margins and the best returns on capital in the industry for a long time., the price is intriguing as well.

Their goal is to be the premiere airline for people on the west coast. It has been a huge benefit for them to have such strong local markets in Seattle, Portland and California that increasingly needs to be evaluated, but that has been a big driver for them for the past few years. It’s won every award you can.

The Wall Street Journal recently bumped Delta to #1 and Alaska to #2. Alaska is a well-run airline. For anyone who does not go there or has not flown it, ask someone in Seattle for an opinion to Alaska. It will be pretty eye-opening as to how much people like the airline. The Virgin integration is a risk. If they botch the integration — and there has been some friction — anything that would narrow Alaska’a cost advantage over Delta and the other network carriers would be a major concern. It would be concerning if they started losing customers. The culture and the mentality they have built is special. Hopefully it will not erode over time.

Being as concentrated as they are in the Pacific Northwest, they are probably more exposed to natural disasters than others. Hurricane Irma and Maria were more disruptive in terms of cancelled flights over long periods of time than major disasters in the past here like 9/11 and the big carriers sailed right through it. Don’t get me wrong, they lost hundreds of millions of dollars, but they still had perfectly acceptable financial results because of it. It’s incredible. Capital allocation, it’s been incredible. It didn’t exist in this industry ever, but because the airlines are not just fighting to survive, they are allocating capital in a thoughtful way and they are mindful of return on capital for the first time ever.

They are reinvesting in their businesses and extending their competitive advantages. The network carriers are re-entrenched and investing in their hubs. The ultra-low cost guys are reinvesting in lower costs and for the first time ever, it’s rational and it makes. What’s also amazing is over the past few years, they’ve all shrunk their share counts by 15-35% while they’ve also reduced debt and while they’ve also made massive capital investments to improve their business, so it is impressive. Customer anger — it astounds me how much negative attention this airline gets.

While this consolidated industry makes more money than ever, the customers are winning, too. Airfares are down — the data is clear, and it includes all fares and fees. People hate fees, and there is a notion there was some Golden Age of flying, but that is nostalgia. This is the best time ever to be an airline passenger because you have never had more choice, you’ve never had lower fares. You’ve never had more safety and reliability at any point in the past. This explains all of it. Good ol’ fashioned “deprival super-reaction syndrome” is our friend, as Charlie Munger likes to call it. Customers used to have something and it got theoretically taken away or at least now you have to pay for it in segments and chunks and people cannot handle that thought rationally. The airline business has plenty of rest. If you don’t have at least a two or three-year time horizon here, I don’t think there’s any way to project what exactly is going to happen, but if you do have a two or three-year time horizon or better yet, a longer time horizon than that, this is one of the most interesting things available in this market.

The cardinal sin would be that value investors buy businesses at perceived low prices and it turns out they have bought crappy businesses at the top of the cycle for a price they are never going to recover. That is the right risk to be focused on, and it is misplaced in this industry. Not to be dismissive of the macro or the micro — this is still a high fixed-cost business. It is still somewhat capital intensive: 7-9% of sales has to be reinvested. There is still a lot of competition. Management could wake up one day and lose its mind, but that is extremely unlikely. This is not that bad of an industry anymore, yet it is priced as such.

Not to pick on Tesla and Elon Musk again, but he announced one of his rocket projects at SpaceX — the BFR [Big F—ing Rocket]. He wants to fly to most places on earth in under 30 minutes and anywhere on earth in under 60 minutes, with a cost per seat at about the same level as a full-fare economy flight. I’ll take the other side of that one.

I stole this from Joel Tillinghast’s book: Everyone is focused on what’s next — whether oil is going to do something, this quarter’s EPS, or whether unit costs are rising faster than revenue this quarter — but what are these companies going to be doing in three years? Is the price I pay today on that basis reasonable?

Can I handle the adversity? It is easy to imagine the average analyst presenting this to his portfolio manager, looking at the volatility, and they both turn away with fear. There were 20%, 30%, and 40% drawdowns in the airline industry last year despite the fact there was not much wrong with the results, but the volatility scares away people.

The following are excerpts of the Q&A session with Philip Ordway:

Q: A fellow MOI Global instructor explored Wizz Air at European Investing Summit 2017. Do you think Wizz Air is worth exploring?

A: Absolutely. It has more of a focus in Central and Eastern Europe than does Ryanair, but there is room for both to exist. Wizz Air has doubled, the price in the market has doubled over the past year and I have less of a comment about whether it’s immediately cheap, but I don’t care as to whether it is immediately cheap because the business model absolutely works. Like I said, it’s Indigo’s brainchild. Tt will do well over time. It has a bright future. There is plenty of room for Wizz Air. To coexist with Ryanair and everyone else in Europe and to a lesser extent, EasyJet or anyone else. It is a fascinating company, absolutely worth exploring.

Q: You spoken eloquently about the profitability and the breakeven dynamics. What would make you change your mind?

A: I would change my mind on individual companies for various reasons. If Spirit decided it was going to go into smaller cities with smaller aircraft, or if it decided to do anything that takes it away from the ultra-low cost strategy, I would not want to own Spirit no matter the greatness of the industry backdrop. They need to stick to a disciplined, ultra-low cost regimen. The same applies to the other characters. On an individual company basis, there are many things that would make me sell.

On a larger scale, I cannot conjure up what would make the industry go back to the battle days. Between the consolidation and the better balance sheets and the cash flow pouring out of the credit card and mileage programs, these companies will do surprisingly well through the next downturn. If we have a recession, a commodity price shock, natural disasters, or a terrorist attack, those will prove to be temporary problems, as they have been in the past. If we have a nasty recession and the market sells off, there may be better opportunities out there. However, if I have the appropriate time horizon, there is no reason I would need to sell purely based on a cyclical or macro reasons.

Q: Warren Buffett has bought airline stocks in recent memory as an industry basket. Are you aware of other industries going through a renaissance?

A: That is worth thinking about. It is not a great analogy or comparison, but I get weird looks when I point out that the banking industry is in better shape than it has ever been since the advent of the FDIC and the Great Depression. There was a small test case a couple years ago when oil fell sharply in a short period and everybody assumed the oil-exposed banks in Texas and North Dakota were going to go down the tubes. That did not come to pass.

My focus is reasonably narrow on things I already know or can understand over a period of a couple of years — industrials, financials, consumer retail, healthcare. The latter is going to have a lot of change in the coming years. I don’t know whether it is a renaissance or a reshuffling or a slow death march.

About the instructor:

Philip Ordway is Principal and Portfolio Manager of Anabatic Fund, L.P. Previously, Philip was a partner at Chicago Fundamental Investment Partners (CFIP). At CFIP, which he joined in 2007, Philip was responsible for investments across the capital structure in various industries. Prior to joining Chicago Fundamental Investment Partners, Philip was an analyst in structured corporate finance with Citigroup Global Markets, Inc. from 2002 to 2005, where he was part of a team responsible for identifying financing solutions for companies initially in the global power and utilities group and ultimately in the global autos and industrials group. Philip earned his M.B.A. from the Kellogg School of Management at Northwestern University in 2007 and his B.S. in Education & Social Policy and Economics from Northwestern University in 2002.