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The Little Airlines That Could

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A hint -- just a hint -- of being in on the secret creeps into Dan Morton's voice.

"People in the investment community have always said, 'I'd love to have just one more time when I could buy airline stocks and make the kind of money I made in the early '60s," he remarks.

Then he chuckles. "It's already begun. It began last year, to a small degree, and will pick up in the rest of 1984 and on into 1985. Airline stocks in general -- though not all, by any means -- will move to dramatic new highs."

Now Morton is not a disinterested observer. After 15 years in the airline industry and 12 years as a consultant, he has spent the past 3 as head of Daniel Morton & Co., a Stamford, Conn., firm that consults with the airline industry and financial institutions. Still, although he lacks distance, he can hardly be said to be uninformed.

What happened about 25 years ago, Morton points out, was primarily a technological change, notably the widespread adoption of jet aircraft. As air traffic swelled, nearly all the airline stocks rose substantially.

This time around, it is not technology but deregulation that is making the difference. The process began six years ago, with the passage of the Airline Deregulation Act of 1978. But a series of unusual events since then has masked deregulation's effects. First came the Iranian revolution, which pushed fuel prices well beyond their already inflated levels. Then came the Professional Air Traffic Controllers Organization strike. Then the recession. "For the first time in the history of aviation, we had two back-to-back down years -- 1980 and 1981," Morton points out. And the airline business, which depreciates its aircraft over 15 years and acquires facilities for 20-to-40 year utilization periods, isn't exactly a fast-turnaround industry. So only now, he says, are sales and profit curves beginning to get back on track.

Whatever the reasons, there is little doubt that business is booming. Traffic rose from 248.9 billion revenue passenger-miles in 1981 to 281.3 billion in 1983, with industry revenues going from $36.7 billion to $39 billion. The shape of the industry and the rules of the game, moreover, have changed dramatically. In 1977, according to the Air Transport Association of America, there were only 36 certificated interstate carriers. Now, thanks to a flurry of start-ups and once-sleepy local airlines shooting for the big time, there are roughly 120. Routes, fares, and the flying public are all up for grabs.

From the investor's viewpoint, all of this means that putting your money into any old airline stock is not quite the same as choosing the right airline stock. "In the past," says Morton, "the industry was a regulated industry, and the stocks pretty much moved in concert. That's not going to be the case in the future." And there is an obvious world of difference between buying stock in one of the majors and buying stock in a young, growing airline. In the latter case, the future of the industry as a whole is less important than how the airline's management chooses its route structure, builds its traffic, and holds down its costs. When it comes to the smaller airlines, says Tony Lowbeer, an analyst in the New York City office of the brokerage firm Rooney, Pace Inc., "Ordinary investors need ground rules." Beyond the obvious questions of management experience and balance sheets, most experts look first at an airline's cost structure. "I am not interested in an airline unless it has low costs," says Lowbeer, noting that otherwise attractive regionals like Midway Airlines Inc. and New York Airlines Inc. don't have low enough costs for his tastes.

How low is low enough? Another analyst, David Sylvester of Hambrecht & Quist in San Francisco, says that 6 cents per seat-mile is a useful rule of thumb for most regionals. More than that and the airline better have a lot of other factors working in its favor.

Surprisingly, although most low-cost carriers aren't unionized, unionization doesn't preclude an attractive cost structure. Helane Becker, an analyst with Prudential-Bache Securities Inc. in New York City, points to the example of Southwest Airlines Co., which is unionized and which operates at less than 6 cents per seat-mile. The secret, she says, lies in Southwest's short-haul route structure. A typical trip -- from, say, Houston to Tulsa to Kansas City to Oklahoma City to Dallas and back to Houston -- covers a lot of ground and carries a lot of people, yet needs only a single crew. Airlines with longer routes, by contrast, have to give their crews time off at the end of a run, and the companies' productivity suffers as a result.

A second key variable is the market served by the airline. "I want to fly in markets that the Big Three are only in peripherally," says Lowbeer, referring to United, American, and Delta. Becker's favorite example of a company with a good market is Piedmont Aviation Inc. -- which, she points out, flies mainly out of such "underutilized and underserved airports" as Dayton International Airport, Baltimore/Washington International Airport, and Douglas Airport in Charlotte, N.C. Piedmont also enjoys monopolies or near-monopolies in several routes: If you want to go nonstop from Dayton to Los Angeles, you go on Piedmont or you don't go.

"The point is that you've got a company that's keeping itself relatively well insulated from fare wars," says Becker. "They really have no competition." A monopoly, she adds, means that the line can have enough flexibility in pricing to turn a profit even with a low "load factor," or percentage of seats filled. "Even when they operate at 57% of capacity, they're making money."

Airlines that do rely on fare wars attract mixed reviews. "I want to know an airline's not going to try to gore the big guys too badly," says Lowbeer, "and if they do compete against them, they better do it on a combination of service and price rather than price alone." Hambrecht & Quist's Sylvester, by contrast, favors "carriers that plan to stimulate travel demand by charging low fares." Sylvester thus likes People Express Airlines Inc., for example, pointing out that the company dominates cut-rate travel in the Northeast. Lowbeer, mistrustful of People Express' strategy, worries that the airline is growing too quickly and can be hurt too easily if the majors decide to compete on price by removing super-saver restrictions.

Among the most interesting competitive ploys, says Carol Robichaud, vice-president of research for Blackstock & Co., a brokerage firm based in Jacksonville, Fla., are cooperative relationships between a regional airline and one of the majors. Robichaud's favorite example is Atlantic Southeast Airlines Inc., which she has been recommending for purchase since February of this year.

Established in 1979 by three former executives of Southern Airways Inc., ASA flies a hub-and-spoke route system out of Atlanta. But instead of competing with Delta Air Lines Inc., which also flies huband-spoke out of Atlanta, it complements it. Where Delta flies to most major U.S. cities, ASA confines itself to small and medium-size cities in Georgia, Alabama, and other neighboring states. Roughly 85% to 90% of the line's passengers connect with other airlines, with the major portion going on a Delta flight, and ASA designs its schedules to cut the minimum between-flight waiting time at Atlanta's Hartsfield International Airport to roughly 30 minutes, compared with most airlines' minimum waiting time of 55 minutes. Capitalizing on its relationship with Delta, ASA recently began a program it calls Delta Connection, which, in some cases, allows travelers to buy ASA and Delta tickets together at a discount from the combined fares, and, not incidentally, allows ASA to list its flights with Delta's DL symbol on travel agents' computerized reservation screens.

ASA ranked No. 10 on this year's INC. list of the 100 fastest-growing publicly owned companies in America, and by Robichaud's estimate the prospects for continued growth are good: Revenues, she believes, will rise to around $27.5 million in 1984 (from $23.8 million in 1983), and earnings per share are likely to be about $1, compared with 70 cents last year.

The major risk associated with ASA and such otherwise-attractive small airlines, ironically, involves technology. To date, most of them have made do with used aircraft, often picked up at fire-sale prices: planes that Dan Morton observes might cost anywhere in the neighborhood of $25,000 to $50,000 per seat. Now a new generation of fuel-efficient turboprops -- deHavilland Dash 8s, Embraer Brasilias, Saab-Fairchild 340s -- are at hand, and a lot of airlines are racing to buy them. These, Morton notes, can cost up to $150,000 per seat.

"The risk you're taking is that they are moving into operation of some expensive flight equipment. With that comes a degree of financial leverage they have really not had to experience up to this point," he says. Depending on how well the aircraft perform, though -- and how well the planes' capabilities match the airlines' route structures -- they may well pay off in the long run.

In the meantime? Helane Becker of Prudential-Bache, whose firm is unusually bearish on the short-term future, refuses to recommend stocks of any sort for purchase now. But, she notes, the airline investor would do well not to forget the longer term. "If you want to look past the next few months," she says, "we think the underlying values are there."

SMALL-AIRLINE STOCKS: PICK OF THE ANALYSTS

Among the favorites of airline analysts contacted by INC. are:

Stock price

Date began 52-week 52-week

Company operations high low 7/12/84

America West 1983 12 1/2 6 7/8 8 1/2

Atlantic 1979 14 5/8 7 5/8 12

Southeast

Muse Air 1980 17 3/4 6 1/2 6 1/2

People Express 1980 25 7/8 7 5/8 7 7/8

Airlines

Piedmont 1940 42 1/8 27 1/8 29 1/2

Aviation

Southwest 1967 35 1/8 19 19 3/4

Airlines

Last updated: Sep 1, 1984




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