A time-tested way to find the next small-cap air carrier is to search for a large-cap airline that recently merged or acquired another airline. United-Continental (NYSE: UAL), the result of the merger of United Airlines and Continental Airlines, is the most recent and obvious example. Now that American Airlines (PINK:AAMRQ) has filed for bankruptcy, every legacy passenger airline in the U.S. has ended up in Delaware’s Chancery Court at least once. A short float of 10.22% for United-Continental should have its shareholders concerned toward that end.
George Anders’ Merchants of Debt (Beard Books, 2002), about the leveraged buyout firm Kohlberg Kravis & Roberts, emphasized that airlines were avoided by the firm due to the uncertainties of that industry. For there to be a successful leveraged buyout, the target company had to have predictable cash flow that could service a heavier debt burden. Because of the vagaries of the airline industry (fluctuating fuel prices and business conditions, etc.), airlines didn’t qualify.
Merchants of Debt, meet the new United-Continental.
Basically, in acquiring Continental Airlines for more than $3 billion, United-Continental has committed the classic financial mistake of lending short term and borrowing long term. With a debt-to-equity ratio of 5.69, United-Continental’s debt will certainly be long term. In fact, United-Continental’s long-term debt-to-equity ratio is 5.11. In terms of the short-term funds needed to service that long-term debt, earnings growth for United-Continental was -3.78% for the most recent quarter. With a profit margin of just 1.78%, servicing such an onerous debt burden will be crippling.
The invisible hand of the market has made its opinion known by smacking down the price of UAL since the deal’s announcement in May 2010. At that time, UAL was trading over $26 a share. Now, it’s around $18.40 a share. A short float of 10.22% is betting that it will fall lower (a 5% short float is considered troubling). Both insiders and institutions have been selling, which is not reassuring.
There is much to justify this selling by insiders and institutions, along with the high short position that is taking UAL lower. Crude-oil prices are rising, which devastates an airline since fuel is about 40% of expenses. In a recent Financial Times interview, Ali Niami, the oil minister of Saudi Arabia, stated that it’s his country’s objective to maintain oil prices at around $100 a barrel. A World Bank forecast just reduced global growth estimates by 25%, which is of great concern to United-Continental since it is now the largest airline on the planet.
Since the merger announcement, the decline in the market capitalization of UAL has roughly equaled the cost of the acquisition. This is nothing new for the airline industry. Republic Airway Holdings (NASDAQ: RJET) acquired Frontier Airlines for $1.1 billion in December 2009. The market capitalization for Republic Airway Holdings is now around $175 million, and it has a short float of over 15%. From the “isn’t it ironic” file, the greatest jump in the stock price of Republic Airways over the last year was when it announced its intentions to sell Frontier Airlines in November 2011. (Big surprise: There have been no takers.) United-Continental now appears to be nose-diving in that direction as well.