“It’s not debt per say that overwhelms an individual corporation or country. Rather it is a continuous increase in debt in relation to income that causes trouble.” – Warren Buffet
Is it cliché for a financial newsletter to lean on Warren Buffet for its opening line? Absolutely. Do we care? No, not really. Why? Because 1) it’s a relevant anecdote to the section that follows and 2) it’s Warren Buffet, mate.
Plenty of words have been written about airlines, their bailouts and what it all means for the future of capitalism. Articles usually begin with something like “Is Capitalism Dead” or “What Happened to the Free Markets?”. Transparent enough, they are seemingly intended to produce a click, simultaneously confuse, and enrage the reader, then send them back into their Twitter feed a little more dead inside. We are not interested in adding to the noise. What we are interested in is adding some meat to the conversation which is hopefully why you are reading this now. Here’s what’s to follow:
This report is intended to be part fundamental research, part macro, part finance theory, and part policy. Our intention is for this to be the launchpad for deeper understanding and conversation about how we fix an obviously broken system. We are hoping to connect some dots along the way to create a more complete story so as to not limit ourselves in only focusing on a fractional viewpoint of a much larger whole.
So, let’s get started.
The airline industry is especially capital-intensive, usually ranking somewhere behind energy and telecommunications in spend (Capital Expenditures) and, consequently, intangible, long-lived assets (Property, Plant and Equipment). Capital-intensive industries are unique to their capital-lite peers (e.g. software) in that their long term capital allocation decision planning involves investments inexpensive, long-lived assets that are expected to generate future cash flows over a very long period of time. Therefore, the process of allocating capital must be extremely well managed because the decisions made today will greatly affect their ability to generate investor returns many years in the future, meaning missteps are exaggerated against capital-lites. Spending $1 billion on new 5G wireless infrastructure in Manhattan carries with it a certain burden that the R&D spend on a new dating app just doesn’t have. Said in more formal financial analysis speak, the allocation of Capital Expenditures (CapEx) to build an operating asset base, Property, Plant, and Equipment (PPE), will determine a firms’ ability to efficiently create incremental Cash Flow from Operations (CFO from here on out).
We believe CFO to be the most deterministic fundamental measure of a firm’s ongoing success. CFO determines the firm’s ability to invest back into the future growth of the company (CapEx), and/or its ability to finance itself through the financial engineering of its capital structure (issuing or retiring equity (stock buybacks) and/or issuing or retiring debt). Yes, we are purposefully leaving dividends out for the sake of this conversation.
Understanding the relationship between cash on the balance sheet, CFO and the allocation of that combined cash to either 1) additional PPE through CapEx or 2) Financing the capital structure of the company, is so important that we decided to draw this flow diagram to burn it into your memory as we will continuously build off of this design (we like to be overly dramatic only to prove a point from time to time):
What is critically important about the Capital Allocation Decision Tree above is that it illustrates the decision-making process of executive teams, which directly influences the probability of success of every business. This is without exception. How and where companies spend their cash, represented by the ratio between investing in long term growth assets (Option #1) vs. maximizing value through engineering their balance sheet (Option #2), is a balancing act of importance that cannot be overstated. It should be understood that both options are necessary to ensure long-term investment value is maximized, so the ratio between the two is where our focus will be.
Keep this framework top of mind as we dive into the airlines. Our attention will be on the big four (American, Delta, United and Southwest). In aggregate, they gobbled up more than half of the $25 billion of the recent bailout money, they represent about 60% of total routes flown in the U.S. and they employ over 380,000 people.
*The following is not intended to be a fully comprehensive fundamental research report, but rather, a 30,000-foot view at some key financial metrics to gain perspective of relative performance and to set the stage for our deeper discussion.
Let’s first look at how the big four performed relative to each other from the most fundamental of fundamentals: their ability to generate cash flow.
What we are looking at is five-year compound annual growth rates (CAGR) that look anaemic across the board, with American particularly frightening. Compared with firms from similarly capital-intensive industries, the relative numbers don’t look much better. For comparison, energy and telecom players Chevron and AT&T grew their CFO over the same five-year time frame, 9% and 8%, respectively. In absolute terms, cash flow appears to be hard to come by.
Let’s get some perspective and focus on the efficiency of these firms in creating cash flow relative to their operating assets, Property, Plant and Equipment (PPE from here on out).
Still not looking great. CFO relative to PPE is a crucially important piece to the fundamental puzzle because it isolates the past allocation of capital to operating assets and informs us if that allocation was a sound investment. If PPE produces appropriate amounts of cash flow then it makes sense to continue to allocate capital to new assets to create a virtuous cycle to generate more cash, to purchase additional assets, to create more cash, and so on and so forth
If this cycle does not hold true, and the allocation of capital to PPE does not produce incremental cash flows, then the decision to allocate additional capital to PPE begins to get hyper-scrutinized as this relationship is the foundation on which all successful companies are built. The question to ask yourself if you are an allocator of capital (AKA the Corporate Finance Team) is “Is the problem not enough capital being allocated to cash-generating assets, or are the assets simply not producing enough cash flows?” A look below and it appears the answer is the latter:
Southwest aside, the other three firms all increased their CapEx spending by non-trivial amounts over the past five years and even more than their peers in energy and telecom. As an aside, Southwest’s ability to allocate less cash to assets and still generate incremental cash flow may speak to the strategy of a regional airline requiring less capital than non-regionals and the efficient utilization of that capital.
Let’s recap before proceeding forward. Industry-wide, CFO is growing slowly, CFO to PPE is declining, and CapEx is increasing. This means that more resources (cash) are being allocated to assets (PPE) that are becoming marginally more inefficient at producing returns (cash-flows). Fundamentally speaking, this is not a relationship that can hold over time. Without additional cash raises (through additional debt or equity), on a long enough time horizon, these companies will run out of cash and be forced to call the lawyers…or the government.
If you’re an investor and you’re looking to allocate capital into these companies, when studying their long-term return potential, you should be asking yourself: “How much cash flow could be generated by my investment in them?”
Remember the scene in The Dark Knight when The Joker lights a mound of cash on fire? He could have just given the cash to the airlines and they would have more or less done the same thing with it, albeit in a slightly more civilized manner (but Oscar-winning performances rarely are). Invested Capital includes both Net Debt (debt less cash) and Equity. Over the last five years, Southwest has returned 1% annual cash return while the other three have all destroyed value. (As another aside, as of this writing Buffett just held his virtual Berkshire Hathaway conference and revealed he sold all his airline stakes at a significant loss. Not saying he front ran this publication…but he probably did. Crafty old man.)
So, if you’re the airline executive team and you realize that your assets are not producing enough cash to satisfy your investors, where do you turn? The obvious answer is Option #2 of the Capital Allocation Decision Tree, you need to financially engineer your balance sheet to juice returns. And, as we will see next, the environment to do so has never been more accommodative for financial tinkering. Also, now would be a good time to briefly go revisit the Capital Allocation Decision Tree to refresh what Option #2 is.
Act I looked from a high level at the airline industry and how their allocation of capital to Option #1 has not panned out. Sub-optimal cash flows from their operating assets has driven the industry to life-support territory, the COVID pandemic pushed them over the edge and they required a government bailout to keep breathing (to be clear, we are not suggesting the government should have done this, just accepting the fact that they did). Exploring ‘why’ the productivity of their assets has declined requires many additional words that won’t be explored in this piece. We are going to accept the fact that efficiently creating cash flows appears to be excruciatingly difficult. We are not out to fix these companies, but just to explore what went wrong, which brings us to Option #2: The financial engineering of the balance sheet as a means of generating investor returns.
To understand why Option #2 is an attractive one, we need to understand a couple of truths about the macro-environment we live in today. Interest rates and their influence on the accessibility to the debt markets paired with broader stock market returns (a decade+ long bull market fueled by debt and passive flows) are key drivers to a firm’s capital structure decision making. Option #2 allows firms to do just that, alter their ratio of debt to equity to minimize their Weighted Average Cost of Capital (WACC from here on out) which maximizes the value of the firm.
When it comes to interest rates, there is enough literature out there from the Financial Times to the FinTwit crusaders all dedicated to verbally mauling the Fed and their irresponsibly aggressive and long-lived expansionary monetary policy in the years following the Great Financial Crisis of 2007-08. They are all basically saying the same thing: interest rates have been too low for too long. Why does this matter? Because of debt, that’s why.
In a long-term low interest rate environment what you expect to see is a market-wide increase in debt because low rates mean that it’s cheaper to refinance your current capitalization. Low rates incentivize consumers and companies to invest and spend given lower cost of capital and lower incentives of savings. As of this writing, the 10-year treasury is down somewhere near 0.60% from ~5% in 2007, and corporate debt has grown from ~$6 trillion in 2007 to just over $10 trillion over the same time frame. When companies issue debt and receive cash from debt holders, they must decide how to use those new funds, which again takes us back to the Capital Allocation Decision Tree. As we’ve previously explored, management can decide to either buy additional cash-generating assets to create incremental future cash flows (Option #1), or, they can refinance the firm’s capital structure (Option #2).
Where do you think we are going with all this?
Precisely…share buybacks. Low interest rates for an extended period have created an environment where firms have the ability to generate a significant amount of investor value when applying a Discounted Cash Flow model, simply by lowering their WACC by taking on cheap debt and retiring expensive equity.
Share buybacks act as the mechanism for adjusting capital structure. If a firm issues debt for cash and then uses those funds to purchase assets that will eventually create new cash, then the capital structure will eventually adjust itself back as that new cash flow should increase the equity value of the firm. But, if a firm uses the new cash to buyback its own stock, debt increases while shareholders equity decreases. They have not added any new productive assets, what they have done is added debt to lower their WACC, which adds value to the stock price simply through the magic of math. (Much more on that in Act III)
To be clear, this is not entirely unique to the airline industry, it is market-wide, and is concentrated amongst those firms struggling to keep up in an increasingly competitive and innovative world. In a recent interview with 13D (one of the best financial publications out there), Dr. Lacy Hunt said this: “Firms that are struggling to survive are not going to be innovative. They’re trying to engage in financial activities that can keep them afloat because they’ve made financial mistakes in the past and they put too much of their effort into financial fine-tuning (Option #2) rather than the development of new technologies, new methods of distribution and production, and new product lines (Option #1) that could have been beneficial to them.”
Earlier, we mentioned broader market returns as another driver of capital allocation to Option #2. If the broader stock market is returning 10% a year and your assets are only capable of returning 7%, you need to find a way to keep up with your benchmark. If you run a capital-intensive business with low return on assets, and you are competing against asset-lite firms in a decade+ long bull market, Option #2 turns into your best friend, and buybacks are his favorite tool.
According to a Harvard Business Review study published in January, “Buybacks’ drain on corporate treasuries has been massive. The 465 companies in the S&P 500 Index in January 2019 that were publicly listed between 2009 and 2018 spent, over that decade, $4.3 trillion on buybacks, equal to 52% of net income, and another $3.3 trillion on dividends, an additional 39% of net income. In 2018 alone, even with after-tax profits at record levels because of the Republican tax cuts, buybacks by S&P 500 companies reached an astounding 68% of net income, with dividends absorbing another 41%.”
We do not believe this to be a sustainable path forward. At some point, there is no more equity to buyback. Firms need to find ways to create investor value through cash flows. After all, they are operating companies, they exist to create value through their operations, not through continuous capital structure engineering. Without a doubt, they need to tweak their capital structure when it makes sense to do so. If debt is cheap, their ability to service that debt is realistic, and it optimizes their cost of capital, then, by all means, do so. As a fiduciary, it is their responsibility to do so. But in the long game, a healthy company needs to create ongoing investor value through operations.
Back to the airlines, we can see why, given their deteriorating fundamentals paired with a very accommodative macro environment, they would shift their capital allocation decision making towards Option #2. Mathematically, value can be created almost out of thin air while operationally generated value takes time and sound decision making.
What does an industry shifting its capital structure through incremental debt to equity with buybacks look like? It looks like this:
Between the big four, five-year buybacks reached $40 billion and debt to equity of nearly 170%, up 40% over the same time frame. Remember, the total bailout of the airlines, not just the big four, was $25 billion, at the future expense of taxpayers. Meanwhile, in the last five years, the four largest airlines have spent $40 billion of cash in stock buybacks. This bears the question: Should we rescue an industry that has spent more than 1.6x the bailout money in financial engineering that mainly benefits shareholders and management teams? Pause and think about that for a moment.
Issuing debt to receive cash and using that cash to buyback equity has resulted in average cash to debt ratio for the big four of ~40%. Not a very defensible position in case something, like a worldwide pandemic, should come about…
Let’s recap what we’ve covered so far:
In the early days of your finance studies, you learn about the most fundamental decision-making tool, that of the trade-off of between risk and return. This trade-off is an omnipresent condition of our lives, from Friday night decisions of where to go out to the partner you’ll choose to marry. It’s so fundamentally important to sound decision making that it should be taught in Life 101.
As an investor, I am willing to invest my capital in a company because I believe that I am taking on a calculated risk to receive a probabilistically determined return. In caveman speak, I give cash, I receive risk of losing cash, I may possibly receive more cash in the future.
As a capital allocator of a firm, I understand that I need to minimize my WACC to maximize investor value. To my core, I understand every element of the risk and return profiles of my two options: debt and equity. This means that I understand Static Trade-Off Theory, the theory and the math behind how capital allocators should think about Option #2.
Here’s a little financial theory and history. In 1958, professors Franco Modigliani and Merton Miller (MM from here on out) began laying the foundations for modern capital structure theory. They studied capital structures of firms to try and figure out what the optimal ratio between debt and equity for a firm is to minimize their WACC (through Option #2). They knew it needed to include some allocation to debt and some allocation to equity, as each carries their own distinct risk vs. return profile. After multiple iterations over the course of years, they figured out that in a world in which 1) the interest payments that a firm makes on its debt are tax-deductible (creates a tax shield), and 2) at a certain level of debt, the risk of bankruptcy increases (bad for both debt and equity investors), there is some optimal ratio between debt and equity that needs to be balanced. They called this the Static Trade-off Theory. An optimal WACC, determined by Static Trade-off Theory, is the sweet spot mix of debt to equity that will ensure investor value is maximized.
How? It’s math.
A VERY simplified version of a Discounted Cash Flow equation looks like this:
The value of a firm is simply the sum of all future cash flows discounted back to the present day at the firms WACC. As we discussed in Act I, cash is king, and a firm’s ability to generate future cash flow is its sole purpose on earth.
If you don’t see it now, read the below sentence then go back up to the equation.
The numerator is determined by Option #1, the denominator, by Option #2. No, you can never escape the Capital Allocation Decision Tree. It owns you.
If you are a finance executive and your sole purpose on earth is to create investor value by continuously increasing the value of your firm, you can use this financial engineering math magic. No need to increase your cash flows (sarcasm warning). By simply lowering your WACC, you can create ‘value’ out of thin air.
The big caveat we have purposefully skirted up until now is the introduction of Bankruptcy Risk. According to MM, the more debt you take on the riskier your firm becomes because with debt you must pay interest payments and eventually pay back the principal. Again, the key is finding the optimal weight of debt to equity. Assuming a company is of good credit quality, debt is a cheaper form of financing because the claim debt holders have to assets is limited to the amount of principal they invest, plus interest payments (and the company gets the tax shield benefit). From a debt investor perspective, return is capped, but so is risk. Equity financing is more expensive because equity holders take on more risk; if the company goes bankrupt, debt holders have first claim to assets. Therefore, equity holders require a higher return on their investment than debt holders. They expect a higher return for their proportionately higher risk.
In a hypothetical world, MM theory states that if there were no bankruptcy risk, then firms would always choose to finance themselves 100% with debt because it’s cheaper. Because it’s cheaper, the firm’s cost of capital would be lower and investor returns would be maximized.
Back in a reality where bankruptcy risk should exist, if a firm decides to finance itself with 100% debt, then it is highly likely they go bankrupt. Even though debt holders require a lower rate of return and even though interest payments create a tax shield, the firm is not likely to be able to run their operations with large sums of cash going out the door to finance the company. Remember, companies need cash flow from operations to fund additional, ongoing operations; they cannot re-finance themselves into eternity. Unless SoftBank is their lead investor…
Why are we talking about all this theory and alternative realities?
Because theories and alternative realities were required before we peel back the next layer and transition into understanding what the government bailout of the airline industry has done. The bailouts have fundamentally broken the basic principles MM set forward 70+ years ago. Principles that value and fundamental investors have relied upon for years to understand the most basic existential question keeping them awake at night “what is this company worth?”. More likely than not, this round of bailouts (along with the ones during the Great Financial Crisis) may have permanently altered the decision making of investors and capital allocators to the detriment of society.
Recurrent bailouts remove bankruptcy risk. Actually, even worse. They remove bankruptcy risk for investors and capital allocators and shift that risk to society (i.e. taxpayers).
By breaking the Static Trade-off Theory and shifting bankruptcy risk to society, risk vs. return goes from broken to unrecognizable, and now we introduce Moral Hazard.
According to the only reliable source of information on the internet these days, Wikipedia states that a Moral Hazard exists when an individual has an incentive to increase their exposure to risk because they do not bear the full costs of that risk. Because bankruptcy risk has now been shifted to society, investors and capital allocators are willing to take on more risk (debt) because they no longer bear the full costs associated with the increase in bankruptcy risk.
Professor Scott Galloway at NYU was one of the first to recognize this and used the line “Privatized Gains and Socialized Losses”, which is about 4,500 words less than it took us to get here.
That was all a bit depressing so let’s try to end this on a high note and figure out how we move forward in a more socially responsible manner.
MM figured out that some ratio of debt to equity will minimize WACC and therefore maximize shareholder value. What they were not able to foresee was the government shifting bankruptcy risk from investors and corporations to society. Therefore, we need to adapt the Static Trade-off Theory to include this new fact of life. It is time to accept the fact that maximization of firm value cannot come at the expense of society, who does not get to participate in the return. What we need is a new equation.
Recall that firm value is simply the sum of their future cash flows discounted back to today at their WACC. And maximization of firm value is the point at which WACC is minimized.
To protect society, the ratio of Debt to Equity (D:E) in the WACC equation requires regulation. Yes, regulation is an ugly word in the world of finance, but because we no longer allow free markets to regulate reckless financial decisions, it’s probably time we require something else too. We need to offer a realistic solution because as of this morning, the U.S. Federal Government debt (AKA taxpayer debt AKA society debt) just topped $25 trillion. Which means that society already has a sizeable hole to try to dig itself out of.
How do we regulate corporate capital structures to minimize harm to society? One suggestion, just add a C.
Cash is the cushion that offsets reckless capital structure tinkering. A minimum threshold of Cash to Debt (C:D) is a seemingly obvious, overly simplistic solution, but it’s a start.
By forcing corporations to carry on their balance sheet a ratio of C:D, we can ensure at least some margin of safety to protect society. This is the same recommendation we make in the personal finance world. ‘You should always have 6 months of cash in case you lose your job’. We’re just requiring corporations do the same, which seems reasonable.
Creating a C:D law carries with it knock-on effects that need to be explored in much more detail. One such effect is investors will need to alter their return expectations. If firms are required to carry on their balance sheet a cash cushion, cash being a non-cash flow producing asset, then returns on assets will be lower. This is the harsh truth of a new, slightly more socially responsible, reality.
If we hold C:D constant, we don’t actually care what happens to D:E. If companies wish to take on loads of debt to buy back their own equity, they are free to do so, so long as the C:D constant holds true. What that C:D ratio is, again, needs further exploration. But maybe we start with 1:1.
1:1 would not have allowed American Airlines to accumulate ~$24 billion of debt while buying back $12 billion of stock and be left holding just under $4 billion of cash at the time of a pandemic occurring. Maybe then, just maybe, they would not have needed $6 billion from taxpayers to stay alive. Looking back at all the airlines up on the ‘Cash to Debt’ chart, the 40% average in 2019 would need to get to 100%.
No one here has ever operated an Airline, so we won’t pretend to know. That’s for the operators to figure out.
One thing we do know is that Moral Hazard is bad, and it’s worse if it is a trend. LTCM, 2008, and now this. If you stack the cards against society too many times, bad things can happen. Not saying they will, but they can.
Therefore, one solution could be some cogent form of capital structure regulation. The alternative would be we embrace real, full-frontal all-in free markets. If a company mismanages itself and the cold world of capitalism decides it’s time for them to go, then we say good riddance. No more ‘too big’ or ‘too systemic’ to fail. We’re indifferent to either path, as long as we choose one and be faithful to it.
Though, until the latter becomes reality, something probably needs to change. And it could start with a C.