Are Legacy Costs Really AMR's Biggest Problem?

Rubens writes:

"Can you give some specific advice to the big airlines on how they can cut costs and become profitable? I don't think you really understand their situation. To compare the big airlines with the budget ones is like comparing a Ford and GM plant with a Toyota one. Ford and GM has massive legacy costs of high salaries and benefits, and so do the big airlines. American is one of the few (or is it the only one?) of the big airlines that hasn't filed for Chapter 11 in recent years, which would have let them reduce costs and renegotiate legacy employee agreements."

Thank you for the comment, Rubens.

Unfortunately, it simply isn't true that legacy costs are the problem for American. In fact, Southwest actually spent more on wages, salaries, and benefits than American did in the first quarter.

As you can see from the Q1 summary below, American's cost structure is higher than Southwest despite the fact that they spend less than Southwest on compensation expense. The difference in fuel costs is due to Southwest's hedges (which tapers off over time) and it is too late to hedge those now.

airlinecompq108.PNG

However, AMR operating losses in Q1 amounted to 3.3% of sales, which just so happens to be the difference in "other" operating costs. So, if AMR could simply get their non-fuel cost structure in line with Southwest's, they would have broken even in the first quarter.

UPDATE: I left off one statistic I meant to include. AMR employs 152% more people (85,500) than Southwest does (33,895) yet AMR only has 125% more in revenue. So staffing levels are another area they could cut to get their revenue per employee ratio down.

Full Disclosure: No positions in the companies mentioned at the time of writing

$130 Oil Leads to Irrational Moves at American Airlines

With oil prices surpassing $132 per barrel today for the first time ever, American Airlines (AMR) has reacted by raising prices. Most notably the airline will charge travelers $15 to check a bag. The company calls this a "revenue growth initiative" in their press release, but it is really just silly. When high fuel prices are pressuring an already bloated cost structure and a weak economy is reducing air travel, price increases are not going to help AMR. It simply does not address the problem.

In such a competitive industry, weak players increasing fees will only result in more people going to discount airlines, which are run far better than their larger counterparts. There is a reason Southwest Airlines (LUV) has been taking market share and has never lost money in any year since its founding more than three decades ago and it is not because they started to charge their customers for things like checking baggage. In fact, they have used those boneheaded ideas in their brilliant marketing campaigns:

Other airlines charge all kinds of fees. Southwest doesn't.

The problem for AMR and the rest of the airlines that go bankrupt every five or ten years (this time will be no different) is that they rarely directly tackle the problems that are causing them to bleed red ink. Raising prices in a price sensitive industry reduces revenue and does nothing to address bloated costs. The airlines need to get their costs in line with their revenues. It is not rocket science; Southwest and JetBlue (JBLU) have done wonderfully over the years.

The AMR story is not very much different than the management of our federal government lately. Gas prices are crippling lower class Americans? Okay, then we will give them tax rebate checks and tell them to go out and spend that money on $4 gasoline. How does that solve the problem? As Dr. Phil would say, "money problems are not solved with more money."

All the government is doing is paying us to buy gas when buying gas is exactly what is causing fuel prices to be so high in the first place. We are sending money straight to the oil executives and the nations who export their oil to us. This transfer of wealth, both from poor to rich and from the U.S. to the oil producing nations, doesn't even begin to address the energy problems we face. As 5% of the world's population using 25% of the world's oil, paying our citizens to buy gas is the last thing we need.

As long as these are the things that AMR and the government are doing about sky-high oil prices, the investment strategy is not very difficult to pin down: stay long oil producers, foreign currencies, and the rich and stay short the airlines, the dollar, and the poor.

Full Disclosure: No positions in the companies mentioned at the time of writing

Chesapeake Energy Boosts 2008, 2009 Production Forecasts on New Discoveries

Following up my March 12th post on natural gas producer Chesapeake Energy (CHK) (More on Chesapeake Energy), on Monday the company announced major new discoveries and boosted its production growth forecast for the next two years.

Thanks to a huge find in the Haynesville Shale in Louisiana, in addition to seven other new finds, Chesapeake now expects 2008 production to grow by 21% (vs 20% a month ago) and another 16% in 2009 (vs 12% a month ago). An additional $950 million in capital expenditures will be required between now and year-end 2009 to fund these projects, which will result in CHK tapping the financial markets for capital.

While capital raises were not in CHK's prior plans, the company has already started to increase its hedges (thanks to the recent run-up in natural gas prices), in order ensure that shareholder returns on these new projects are substantial. Chesapeake has now hedged 71% of its 2008 production at $8.77 per mcf, 40% of 2009 production at $9.13 per mcf, and 12% of 2010 production at $9.34 per mcf.

To give you some perspective, CHK averaged $8.14 per mcf of gas in 2007 and $8.76 in 2006. So, CHK's averaged realized price should be around 2006 levels this year, but production will be about 50% higher than it was two years ago. I bring this up because Chesapeake earned $3.61 per share in 2006 and the current 2008 estimate is only $3.54 per share. It appears CHK will earn more than the current consensus estimate in 2008. Analysts' 2009 projection of $3.46 also appears too conservative.

Full Disclosure: Long shares of CHK at the time of writing

Should We Buy the PetroChina Stock Warren Buffett Sold?

First of all, let me say that I think Warren Buffett's investment in PetroChina (PTR) was probably one of the most impressive bets he has ever made. Before China or energy were hot commodities he found a company that was emblematic of both and turned a $488 million investment into $4 billion, an astounding 700%+ return in five years. I'm not sure where that ranks among his all-time best investments (Buffett experts, please let us know), but it is surely his best in recent memory.

Buffett sold his PTR stake in the 150's, after which the stock soared to above $260 per share. China's market has since dropped precipitously, and PetroChina shares now sell for around $120 each. Despite Buffett's decision to exit the stock (20% above current levels), I think PetroChina looks like a good investment today.

Before I get into why I think so, let me share what Buffett had to say about his PTR investment in his recently released annual letter to shareholders:

"We made one large sale last year. In 2002 and 2003 Berkshire bought 1.3% of PetroChina for $488 million, a price that valued the entire business at about $37 billion. Charlie and I then felt that the company was worth about $100 billion. By 2007, two factors had materially increased its value; the price of oil had climbed significantly, and PetroChina's management had done a great job in building oil and gas reserves. In the second half of last year, the market value of the company rose to $275 billion, about what we thought it was worth compared to other giant oil companies. So we sold our holdings for $4 billion. A footnote: We paid the IRS tax of $1.2 billion on our PetroChina gain. This sum paid all costs of the U.S. government - defense, social security, you name it - for about four hours."

First of all, the paragraph quoted above tells us that when Buffett says his desired holding period for an investment is "forever," that is not entirely true. He buys a stock that he feels is undervalued, and when it reaches fair value in his mind, as PTR did, he sells it. I think any investor trying to outperform would be advised to do the same.

Now, there are some interesting things about this story to mention. When Buffett started buying PetroChina the price of crude oil was $25 per barrel. He tells us in his letter that at that time he felt the stock was worth about 1.7 times its actual market price, or $100 billion.

If we use his own valuation and simply adjust it to reflect higher oil prices, we can determine an approximate value for PTR right now. Oil trades at $100 per barrel today, so that implies Buffett's valuation model gives PTR an intrinsic value of $400 billion, or $223 per share.

Now, you might ask if that math should be trusted why would Buffett choose to sell last year for only $150 per share? Well, it just so happens that crude oil was trading at $70 per barrel when Buffet sold PTR. Since then oil prices have jumped another 50%, which would imply that had he used a $100 oil price assumption, Buffett's fair value for PTR would be about $225 per share. Pretty darn close if you ask me.

So, did Buffett sell PetroChina too early? Well, that depends on how you view the energy landscape. If you think that energy prices are in "bubble" territory and are overvalued at current prices, then he probably got out at a great time. However, if you are like me and think the bull market in commodities (including energy) has a lot of time left to go which could push crude oil to $150 or more in coming years, then yes, Buffett left a lot of money on the table that investors can now take for themselves. After all, PTR trades at $122 per share right now, about 80% below Buffett's own fair value calculation if you believe oil prices stay elevated long term.

Full Disclosure: Long shares of PetroChina at the time of writing

More on Chesapeake Energy

"madhatter" writes:

After reading your old post, I'm just curious as to why you personally like CHK out of the bunch? Based on fundamentals alone, it seems like DVN or SJT might be a better play on nat gas (even though I realize the latter is a trust). Does CHK have something that I'm missing? Because their fundies seem to put them in the middle of the pack as just 'average' in terms of nat gas players. Thanks for your thoughts.

I neglected to expand very much on Chesapeake Energy (CHK), since I've written about it before (to read prior posts simply do a search for "chesapeake" from the left sidebar of this blog), but it has been a while so let me go into more detail. Here are four main reasons for my bullish stance on CHK:

1) Chesapeake is the largest independent domestic natural gas producer

This is beneficial for several reasons. They have a very large, diversified asset base from which to grow production and reserves. When you are such a big player and have extensive experience drilling in different areas of the country, it gives you an advantage that should lead to very high success rates with future drilling programs. Also, it means Chesapeake would be an ideal acquisition target for one of the big oil giants at some point in the future if and when management decides to consider an exit strategy.

2) Industry leading production and reserve growth

Indeed, the numbers back up the points made above. Chesapeake's organic production and reserve replacement rates are among the highest in the large cap natural gas sector (they might be the highest, but I do not have data in front of me to prove that, so I will include the "among" qualifier). In 2007, CHK increased gas production by 24% over 2006 levels and the company's reserve replacement rate was a staggering 369%. Company guidance for 2008 is for 21% gas production growth, followed by another 13% in 2009.

I think you will be hard-pressed to find large natural gas producers that are posting organic growth rates much higher than that (clearly small firms can have large growth rates due to a small starting base). As a result of past growth and the expected continuation of it for the foreseeable future, I feel Chesapeake's fundamental outlook is as strong as, if not stronger than, the competition.

3) Extensive Hedging Program

Chesapeake has the most extensive gas hedging program in the industry. The company has 70% of 2008 gas production hedged, as well as 33% of 2009 production. I like the hedging program because it reduces the commodity price risk the company faces, so its earnings stream is very predictable. The gas market is very volatile, and as a result, Chesapeake doesn't get hurt too badly when prices fall, but when markets are strong (or weather patterns cause temporarily sharp increases in prices) the company steps in and increases its hedges to lock in high prices that might not be realized otherwise.

4) Superior Management, Insider Buying

CEO Aubrey McClendon has been one of the most aggressive insider buyers of his company's stock that I know of. Given his superb track record of producing strong financial results, this is not surprising. McClendon has long been singing the praises of his company's stock, but unlike most executives who do so, he has been putting his money where his mouth is (and he's been right). He is the largest individual shareholder in the company he co-founded. In 2008 alone he has purchased more than 1.63 million shares of CHK on the open market at prices between 35 and 46 per share. That is ~$70 million of his own money! Investors should feel comfortable that they are investing right alongside him. Plus, with such a large stake in the company, you can bet that when he wants to retire, the company will be up for sale to maximize shareholder value.

The reader mentions Devon Energy (DVN) and San Juan Basin Royalty Trust (SJT) as other, potentially more attractive natural gas plays. I am actually a big fan of Devon. However, it's not really a pure play on natural gas (they are 50/50 between gas and oil). If you are looking for a well balanced domestic energy exploration and production company, I agree DVN should be near the top of your list.

Royalty trusts are interesting plays, given their high yields, but they tend to be less geographically diversified and have less financial flexibility. SJT, for instance, focuses on New Mexico, so their asset base is not diversified and they are much smaller than Chesapeake.

Also, while the high dividends of trusts are attractive, they really do not allow company management to be flexible in how they grow the business. When you pay out most of your income out as a dividend, you don't have much capital available to grow faster organically or make acquisitions. Rather, you are forced to sell debt to raise money, which isn't always an ideal funding mechanism (like now when credit markets are shaky).

So those are my thoughts on Chesapeake. Although I am a big fan of the company, there are definitely plenty of very good energy companies from which to choose from. Do you have other favorites? Let us know which ones and why you prefer them!

Full Disclosure: Long shares of CHK at the time of writing

Natural Gas Update

In July of last year I wrote that the United States Natural Gas Fund ETF (UNG) looked ripe for gains after a 30% drop from $54 to $38 per share. In recent weeks natural gas has become a hot commodity, with prices hitting $10 last week, up from under $6 last year. UNG shares have jumped 25% to $47 each and I think some profit taking is in order. Long term I still like energy in general and gas specifically, but at this point I think owning hedged exploration and production stocks makes more sense than owning the gas ETF after such a large increase in underlying commodity price.

Which gas stock would I point readers toward? Long time readers will be bored with this company, but Chesapeake Energy (CHK) continues to be my favorite domestic natural gas stock (newer readers can refer to my September 2006 piece entitled An Attractive Entry Point For Chesapeake Energy). Like UNG, CHK too has risen sharply (from $29 to $44 since that bullish article), but they have the advantage of being able to hedge prices for their ever-growing production, so they will get hit much less than UNG during the next natural gas sell off, which will surely come despite the recent renewed enthusiasm for the commodity.

Full Disclosure: Long CHK at the time of writing

Barron's Pans Buffett's Berkshire

When I heard the media reporting that the Barron's cover story this weekend was a piece warning investors that shares of Berkshire Hathaway (BRKA) were overvalued, I was both surprised and in agreement. I think many publications would avoid panning Berkshire's investment merits, even if they believe the stock to be too high, just because we are talking about the greatest investor who has ever lived. On the other hand, the case that BRK is overvalued is pretty strong, so from that standpoint, Barron's might be doing investors a favor by pointing it out.

I didn't read the full article, but the news wires are reporting that Barron's concluded that BRK is about 10% overvalued at current levels. I decided to take a quick look at the stock's valuation to see if I agreed with that. I was already aware that Berkshire's P/E was well above 20, which is why I do not own any shares in the company, but at that same time, one could surely argue that most of Berkshire's value should not be measured using a P/E ratio. As a result, I did some quick number crunching using book value rather than earnings per share.

The reason for using book value is quite simple. A majority of Berkshire's net worth comes from stock holdings in public companies as well as operating businesses (from which most of the net income is derived from the insurance business). Insurance companies are valued using price-to-book ratios (typically they garner a ratio slightly above one) and common stock investments can be valued easily using current market values.

As of September 30th, Berkshire's book value was $120 billion. Of this, more than half ($66 billion) lies in the company's stock holdings. That leaves $54 billion in book value from Berkshire's operating businesses. If they were solely in the insurance business, I might assign a price-to-book value of somewhere around 1.2x to them, but Berkshire is more than just insurance. As a result, you could conclude that Berkshire's operations should be valued at two times book, so let's use that number.

Quick math nets us a value for Berkshire of $174 billion (2 x $54b + $66b). At Berkshire's current quote of $137,000 per share, that would make BRK about 18% overvalued, even more than the Barron's estimate. Buffett clearly is worth a premium for most investors, but at the very least, Berkshire stock hardly looks like a bargain after a huge move upward in recent months.

Full Disclosure: No position in Berkshire Hathaway at the time of writing

Thoughts on Crude Oil's Record High Above $88 Per Barrel

I have recently suggested investors consider taking some profits in the crude oil market, but prices in the low 80's price range has not stopped the commodity from continuing its ascent. Crude oil is hitting new historic highs today above $88 per barrel. The contrarian in me prefers to buy weakness and sell strength, so even though the current rise could continue, I am not going to jump on the momentum train and suggest people pile into crude in the short term. Longer term, though, I think it is worth taking a look at what will ultimately dictate where oil prices go.

To understand oil market dynamics, one can simply boil it down to supply and demand. There is a debate right now among energy watchers as to whether or not we are actually reaching a peak in world oil production. Obviously, if that is indeed the case, and demand continues to rise on the heels of a global economic expansion, higher oil prices are the likely result. However, official projections from various agencies still project that production will increase to meet higher demand, despite evidence in recent years that production gains are easier said than done.

Consider information from the U.S. Energy Information Administration. The EIA's own data shows that despite a trend of ever-increasing oil demand around the world, production has actually been leveling off. In 2005 and 2006, world oil production was 84.63 and 84.58 million barrels per day, respectively. Estimates for 2007 stand at 84.72 million barrel per day.

As you can see, world oil supplies have been essentially flat for the last 3 years. Interestingly, energy experts have predicted production increases in the past for this period, but such gains have not been realized. This data gives the "peak oil" theorists some ground to stand on.

Once again, the EIA is projecting 2008 oil production worldwide to increase meaningfully, to 87.06 million barrels per day. If this forecast proves true, those suggesting that international oil production has already peaked will be dismissed. However, if production fails to meaningfully rise during 2008 in the face of higher demand (for the fourth consecutive year), chances are the oil markets will reflect this dim supply/demand outlook in the form of higher prices.

The chart below shows the data I have referenced above in graphical form. In my view, this is the trend we should be watching to see where oil prices are headed in the intermediate to longer term. The short term, however, is anyone's guess.

Source: U.S. Energy Information Administration web site

Crude Oil Might Be Ripe for Some Profit Taking

Short term movements in energy markets are very much tied to supply and demand. Seasonal variations in the dynamics for crude oil and natural gas can allow for some very successful trading in these areas. With crude oil prices sitting around record highs of $79 per barrel, and the summer driving season winding down, it might be prudent to take some chips off the table if you purchased shares of the United States Oil Fund (USO) as I suggested back in January when the crude oil ETF was down 40% from its high.

Since then shares of USO have risen more than 35% to $59.43. This is not to say that I would get off of the energy train for good. But if you have an elevated exposure to crude oil specifically, maybe take some profits. Oil prices could go up further if we get any strong hurricanes in the next month or two, but the seasonal oil play is nearing an end, so lower prices would not be surprising as we head into the winter.

Rather than move out of energy completely, moving some crude oil funds into natural gas would be a good value alternative given that natural gas prices are depressed right now. Winter heating season is coming soon, so there will be more potential catalysts for that commodity in coming months. Natural gas plays would include the previously recommended United States Natural Gas Fund ETF (UNG), Chesapeake Energy (CHK), as well as Select List pick Gastar Exploration (GST).

You may have noticed that Warren Buffett is trimming his position in PetroChina (PTR), the large Chinese oil producer. I doubt these actions are being made on a short term trading prediction (Buffett is the epitome of a long term investor), but it reinforces the need to buy low and sell high to maximize returns.

Crude oil is on a roll right now, and that fact makes it hard for some people to not want to keep riding the wave, but selling into strength is a crucial strategy for those looking to maximize long term investment returns. Buffett's purchase of PTR as a play on both China and crude oil, before those two areas were popular investments, should go down as one of his best investments in recent history. And yet, he isn't being shy about taking some profits.

Full Disclosure: Long shares of CHK, GST, and UNG at the time of writing