Airline Promo Gone Bad

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Gary Leff is one of the foremost experts in the field of miles, points, and frequent business travel - a topic he has covered since 2002. Co-founder of frequent flyer community, emcee of the Freddie Awards, and named one of the "World's Top Travel Experts" by Conde' Nast Traveler (2010-Present) Gary has been a guest on most major news media, profiled in several top print publications, and published broadly on the topic of consumer loyalty. More About Gary »

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  1. With the exception of Apple, buying back stock is the biggest waste of capital in the American economy. Companies that buyback stock using borrowed money, and then go bankrupt, should have their boards go to jail!

  2. @JohnB
    I have to strongly disagree. With interest rates so low, buying back stock at a valuation of 7x earnings is incredibly accretive to earnings. The stock may not react initially, but it sets up earnings to be a lot better than they would have otherwise been. That means either investors will bid the stock up when they see the higher Earnings per share reported, or they won’t, and the stock will be even cheaper at 6x or 5x earnings. Maybe other issues continue to cause investors to stay away and for the stock to remain cheap, but from a management perspective borrowing at low rates to buyback your cheap stock is a solid strategy.

  3. @Rob, you do know that the money, which has already been spent for a nonproductive purpose. needs to be paid back, right? So AA needs to generate even more cash flow which they haven’t been able to produce enough of to fund their capital expenditures. And that leverage of capital works both ways. Yes, if they starting earning more money (no reason to think they will), then the earnings per share are accelerated. On the other hand, if losses arrive (which seems likely, since perfect conditions for airlines, like low interest rates, low fuel prices and robust economy, aren’t likely to continue forever), then those losses are magnified, and borrowing capacity has already been used up to try to pump up the stock price

  4. Thanks for posting about the Aeroplan fiasco. I had only seen this on one other blog (canadian) site prior to this. I’m kinda surprised there’s not even a mention of this over on FT or OMAAT.

    However, now that AA has opened the door, seems Aeroplan is following. Although I think the Aeroplan one is more “wide open” (if you will). But both companies seem to be taking a zero tolerance policy.

    It wouldn’t surprise me in the least if we see Delta (for example) start whacking accounts who got more than one DL Amex bonus (per card) in a “lifetime” in the future.

  5. @farnorthtrader
    I get your point, but you are pre-supposing that they will go bankrupt. Every dime spent by any company can be considered wasted if you knew beforehand that it would go bankrupt. You may have a different perspective of the future of AA’s prospects than management does (or clearly the lender that made the facility available) but deploying cheap capital to buyback cheap stock is a solid financial move assuming the company will be a going concern. The other major plus of this strategy is the tax efficiency since interest on the debt can be expensed, whereas paying capital back to shareholders via dividend cannot and also generates taxable ordinary income for shareholders.

  6. @Rob:

    Exactly. As much as I think Doug is a horrible CEO, the fact that they are buying back billions of stock at these low prices actually embeds a ton of upside leverage into the company.

    I would much rather a company buy back stick at depressed prices than at or near all-time-highs (a la Boeing). I like to rip AA for a lot of things, but this one is going to pay off for them in a big way.

  7. @Gary: “The buybacks have signaled lack of productive investment opportunities for cash at the airline. ”
    Or that management considered the stock to be undervalued, making it a good investment.

  8. @toomuchflying and @L3

    I agree. Gary’s point about buybacks signalling a lack of better growth opportunities is typically right. I just don’t think it’s right in this case. At this low valuation and low interest rates, I think most professional investors are viewing share repurchases as a vote of confidence. Let’s not forget that buybacks are a board level decision. It’s not like someone bought some stock on a whim. This was carefully considered. Let’s also not forget that on the outside we are all playing armchair quarterbacks. The people making this decision are insiders with access to all internal financials.

    Sure they can all be wrong, AA could ultimately go bust and @johnB could turn out to be right, but that’s by no means guaranteed and I would argue it is a non-consensus view. That’s why stocks go up and down and don’t just stay flat. People have different expectations and those expectations change with new information/earnings reports etc.

  9. @Rob, and following comments, I have no idea if the company will go bankrupt or which direction the stock price might go next or at any time in the future. Neither do you and, obviously, from previous comments about where they thought it was going to go, neither does AA. What we can say for certain, is that borrowing to buy stock has a negative effect on earnings (not earnings per share) and a negative effect on debt to equity ratio. Those are the only facts. Generally speaking, the only effect that can be said about borrowing to buyback shares is that it will amplify any future impact on the share price, so fi the price, goes up, it will likely go up more, if the price goes down, it will likely go down more.
    Back in the day (maybe two decades ago), the only time that a company would buy back shares was if they had so much cash that they really did not know what to do with it. Doesn’t do anything to help the company itself but doesn’t do the company any harm if there was really nothing else productive to do with the money. Somewhere along the way, management started noticing that this provided a nice bump to the stock price and a nice bump to their bonuses and stock options, so now leverage is used to try to manipulate the stock price to the benefit of management. It harms the company by having to commit to interest payment as opposed to having optional dividend payments, by increasing the leverage ratio making future borrowings more expensive, by requiring future cash be used for debt payments instead of productive capital investments and by causing the company to pay out bonuses to management that were not earned by the performance of the business, but by the manipulation of the stock. It is not only in the event of bankruptcy that borrowing money to buy back shares hurts the company.

  10. @fartnorthtrader: ” Those are the only facts”.

    No. If the purchase credibly signals undervaluation the stock price rises and stockholder total return is higher due to the buyback.

  11. Pretty much every company eventually goes bankrupt. Even titans of industry like the Penn Central RR. Any canal companies from the 1830’s still around?

  12. @farnorthtrader: “Back in the day (maybe two decades ago), the only time that a company would buy back shares was if they had so much cash that they really did not know what to do with it.”

    Wrong. They could always pay dividends.

    “…Doesn’t do anything to help the company itself”

    Repetition, but still wrong.

    “…there was really nothing else productive to do with the money.”

    This has never occurred in the whole of human history. Have you heard of T-bills or savings accounts?

    “Leverage…It harms the company by having to commit to interest payment as opposed to having optional dividend payments, by increasing the leverage ratio making future borrowings more expensive, by requiring future cash be used for debt payments”

    So , optimal leverage is always zero?

    “so now leverage is used to try to manipulate the stock price to the benefit of management. …requiring future cash be used for debt payments instead of productive capital investments and by causing the company to pay out bonuses to management that were not earned by the performance of the business, but by the manipulation of the stock.”

    This has never happened either. When you tried it I mounted a proxy fight that fired your arse and replaced you with someone who knew the consequences of that behavior, so did not engage in it. There is a market for corporate control you know.

    You appear to be a fount of economic error. Useful for Finance 101 exam questions, but not in the real world.

  13. @farnorthtrader.
    Sorry, I disagree with the “buybacks harm the company” thesis as well as the “leverage is bad” thesis. And I reject the “back in the old days” logic. 20 years ago Libor was at 7%, today it is 1.8% That alone completely flips your points upside down the other direction.

  14. @L3, regarding your first comment:
    “No. If the purchase credibly signals undervaluation the stock price rises and stockholder total return is higher due to the buyback.”
    The use of “if” at the beginning of your statement clearly shows that this is a speculation, not a fact. Absolutely true that “if” the purchase was at below the true value of the shares, then it would be accretive to the company and the remaining shareholders, however, I have no idea why you would assume that every other investor in the market has no idea that the value of the shares are much higher, or that if they know it is much higher, they have not acted on it. Clearly, you believe this to be the case, so I assume that you have already fully leveraged your purchases of AA to the greatest extent you can and are now happy that AA is further extending that leverage for you.

    In regard to your second comment, yes, they could pay dividends with extra cash, but it is effectively pretty much the same thing, they are paying the money to shareholders. Moot point because it was in regard to surplus cash, not borrowing to buy back shares, however, possibly a good thought exercise. Would you be equally as supportive of management if they borrowed to pay a dividend on the basis that AA can borrow at lower rates than what their shareholders could?
    In regard to investing in T-bills, economically, that is not a productive use of money, it serves only to preserve the spending power of your money as risk free assets like this more or less only pay the inflation rate in the long term.
    Not sure where you thought I said that optimal leverage is always 0. Never mentioned by me and I have never even considered it as a concept. Leverage is vital in acquiring productive assets like aircraft. You need to be able to earn more than the cost of borrowing and gain more cash flow than required for servicing in order for leverage to have a positive effect on your company. Explain for me how a stock buyback allows you to earn more than the interest expense or gain more cash flow than the debt servicing. The only possible way that it can is if you later sell the shares for more than you bought them for plus the interest you paid on the borrowing. If that is the case, then you are saying that you think it is a good idea for AA to speculate in the stock market. I would prefer that they stick to the airline business, it is where their expertise is supposed to be (although that is extremely questionable as well).
    Finally, you suggest that I am not seeing the real world, a comment which followed an assertion that no management of a publicly traded company has ever made a decision in their own best interest without activist shareholders firing their arses. Are you sure that every management decision in their own self interest has resulted in their arses being fired? Who isn’t living in the real world?
    Has it happened? Yup, I am sure that there are examples where self serving managers were kicked to the curb without reaping the benefits of their questionable behavior, but they would be rare. To be clear, I don’t think most public company management (and directors that they are naturally allied with) are working solely in their own best interest, but there are certainly some that are, whether they realize it or not.
    I didn’t really intend to get into a pissing war, however, it would seem that your intent is otherwise, so I shall join you. At least I could (and did) pass Finance 101; it would appear that you would be incapable of even that. For reference, both a major in finance and a masters in finance and 20 years working in the markets and banking to the level of CEO, plus 10 years owning my own privately held company. Perhaps you would like to advise the background that has endowed your thoughts with such wisdom that you can confidently call out my real world and finance experience?
    @Rob, we can obviously agree to disagree, although I want to point out that I never said buybacks are bad, I said leveraged buybacks are bad. We can still disagree, but need to make sure that we are disagreeing about the same thing. Buybacks with surplus cash are basically neutral for the company, positive for the shareholders, and positive for the economy as a whole, as that money can be reinvested in more productive (than T-bills) endeavors for both the shareholders and the economy. Leveraged buyouts, on the other hand, are net negative for the company, speculative for the remaining shareholders and net neutral for the economy. I have explained why they are bad for the company. The effect on the shareholders depends entirely on whether the stock goes up or down, which has no direct connection to the buyback. The effect on the economy is neutral as they have just taken money out of the economy by borrowing it and put it back by buying their shares with it.
    Changing interest rates have very little effect on my logic. The risk profile at lower interest rates is improved because the costs of servicing are reduced, but the signal from lower interest rates is that weak economic growth is coming, which raises the issue of whether the stock price, instead of being at a low point as you seem to believe, is actually reasonably valued or even overvalued still.

  15. @farnorthtrader
    You’ve got some good thoughts, but my impression is that your beliefs are based more on preconceptions about the way things should work, versus experience with financial modeling. When you run the numbers it is a no-brainer and interest rates are central to the analysis. To dismiss them out of hand kinda gives you away.

  16. @Rob, Thank you for seeing that there is a basis for another possibility. There is no possible model which makes any financial transaction like this a no brainer or everybody would be doing it. For an extreme example, see Lehman. For a less extreme look at GM. They bought 20 billion of their own stock between 1986 and 2002 (and not even leveraged). They believed their stock to be undervalued and that their cash was surplus. They knew a lot about their company. Their business is less cyclical and less risky than the airline business. Yet still, a few years later, they had to be bailed out or would have disappeared. It was the wrong decision for the company based on wrong assumptions about what the future possibilities could be. In their models, they failed to conceive of a severe downturn. If they had borrowed to finance those buybacks? That would have been exponentially stupid. AA, at this point, if they really are doing this because they believe their stock is undervalued, having to be projecting that the current combination of robust economy, low fuel prices and low interest rates will not only continue, but improve. If that projection is wrong, they are screwed. If they have inside information that they have not shared with the market and bought back their shares, they are in violation of a whole raft of regulations and subjecting themselves to shareholder lawsuits. I see two other possibilities here, neither of which is very flattering for the management of AA. First, they may think that they are freaking brilliant and the world just hasn’t appreciated their genius and, therefore, the stock is undervalued. I happen to believe that they are not freaking brilliant, but others can disagree, in which case, stock buyback is a great idea because, eventually, their genius has to be understood, right? The final possibility is that they are trying something, anything, to try to prop up their stock price so they can save their jobs and keep those bonuses rolling in as long as they can. In this scenario, It may work out for shareholders, it may not, but they aren’t doing this for the benefit of the shareholders or the improvement of the company. In AA’s case, my money is on this last one.

  17. @farnorthtrader
    We’re kind of going in circles at this point, because again, your perspective requires the assumption of a downturn. Of course buying back stock or making any investment with leverage or even without leverage is going to appear to be stupid if we have a severe downturn. But that is certainly a non-consensus view considering that the market is making all time highs and the economy is growing at a healthy clip. Regardless, the math of borrowing at low interest rates to buyback your stock at 7x earnings is going to be mathematically accretive to earnings and is a smart and tax efficient deployment of capital. Lehman and GM were not buying back their stock at 7x earnings. They were buying back their stocks at market high valuations, based on overstated earnings and were collateralizing their debt with impaired assets. Ill timed stock buybacks were the least of their problems.

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