Gritta, Richard D.

English

University of Denver

COMMENT: DEBT FINANCE AND VOLATILITY IN RATES OR RETURNIN AIR TRANSPORTBY RICHARD D. GRITTA*IntroductionAir transport has long been noted as a high "risk" industry. Onecomponent of this risk, identified as "business" risk by many airlineseconomists, stems from the intrinsic nature of the industry and the intensecompetition facing many of the carriers.' It results in unstable revenueand operating profit levels.' To investors, a second component, "finan-cial" risk, has been added. Its cause is the carriers' excessive dependenceon long-term debt finance. Its result is instability in rates of returns tocommon stockholders.The purpose of this paper is to summarize briefly the financing patternsof the ten Domestic Trunklines for the period, 1960-1972, in order toshow this over-reliance on debt finance and to quantify its effect on ratesof return. In an era of depressed airline stock prices, an analysis of theseeffects is of interest.Financing Patterns:The source and application of funds statement often yields insights intocarrier attitudes toward various types of funds. Table I presents the majorsources of funds to the Ten for 1960-1972 inclusive. Of particular intereston the exhibit is the heavy proportion of all sources arising from long-term debt finance. More debt equals more financial risk.At the high end of the scale are TWA (long-term debt accounting for34.9% of all funds), Continental (33.5%), Braniff (33.3%), National(29.4%), and Eastern (29.3%). Only Delta (10.0%) and Northwest (10.7%)are more conservative. UAL (27.2%), Western (21.8%), and American(19.8%) fall in between the two extremes. When other non-current liabili-ties (mostly deferred credits, etc.) are included, the figures are even more* Asst. Prof. of Finance, Graduate School of Business, University of Santa Clara.B.B.A., University of Notre Dame, 1965; M.B.A., Indiana University, 1967; D.B.A., Uni-versity of Maryland, 1971.I. For an excellent discussion of this topic, see: Frederick, John H., Commercial AirTransportation, 4th ed., (Homewood, Ill,: Richard D. Irwin, Inc., 1961), 331-332.2. There are many ways to measure business risk. For these measures and a comparativeanalysis of the high levels of this risk in air transport versus other utilities and industrialsub-groups, see: Brown, Victor H., "Testimony of Victor Brown", Domestic Passenger FareInvestigation, (Washington, D.C.: Civil Aeronautics Board, August 1970), Docket 21866-8, Exhibits BE-101 through BE-107.1Gritta: Comment: Debt Finance and Volatility in Rates or Return in Air TrPublished by Digital Commons @ DU, 1974THE TRANSPORTATION LAW JOURNAL= -. r-. *1 *'o"-' -" o 00 0 ..~, -. C S 'CC C - CC 0 -Co o->' 1~0 o-> ~0¢ -; C ''0* 0 o 2.a 1w, -2. " '.C-1 -5, 0C. u 0.=0 00.Ioo o -.• - . 0 ' -- .*. (b -o . Cd-0 n 0 a0,C0CL .. 2 . S P'o ;1. 0 -~a 0.01' Co -a C. olo10 C, wID 1> En0z1> 01> I~WJC;W-nwA0~§~ >-w 1>~PIo-0~ ?0 CC'tJ IzZa~a~oIr00 w -: 4 >2Transportation Law Journal, Vol. 6 [1974], Iss. 1, Art. 8https://digitalcommons.du.edu/tlj/vol6/iss1/8RETURN IN AIR TRANSPORTsignificant. American's proportion is increased from 19.8% to 26.9%(other non-current lia.7.1%), UAL's to 35.4%, Continental's to 40.9%,etc.' Such excessive reliance on long-term debt is not characteristic ofother industries displaying similar conditions of cyclical vulnerability,intense competition, etc.4 The majority of the Ten thus stand as an exam-ple of a violation of a sound "principle of finance". That principle assertsthat firms (and/or industries) facing high levels of business risk shouldnot assume high debt burdens (that is, high financial risk).5How this debt finance has affected widely known investor measures offinancial risk, such as the Moody's debt ratio (long-term debt/total capi-talization), can be seen from the following data. The carriers are rankedin descending order of financial risk.TABLE IITWA 64.4% National 52.1%Braniff 61.5% Western 50.3%EAL 59.5% American 45.6%Continental 58.4% Delta 26.4%UAL 55.4% Northwest 24.9%SOURCE: As of Dec. 31, 1972. Calculated from data in the Air Car-rier Financial Statistics, (Washington, D.C.: Civil Aeronautics Board),December 1972.According to one industry expert, a sound ratio in this industry wouldbe in the 30-40% range.' The CAB, in the recent Domestic PassengerFare Investigation, selected 40-45% as the optimal debt ratio for the Ten.,In either case, actual ratios exceed the "norm" by significant margins.3. Even these figures understate the real debt burden to the carriers. Leasing, the equiva-lent of long-term debt finance in this industry, is not considered in the above analysis as itdoes not directly appear on the airlines' balance sheets. Leasing, however, is a major sourceof funds; especially to EAL and TWA, and its inclusion as long-term debt significantlyaffects measures of financial risk. For a detailed treatment of the effect of leasing onfinancial risk, see: Gritta, Richard D., and Peter M. Lynagh, "Aircraft Leasing: Panaceaor Problem?", Transportation Law Journal, V(January 1973), 9-21.4. See, Victor Brown, "Testimony of Victor Brown"; Exhibits BE-101 through BE-132.Brown contrasts air transport's levels of business and financial risks to those of a sampleof 35 Electric companies, 7 Gas, 3 Telephone, and 74 Industrial firms. Only air transportevidences high levels of both business and financial risk.5. Johnson, Robert W., Financial Management, 4th ed., (Boston, Mass.: Allyn andBacon, Inc., 1971), Ch. 10, especially pp. 215-227.6. See the summary of the testimony of David Kosh, in: "The Final Decision-Phase 8,The Rate of Return", Domestic Passenger Fare Investigation, Docket 21866-8, 12-14,issued April 9, 1971.7. Ibid. See the statements of Whitney Gillilland, the CAB Examiner, on page 1 of theFinal Decision.3Gritta: Comment: Debt Finance and Volatility in Rates or Return in Air TrPublished by Digital Commons @ DU, 1974THE TRANSPORTATION LAW JOURNALRates of Return:Financial theory suggests that the effects of combining high levels offinancial risk with high levels of business risk is a compound or multipli-cative one. Unstable revenue and operating profit levels are further mag-nified by debt finance into more volatile rates of return on stockholders'equity (net profit after taxes/net worth.)' Table III shows the net resultson these returns for the 1960-1972 period.TABLE IIIMean Range Stand. Dev. CVAmerican 8.3% -7.3 to 19.1% 7.3% 0.88Eastern -3.3% -40.1 to 24.1% 15.3% 4.64UAL 6.2% -7.2 to 16.1% 5.9% 0.95TWA 5.7% -21.3 to 26.4% 13.6% 2.39Braniff 8.8% -3.2 to 21.4% 6.6% 0.76Continental 11.4% 3.3 to 27.4% 8.1% 0.71Delta 17.8% 7.3 to 29.6% 6.5% 0.37National 10.0% -28.1 to 28.0% 15.4% 1.54Northwest 13.9% 3.1 to 27.7% 8.0% 0.58Western 10.9% -15.4 to 24.7% 10.5% 0.96SOURCE: Computed from basic data in the Value Line InvestmentSurvey, October 21, 1973.The mean return is the arithmetic average of the returns for each carrierfor the period. CV is the coefficient of variation (the standard devia-tion/the mean). It allows for direct comparions of data (that is, by divid-ing by the mean it adjusts for size differentials in the levels of the returnsthemselves).Two factors are clear from this table. First, the reason for the above"principle of finance" is evident. The ranges of rates of returns are wideand the variability marked. Second, those carriers employing the largestamounts of debt are the most unstable. EAL's range is the greatest(-40.1% to 24.1%), its mean the lowest (-3.3%), and its CV thehighest (4.64). As Table II shows, the carrier's debt ratio (59.5%) is ex-ceeded only by TWA's (64.4%) and barely ly Braniff's (61.5%). TWA'srange is -21.3% to 26.4%, around a mean return of only 5.7% (with astandard deviation of 13.6% and the second highest CV of 2.39). Othercarriers high in risk, such as Braniff, Continental, National, UAL, andWestern have somewhat higher mean returns but still significantly wide8. Johnson, Financial Management, Ch. 10 A good analytical presentation of the com-bined effects.4Transportation Law Journal, Vol. 6 [1974], Iss. 1, Art. 8https://digitalcommons.du.edu/tlj/vol6/iss1/8RETURN IN AIR TRANSPORTranges and high standard deviations. Delta and Northwest, the only twocarriers more conservatively financed, have the highest average returns(17.8% and 13.9%, respectively), the narrowest ranges (7.3% to 29.6% forDelta, 3.1% to 27.7% for Northwest), and the lowest relative variances(CVs of 0.37 and 0.58, respectively).' The penalty for the excessive de-pendence on long-term debt in this industry has therefore been quite high.Conclusions:This paper has shown the carriers' heavy reliance on debt finance. Thevolatility introduced into rates of return to common stockholders bearstestimony to the penalty extracted. This instability in returns is highlyundersirable from the common stockholder's viewpoint and is one reasonfor the current lack of interest in airline securities. Empirical evidence hasdemonstrated that common stock price/earnings ratios are correlated tostockholders' perceptions of risk (as measured by the variance in ratesof return).'0 Increasing risk is discounted by stockholders in the form oflower price/earnings ratios and therefore in lower stock prices. For thepast several years, carriers' stock prices have remained at very low levels,outperformed by virtually all other industry indices and by the generalmarket, and at this writing eight of the ten are selling below book value."Considering the key position occupied by air transport in the nationaleconomy, such a situation is significant."What are the implications of the above for the future? In light of thecontinuing high demands for new funds to finance the wide-body jet, onecan only conclude that the carriers would be well advised to pursue asounder course in future financing episodes. This means less long-term9. In fairness to the other carriers, it must be noted here that these two carriers, becauseof competitive advantages and because of optimal route structures (both functions of histori-cal development and CAB policies toward new route awards), are much lower in businessrisk than the other of the Ten. Only these two carriers approach the rate of return norm of13-15% suggested by Weston and Brigham for large industrial firms high in business risk.See, Weston, J. Fred, and Eugene F. Brigham, Managerial Finance, 3rd ed., (New York,N.Y.: Holt Rinehart & Winston, Inc., 1969), 66. Brown's data suggests that the Ten facelevels of business risk similar to his sub-samples of large industrial firms. Brown, "Testi-mony of Victor Brown", Exhibits BE-107 through 110, and 131-132 (a listing of the sub-samples). All the other carriers fall well below the 13-15% norm.10. Weston and Brigham, Managerial Finance, 412-414.1I. Value Line Investment Survey, (New York, N.Y.: Arnold Bernhard & Co., Oct. 19,1973), 254-268.12. The high degree of financial risk in the industry has also had an impact on the creditratings of the carriers. Most airline debt is now rated by Moody's as lower grade tospeculative (Ba to B). See, Moody's Transportation Manual, 1973 edition. The net resultof this poorer credit rating has been to significantly increase the cost of debt funds to thecarriers.5Gritta: Comment: Debt Finance and Volatility in Rates or Return in Air TrPublished by Digital Commons @ DU, 197478 THE TRANSPORTATION LAW JOURNALdebt and more equity finance. Continued additions to debt can serve onlyto further increase the variability in returns and compound the problemsof the industry. While this remedy may be unpleasant in the short-run,(because it will temporarily dilute the stockholder's position), it may wellbe crucial to many carriers' survival in the long-run.6Transportation Law Journal, Vol. 6 [1974], Iss. 1, Art. 8https://digitalcommons.du.edu/tlj/vol6/iss1/8

Comment: Debt Finance and Volatility in Rates or Return in Air Transport

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Comment: Debt Finance and Volatility in Rates or Return in Air Transport

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