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  When it comes to airlines our top choice is KLM

BENJ GALLANDER and BEN STADELMANN

Saturday, January 26, 2002

One of the classic contrarian strategies is to choose a stalwart player in a sector that is totally out of favour. No industry was hit as hard by September 11 as airlines, so naturally the Contra Guys' radar screen turned to this sector. After careful consideration, our top pick in the group is Dutch-based KLM Royal Dutch Airlines (KLM-NYSE).

Our initial focus was the airline that has a virtual monopoly in its home country, Air Canada (AC-TSE). Unfortunately, it also has a severe debt load of about $11 billion, which, even if it was serviced at a lowly interest rate of 7 percent, would cost around $770 million a year.

Dealing with such a massive headache requires a top turnaround artist, and it remains unclear whether chief executive officer Robert Milton is the right man for the job. He has never tackled a financial problem of this magnitude. That does not necessarily mean he isn't up to the task, but we would prefer to see a more experienced hand at the wheel. Someone like Robert Burton at Moore Corp. comes to mind.

During the heady days of its takeover of rival Canadian Airlines, Mr. Milton spoke glowingly of the future of the merged airline. "Air Canada and Canadian Airlines have been underachievers over the years because the pie on international route opportunities has been split. This is our opportunity for once and for all to get on with fully developing this franchise and we see massive upsides for our shareholders and overall stakeholders."

That bold vision has yet to materialize. The franchise has faltered ever since the merger, and not all of its problems can be blamed on the aftermath of September 11.

Among Air Canada's more questionable strategies of late is the pursuit of a discount airline. When faced with a massive debt load, the prudent course is to cut costs radically rather than increase expenditures by launching a new venture. Plus, it is exceedingly difficult for a mainline carrier to operate in a discount market when paying full service costs, as is Air Canada's case.

This past quarter, the net loss was a staggering $598 million or $4.97 a share. Removing non-recurring and other significant items, the profit for the quarter would have been $14 million or 12 cents a share. That's a lot of removing.

This does not mean that a revival for Air Canada is not in the cards, especially if the airline can convince the federal government to toss some real money in its direction. Wisely, the government is staying away from extending a major lifeline. If Ottawa does step in, we suggest accessing some hefty collateral to cover their support. Based on margin of safety, this stock does not pass muster.

While Air Canada is given a pass, one Contra Guy bought industry leader KLM at $11.81 (U.S.) a share. KLM boasts a book value of $41 a share and positive cash flow of $960 million from operations. Those are some mighty impressive numbers that give credence that this firm can survive today's difficult market conditions.

As is the nature of the airline sector, all is not rosy at KLM. The primary negative is that KLM also carries a heavy loan burden, with a debt-equity ratio of two to one. In November, the firm experienced about a 10 percent drop in passengers compared with a year ago, which will significantly reduce cash flow and profitability. Big losses are projected for 2002, although a recent cash injection by the Dutch government of $24.7 million should prove helpful.

However, the overall long-term trends for air travel are very bright. If the talk of opening skies further becomes a reality, operating costs will be reduced significantly. The moderation of fuel costs is a huge boost. And September 11 has backed the industry into a corner where the sacrosanct became questionable, which is leading to better overall business practices. When the economic recovery starts and assuming fuel prices don't jump dramatically, airline stocks should return to vogue.


As an aside for those interested, the final tally for the Contra portfolio in 2001 was a gain of 64.8 percent. Yes, we are very happy about that.

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