Finding values that soar takes hard work

Benj Gallander and Ben Stadelmann
Friday, February 10, 2006

It’s been a while since we last checked in on our Contra holding in the airline sector. It was April 2004 and our pick, Dutch carrier KLM, was in the process of merging with Air France.

It was a complicated and messy transaction that had us on edge. There were difficulties with regulatory bodies and the combination called for a share swap, but an extra incentive to the deal were some warrants that offered tantalizing potential.

Three warrants entitle the holder to buy two shares of Air France at 20 euros ($27.40 CDN) with an exercise period that runs to the end of next year. At the time, Air France shares were worth less than 15 euros, making the warrants something of a longshot on a rosy future.

Well, lo and behold, Air France is showing some long-stemmed success with the stock price climbing to 20.14 euros and the warrants, which trade as American depositary receipts on the New York Stock Exchange, moving to $2.15 (US).

On a merger-adjusted basis, we paid $8.51 for our shares on September 18, 2002. With the stock ADRs currently trading at $24, the combination of the shares and warrants represents a capital gain of over 200 percent. That is a pleasing statistic, and it validates our contrarian decision to buy into this sector when it was in deep disfavour.

But there is another aspect of our specific choice that is worth examining. In addition to the turmoil caused by 9/11, it was crystal clear at the time that the airline industry’s profound problems with overcapacity, high cost structures and excessive debt would lead to the collapse of the weaker players.

Central to the strategy, then, was to find the best of a bad lot. But which was the most promising candidate in this grim game of Survivor: Airline Edition?

At the time, two North American companies were consistently put forward by analysts as the best hopes in a beleaguered industry. In Canada, that champion was Calgary-based WestJet. The upstart airline enjoyed devoted customers, and its competitive efficiency was in no small part responsible for the demise of Air Canada.

When we bought KLM, WestJet cost $12.16 (Canadian). Currently at $11.95, this small loss has shareholders brown-bagging it.

The other hot ticket was Dallas-based Southwest Airlines. Southwest was a pioneer in the regional jet concept and was highly regarded for its enterprising ways in the era of deregulation. It has done better than WestJet, but not gangbusters, at $13.78 (US) back then, $16.34 now, for a gain of 18.5 percent.

All of which illuminates the value investor’s credo, “The difference between a great company and a great investment is the price you pay.” WestJet and Southwest were, and are, finely run organizations with bright futures and have every reason to be proud of their contribution to their industry and the economical service they provide to their passengers. For that they deserve a shiny gold star. However, such recognition does not translate into a lucrative ride for their shareholders.

The reason is quite straightforward, if not fully intuitive to the buy-what-you-know folks. The investing community expects these young whippersnappers to outperform the bloated giants. As this is already priced into their shares, the upside is subdued because the best outcome is to simply fulfill those expectations.

However, as most investors do not anticipate the resurgence of a wily veteran, such a feat wows the crowd. In order to soar as an investor, it is necessary to find opportunity where it is less obvious than a jumbo jet revving up for take off.

We believe that Air France will fly higher. Our initial sell target is $30.75 (US).