KLM has been a Dutch treat

Benj Gallander and Ben Stadelmann
Thursday, March 18, 2004

Richard Branson, the founder of Virgin Atlantic Airways, once grimly noted that the best way to become a millionaire was to start out as billionaire and then buy an airline. Warren Buffett was so dismayed at the inability of airlines to make money, he joked that Karl Marx couldn’t have done as much damage to capitalism as Orville Wright did.

At Contra the Heard, we are always looking for out-of-favour companies. What better place to start than the airline industry?

Sometimes we look for companies in strong industries that have succumbed to competitive pressures and/or management mistakes. Then there are the laggards in a rebounding industry, boats that have been slow to catch the rising tide. In both of these cases we zero in on weakened enterprises that we believe have the ability to recover and prosper again.

But a sector that is in the dumpster is another category that often offers sterling opportunities. In this situation, our strategy shifts from finding corporations that most consider 98-pound weaklings, to choosing amongst the strongest players. The critical path here is to identify survivors; price is less of a factor, since nearly all members of the sector are trading at a significant discount.

This was precisely the scenario in September 2002 when we contemplated how to invest in the travel industry. Historically, airlines have always been economically sensitive, with broad cycles that make them a buy-and-holder’s nightmare. The list of carriers that have been consistently profitable over the years is minuscule.

If a drop in tourism, weak business spending, high jet-fuel prices, soaring pension liabilities and intense competition were not more than enough to bring airlines to their knees, then 9/11 was the final blow. Our early analysis indicated that many of the leading carriers of the day would not be able to meet their debt obligations.

We chose Netherlands-based KLM Royal Dutch Airlines because of its superb book value, attractive debt-to-equity ratio compared with its peers, and solid reputation with customers. It was also a geographical decision: we liked the idea of being in Europe, and Amsterdam is a key gateway to the continent. Unlike the management of many large airlines, who had a “deer in the headlights” response to the awful business conditions, KLM’s executives seized the reins, realizing that tough sledding was ahead.

We bought our shares as American depositary receipts on the NYSE at $9.36 (US). Though we were very bearish on the US dollar at the time, it is important to understand that the purchase of a European ADR in New York exposes the investor to changes in value of the euro. That’s because the price of the ADRs is linked to what KLM shares fetch in Amsterdam, where the majority of trading activity occurs.

Though our purchase was made at a time when travel was in a deep hole, the pit soon grew deeper. The impending war in Iraq scared away more potential passengers and pushed fuel prices even higher. Then SARS hit Asia, and traffic on those lucrative routes collapsed, taking KLM’s stock with it.

Some might have been tempted to throw in the towel at that point, but we could see no reason to be unduly alarmed. The negative events were clearly temporary anomalies, and in no way undermined the basic premise of our investment: people need airplanes to travel long distances. A trip might be cancelled this year, but that creates pent-up demand for the future. We might not like the experience of flying much these days, but we still love the idea of flying.

One of the consequences of being a survivor is that other companies want to hitch up to your wagon. In a move that is somewhat ironic, after KLM navigated this perilous turbulence, Air France is trying to take it over in a combination that will likely be concluded this spring. As KLM remains below our target of $29.74, we are still contemplating whether we want to trade in our windmills for a wheel of brie.