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June 11, 2014 2:40 pm
The airline industry is unstable? Who knew? Shares in Lufthansa fell 14 per cent on Wednesday when the company cut its 2014 and 2015 operating profit forecasts to €1bn and €2bn, respectively, a haircut of 25 per cent apiece. The problem, the company said, was excess capacity in European and US routes. It singled out the big Gulf carriers for the glut.
It is just a month since the airline presented the now rubbished targets. But the change is not as surprising as analysts seem to think. Management had highlighted the risk from US and European overcapacity when it set its goals. A month is plenty of time for things to go bad when consumers are price sensitive and operating leverage is high.
It is worth reviewing the familiar, but still horrifying, big picture. Between 1993 and 2012, return on invested capital in the airline industry never exceeded the cost of capital. No economic profits in two decades. Yes, average annual free cash flow over the past 10 years at Lufthansa is $500m, according to Capital IQ data – at the current price, an average free cash flow yield of 6.5 per cent. That looks reasonable, but the annual free cash flow figures range from €1.1bn to -€300m.
That yield is not much compensation for the volatility. A look at the long-term Lufthansa stock chart confirms this picture. There have been three chances to make big money in the shares, each corresponding to broad rallies in risky shares: 1995-2000, 2004-07, and 2011-yesterday. In the first two cases, the shares traded right back to where they started. Which is what you would expect from a large company in a cyclical industry that does not, in aggregate and across the cycle, make money.
Some investors may think the industry structure is changing for the better as consolidation increases. The news today emphasises what a long-term hypothesis that is.
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