Even though my position is to the long side on BA, I think it makes sense to investigate the bearish case for the shares to question my assumptions. So here are the main areas of worry for BA shareholders currently as I see it -
1) The pension deficit – It was reported on the 7th of Oct that on 31 march 2008 the trustees found that there was a deficit of £1.5b. Although this differs from BA’s estimates in the annual report (of £357m) and the company say it was calculated using different methods, you can bet that the deficit is now a lot bigger considering the large market fall since then. While its possible that the deficit wont be such a long term problem with the merger to Iberia, it could certainly be bad news for BA shareholders when negotiating the swap of shares with Iberia (as Iberia shares are showing with rumours the swap is changing). With regard to the worst case scenario of a funding crisis thats end in bankruptcy, i think this is unlikely at the moment, but cannot be totally ruled out in the long term.
2) The high debt/equity ratio and debt structure – Looking at the BA investor site about current debt levels, they seem fairly high compared to equity and while it seems most of it appears to be long term and doesnt require access the wholesale debt markets for a while, any highly geared companies are under extremely close scrutiny in the current environment as to whether they can fund their operations. A crisis could in theory occur if markets continue to fall causing the pension deficit to increase even more and if the commercial paper markets were to remain frozen, BA could find themselves scrambling for cash.
3) The world recession and the loss of premium customers (particularly from the financial sector) – Obviously this isnt going to be much of a plus for the next year or so and the recovery is likely to be much slower than expected. The main driver of the last expansion, Mortgage Equity Withdrawl, wont be returning in any meaningful sense any time soon and i think its fair to suggest that we have run out of bubbles to inflate for the time being. Because of this and with unemployment continuing to increase, consumer spending will remain weak and people might even realise there is something called saving money. If that isnt enough to concern you its also worth noting that, in the US at least, the scope for additional monetary and fiscal stimulus is starting to look rather limited. The financial crisis might be in its late stages but the economic crisis is only just beginning.
More specifically within the airline industry, BA recently said that their 2008 revenue targets were ‘at risk’ and all the major airlines (at least the ones who havent filled for bankruptcy yet) seem to be tripping over themselves to lower their revenue and/or profit (or more often raise loss) targets.
4) Oil price / fuel costs – On the 03/10, BA announced they still expect fuel costs of £3b for the year. Although this has in theory been reduced with the large drop in oil prices, the high levels of hedging airlines have against the price of black gold means it may well take longer than expected for BA to benefit.
5) the iberia merger swap levels – does BA really want or need, lets be honest, a fairly second rate airline? It seems the play is mainly aimed at gaining access to routes from Europe to the Latin american/ South america markets while trying to compete against the dual threat of the other two super european airlines of KLM/Air France and Lufthansa. The muted swap levels of 60/40 seem to show BA in a weak position considering its brand and revenues compared to Iberia. And will the synergies claimed by BA really materialise?
So, a lot of potentially pretty bad news and enough to think that BA could end up in serious trouble. But the question is, is it bad enough to warrant a share price in the low 100′s (a level not seen since 9/11), a PE of around 3 and a dividend yield of 4%? Or are these figures potential value traps (cheap fundamental valuations that will quickly disappear as the recession starts to bite)?
In my next post, i’ll examine why i’m currently long and by extension examine the bullish case.