The Executives of African Airlines Should All Be Fired!

“As of a couple of years ago, there had been zero money made from the aggregate of all stock investments in the airline industry in history."

- Warren Buffett

I spent the greater part of today perusing through a voluminous collection of reports and investment research papers on the African airline industry, after which, I came to the conclusion that it is more prudent for one to invest in nascent ventures located in war-torn African countries than in African airlines. Simply put, the risk of investing in African airlines is astronomically higher than the risk of investing in a diversified portfolio of emergent ventures located in turbulent African zones.

African airlines have appalling capital structures; their balance sheets indicate that they have a burdensome debt-load. Given the high risk environments that airlines operate in, it would have been more prudent for African airlines to be predominantly (and conservatively) financed through equity instruments, and a minute admixture of the most junior debt securities.

The general rule of thumb when financing any venture is: the risk in the capital structure of the entity should be inversely related to the risk in the business environment of the venture (for the venture to be financially strong). However, with African airlines, the risks in their capital structures are directly related to the risks in their business environments: they are poorly financed. Hence, it should come as no shock that most African airlines are perennial loss-making ventures. Furthermore, it should also come as no surprise that most African airlines are in a comatose state: they are currently teetering on the brink of insolvency.

What this indicates to me, is that the functionaries of African airlines are discombobulated by issues of capital structure. They do not have a single clue on how to finance their ventures optimally. Thus, they should just be fired, as their actions, i.e. loading airlines to the hilt with the most inappropriate senior debt securities, are not in the best interests of shareholders (i.e. maximizing shareholder value). If African airline shareholders knew just how dangerously capitalized their ventures are, there would be a shareholder revolt!

...Solution

In the short term, African airlines should use the capital markets to deleverage, as was done (according to Michael Milken) by US airlines in the 1970s, by paying off these debt securities at lower, discounted prices through tax-free exchanges of equity for debt, debt for debt, assets for debt and cash for debt. Evidently, while this move would undoubtedly dilute the existing shareholders of these airlines, it would help to avoid default; which would, in turn, save the jobs of thousands of non-executive employees of the airlines.

Interestingly, if a de-leveraging exercise were to be carried out by African airlines, their share prices would rise (and not fall). This peculiar share-price dynamic can be ascertained from the de-leveraging exercises that were recently undertaken by Alcoa (NYSE:AA) and Johnson Controls (NYSE:JCI). As you probably know, both these companies were perceived to be high credit risks, and contrary to normal 'signaling dynamics', their share prices actually ROSE sharply after they issued new equity! In his essay entitled Why Capital Structure Matters, Mr. Michael Milken gives a very interesting explanation for this share price dynamic when he says: "When a company uses the proceeds from issuance of stock or an equity-linked security to de-leverage by paying off debt, the perception of credit risk declines, and the stock price generally rises." F.Y.I.: The empirical illustration with the relative price histories of Alcoa and Johnson Controls can be found below:

Click On Image For A Better View

Explanation of the illustration: The point marked a, depicts the high of the rally that immediately ensued Johnson Controls' equity issue. The point marked b depicts the high of the rally that immediately ensued Alcoa's equity issue.

Therefore, we can reasonably expect the stock of African airlines, that currently have a perceived high credit risk, to behave in a similar manner after a new stock issue.

In the long term, I believe that it is imperative for the African airline industry to consolidate intensively. I think that what Africa needs are just four good regional airlines; one that caters for North Africa; one for East Africa; one for Southern Africa, and; another for West Africa. If that is done, I am positive that the consolidated airlines would be positioned to benefit from greater economies of scale than the fragmented airlines, and would, ceteris paribus, be able to access more attractive (and sound) funding options from the capital markets.

Otherwise, the executives of African airlines should all be relieved of their duties!