reposted by permission of Robert Green @ briefing.com

Ahead of the Curve: Northwest Airlines (NWAC) 14.30 +1.55 (+12%) Frequent readers of the Ahead of the Curve column know that we believe that the airline industry is not a lost cause. The market for airline travel is still $100 billion per year in the US alone. Someone will own this business eventually. The transition from a fractured market with over capacity and legacy (unionized labor) expense structures simply cannot last. It all speaks to a great investment opportunity at some point, probably in the next two years, but we haven't been able to pick a clear winner from the pack. So we just watch and wait.

Northwest's earnings report this morning gives a slight clue as to how the playing field might change. Current thinking is that the major airlines, with their expensive cost structures, simply cannot compete and cannot change and therefore cannot last. The "Southwest" model, with much lower cost structures and "low frills" approach to service delivery is viewed as the wave of the future. Southwest gets a strong market multiple while the major airlines get the multiples of stocks about to go into bankruptcy, if not already in it.

Northwest suddenly looks like a model "in the middle" and is therefore much more interesting. It is already the fourth largest carrier. Debt level is high, but the payments are almost manageable (current ratio is 0.9 - a range of 1.0 to 1.5 is usually considered healthy). Today's release is extremely encouraging about the nature of the business, though, because they are raising revenues and keeping costs down - exactly the opposite of what people have come to expect in the airline industry.

Item
Q3 03
Q2 03 (Seq)
Q3 02 (YOY)

Revenue ($M)
2,556 Q303
2,297 Q203
2564 Q302 (YOY)

Operating Expense
2,410 Q303
2,370 Q203
2556 Q302 (YOY)

The line to look at is operating expense. On a sequential basis, expenses only rose $40 million on a revenue rise of $259 million. An even better comparison is the year-over-year (YOY). Revenues were almost identical (Q3 was just $8 million less than a year ago), but expenses were $146 million less.

But the much more interesting thing about this earnings report is how salary is being controlled. Northwest's salary as a percentage of revenue now stands at 37% The major airlines average about 50%. Southwest and the other low-cost airlines average around 33%. Northwest's ratio has declined largely because Northwest has managed to get revenues up while decreasing overall salary levels. The table below shows the progress here over the last four quarters. Maybe not great if you work there, but nice to see as an investor.

Revenue
2,556 Q303
2,297 Q203
2,250 Q103
2,339 Q403

Salary as % of Rev
37 % Q303
41 % Q203
46% Q103
43% Q402

One final note of interest is how far off the analyst community was this quarter. Estimates ranged from $-0.90 per share to $-0.30 per share, which equates to "misses" of about $120 million to $70 million. Revenue estimates were from $2.37 to $2.47 billion, only $100 million under actuals. Clearly, Wall Street did not expect the kind of expense control Northwest showed. Frankly, the wild divergence of estimates from actuals speaks to the power of Regulation FD working. Northwest hasn't given any guidance in more than a year and they clearly aren't leaking information to anyone in advance of public announcements. All good.

For about a year, we have been looking for a "sign" of where the industry might go, without taking a position. Northwest is the first real sign that a major airline might be able to reshape themselves, without declaring bankruptcy and without changing the basic service model. Just a single data point, but it is extremely interesting and suggests that the investment opportunity in the industry will come sooner rather than later. We might wait for another quarter before taking a big position in NWAC, but a small "watchdog" position could be warranted at this time (for investors for whom it would be small portfolio percentage). They might actually be figuring it out: "Raising revenue more than expenses." As Briefing.com's Earnings Manager Brett Ames said this morning, after a deep search for accounting explanations for the huge beat, which revealed nothing, "This is textbook - what every company is supposed to do." - Robert V. Green, Briefing.com

[This message has been edited by doglover (edited 10-16-2003).]