At the end of last month, Singapore Airlines (SIA) announced that it will buy 20 new Airbus 350s and five new Airbus 380s valued at US$7.5 billion (S$9.2 billion). Deliveries will begin in 2017. The last huge capital outlay was in June 2006 when it bought 29 planes worth the same amount of US$7.5 billion.
US$7.5 billion is a major capital expenditure and it is characteristic of many airline companies. Fleet renewal is essential to remain competitive, especially for SIA. If SIA were not to inject capital to acquire new planes, it would lose its edge as being one of the best airlines in the world. Also, no thanks to increasing competition from no-frills airlines, SIA has to be on its toes.
SIA currently operates 101 aircraft. The average age of the fleet is six years and five months (as of 1st Nov 2012). The fleet is one of the youngest in the world. Thus, every six years, the profits that can be returned to shareholders has to be used to acquire new planes and the capital outlay is humongous too. In the future, the price of new aircraft will increase due to inflation and rising manufacturing costs. With the advent of more budget airlines offering cheaper airfare, you can realise why investing in airline companies is not a terrific idea but more of a “terrorific” idea.
The following data shows the cash flow from operations, capital expenditure and free cash flow of SIA from 2000 – 2012.
The cash flow from operations and free cash flow are erratic. The free cash flow for five out of 13 years was negative. Shareholders have not been getting good returns from the business. Free cash flow mandates how well a business does. The erratic free cash flow shows that SIA is operating in a very competitive industry and airline industry is indeed competitive, as many would agree.
It is not surprising that the share price of SIA has been going nowhere since 2001, just like the free cash flow. In fact, one would have been better off buying the market instead of SIA. In the following chart, the blue line shows SIA’s share price performance and the green line shows the Straits Times Index (STI). It can be seen that the STI gave better returns of +20% compared to returns of SIA of -45%.
You might say using SIA as a sole example is not representative of the whole airline industry. What if Warren Buffett also agrees that airline industry is competitive? In a 2002 interview, Warren said the following: “If a capitalist had been present at Kitty Hawk back in the early 1900s, he should have shot Orville Wright. He would have saved his progeny money. But seriously, the airline business has been extraordinary. It has eaten up capital over the past century like almost no other business because people seem to keep coming back to it and putting fresh money in. I have an 800 number now that I call if I get the urge to buy an airline stock. I call at 2 in the morning and I say: ‘My name is Warren, and I’m an aeroholic.’ And then they talk me down.”
To illustrate how free cash flow is important for a company to do well, let us compare SIA with another local company, Vicom, which is the vehicle inspection and testing business. The following data shows the cash flow from operations, capital expenditure and free cash flow of Vicom from 2000 – 2011.
The cash flow from operations and free cash flow are increasing more consistently than SIA. Now, let us look at the share price performance of Vicom against STI.
The STI (green line) has been going sideways but Vicom (blue line) has defied gravity (albeit with a few ups and downs)!
Let me sign off with a quote by Warren Buffett – “How do you become a millionaire? Make a billion dollars and then buy an airline!”