The new airline math

Implications: Writing down goodwill does not mean a great deal - it merely takes attention away from what really needs to be done. But big organizations and their proclivity for silo thinking are adding to industry risk.

Analysis: The NYT has a great story you want to take a look at. Paying special attention to this sentence "reported a combined first-quarter loss of $10.5 billion on Wednesday, most of it an accounting recognition that the two carriers are worth far less than when they emerged from bankruptcy a year ago." This is the new math.

What you do is write down your goodwill; no, make that trash it. As of March 31st, Delta had $2.6bn in unrestricted cash and short-term investments and Northwest had $3.2bn. While its true the airlines are struggling with a complex situation of timing - they cannot get their average fares high enough fast enough to offset fuel prices - which eats into that cash. Remember that airlines sell you something today which you will consume maybe two weeks from now; they only have an idea of how much they will be paying for fuel on the day you fly unless they are fully hedged. Because the fuel prices rises have been coming almost daily, this struggle is growing more complex daily.

The write down of the goodwill is a non-cash item that affects the balance sheet. Remember these are two airlines that recently emerged from Chapter 11 with all sorts of promises. While its true they did not expect this level of fuel shocks, the bottom line is the revised companies are really not worth much - and this write down essentially admits this. Of course we expect to see a write up again once the firms have been combined; after all the managers want to be able to make the balance sheet look better post-merger. But playing accounting games does not really help.

The question Wall Street needs to be asking - and it does not seem to be doing this at all - are the current airline management teams able to weather the storm? There are very good reasons to ask this question. Running an airline is horribly complex. The current management teams do not look especially capable. Their focus is still on market share rather than profitability.

This is a subtle thing. But it is crucial. Now is not the time to be in love with the aviation business, it is time to be brutal in one key place - an airline must know the profitability of EVERY flight. Airline managers still don't know this yet. Running an airline can no longer be done on averages. If a flight does not make money, it must be cut. Fortunately airlines have scads of data to measure this.

If an airline can build its flight profitability models then it will immediately know at what fuel price the fares either rise or the flight is stopped. However, know that large companies are replete with silos. Within each silo are numerous people doing essentially similar jobs. These people will increase complexity around them so that they become essential. That means data does not flow where it should. Consequently, when looking at airlines, don't get caught up in the balance sheet games.

Take a look at which management team is breaking the silos, tearing away at the information flow blockages. The success of the industry is not dependent on how well it structures its finances. Success will ultimately come from being able to know with granular detail what every flight costs. Only when managers know this can they focus on the revenue side and ensure that at least each flight must recover its costs. 

I believe that focus on market share obfuscates, it does not help. Waffling airline management teams that espouse market share are only moving the deck chairs. They are not focused on the core issue that makes this industry so risky. In every other business, successful managers know their cost of sales with excruciating detail. Airlines have for too long played the market share game and the industry's financial performance speaks for itself.