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Apr 29, 2003 - Hedging and Value in the U.S. Airline Industry. 21. David A. Carter, Oklahoma State University,. Daniel A. Rogers, Portland State University, ...
V O LU M E 1 8 | N U M B E R 4 | FA LL 2006

Journal of

APPLIED COR PORATE FINANCE A MO RG A N S TA N L E Y P U B L I C AT I O N

In This Issue: Corporate Risk Management Enterprise Risk Management: Theory and Practice

8

Brian W. Nocco, Nationwide Insurance, and René M. Stulz, Ohio State University

Hedging and Value in the U.S. Airline Industry

21

David A. Carter, Oklahoma State University, Daniel A. Rogers, Portland State University, and Betty J. Simkins, Oklahoma State University

Basel II: The Route Ahead or Cul-de-sac?

34

Richard Brealey, London Business School

Accounting and Valuation: How Helpful Are Recent Accounting Rule Changes?

44

Bradford Cornell, California Institute of Technology, and Wayne R. Landsman, University of North Carolina

A Note on XBRL and the Promise of “Modular” Accounting

53

Mark Schnitzer, Microsoft, and Campbell Pryde, Morgan Stanley

The Promise of Credit Derivatives in Nonfinancial Corporations (and Why It’s Failed to Materialize)

54

How Does the Corporate World Cope with Mega-Terrorism? Puzzling Evidence from Terrorism Insurance Markets

61

Navigating in the Midst of More Uncertainty and Risk

76

Charles Smithson, Rutter Associates, and David Mengle, International Swaps and Derivatives Association Erwann Michel-Kerjan, University of Pennsylvania, and Burkhard Pedell, University of Stuttgart Jim Butcher, Nick Turner, and Gerard Drenth, Morgan Stanley

Incorporating Strategic Risk into Enterprise Risk Management: A Survey of Current Corporate Practice

81

Managing M&A Risk with Collars, Earn-outs, and CVRs

91

Stephen Gates, Audencia Nantes École de Management Stefano Caselli and Stefano Gatti, Università Bocconi, and Marco Visconti, Merrill Lynch

Risk Management and the Cost of Capital for Operating Assets

105

Thomas J. O’Brien, University of Connecticut

Reducing a Company’s Beta—A Novel Way to Increase Shareholder Value

110

Jeremy Gold, Jeremy Gold Pensions

Hedging and Value in the U.S. Airline Industry by David A. Carter, Oklahoma State University, Daniel A. Rogers, Portland State University, and Betty J. Simkins, Oklahoma State University

If we don’t do anything, we are speculating. It is our fiduciary duty to hedge fuel price risk. Scott Topping, Vice President Treasurer, Southwest Airlines1

n the past few years, a growing number of companies have devoted major resources to implementing risk management programs designed to hedge financial risks, such as interest rate, currency, and commodity price risk. Because of the increasing reliance on such programs, it is important to ask the question: “Does hedging add value to corporations?”2 And if it does, the obvious follow-up question is: “How does it add value?” Finance theorists have proposed a number of ways that hedging and, more generally, risk management can increase corporate market values. Stated briefly, risk management has the potential to add value by (1) reducing corporate income taxes; (2) reducing the probability and expected costs of financial distress; and (3) preserving management’s ability and incentives to carry out all positive-NPV projects (incentives that can otherwise be distorted by the pressure for near-term cash flow faced by financially troubled firms).3 To answer the questions of whether hedging adds value and, if so, how, we conducted a study of the fuel price hedging of 28 airlines over the period of 1992-2003 that was published in Financial Management in 2006. 4 The aim of this article is to summarize and evaluate the practical import of the findings of that study.

We chose to investigate the relation between hedging and value in the airline industry for a number of reasons. First, the industry is by and large competitive and remarkably homogeneous. Second, by studying airlines, we were able to focus on the hedging of a single, volatile input commodity— jet fuel—that represents a major economic expense for the industry. Although fuel costs have historically been a distant second to labor costs, the two have almost converged in recent years. 5 Third, jet fuel prices are not only highly volatile (our estimate of annualized jet fuel price volatility during 19922003 was about 27%, as compared to about 10% for major currencies),6 but the levels of volatility are themselves highly variable. The notable variation in both price and volatility levels during the period we studied allowed us to examine more closely the source of potential value from hedging, and how that value is reflected under different price conditions. Fourth, fuel-price increases cannot be easily passed through to customers (see Box 1) because of competitive pressures in the airline industry. Fifth, and finally, airlines face significant “costs” associated with financial trouble. Perhaps most important, airlines facing a sharp downturn in operating cash flow are likely, especially when faced with a material probability of default, to “underinvest” in their future, making cutbacks in discretionary expenditures on everything from advertising to

1. Quote made by Scott Topping on April 29, 2003 in a presentation at Oklahoma State University. 2. Although the answer is far from definitive, the initial evidence would appear to support a guarded “yes.” George Allayannis and James Weston presented the first empirical work regarding the value effect of hedging by looking at the relationship between the use of foreign currency derivatives and value for a sample of large U.S. nonfinancial firms. (See George Allayannis and James Weston, “The Use of Foreign Currency Derivatives and Firm Market Value,” Review of Financial Studies 14 (2001), pp. 243-276.) Additionally, a recent survey by Charles Smithson and Betty Simkins of the empirical literature on the relation between hedging and firm value finds that most evidence is consistent with the notion that hedging adds value. Charles Smithson and Betty Simkins, “Does Risk Management Add Value? A Survey of the Evidence,” Journal of Applied Corporate Finance 17 (2005), pp. 8-17.

3. Other possible motives for hedging discussed in the literature include reducing the cost of capital, asymmetric information, and managerial incentives. 4. See David Carter, Daniel Rogers, and Betty Simkins, “Does Hedging Affect Firm Value? Evidence from the U.S. Airline Industry,” Financial Management 35 (2006), pp. 53-86. 5. In 2005, labor costs and fuel costs at the 10 major U.S. airlines averaged 27.5 % and 25% of revenues, respectively. And for some airlines, fuel costs exceeded labor costs for the first time. 6. Guay and Kothari report that the annualized volatility of major currencies is only 11% (measured over 1988-1997). See Wayne Guay and S.P. Kothari, “How Much Do Firms Hedge with Derivatives?” Journal of Financial Economics 70 (2003), pp. 423461.

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Journal of Applied Corporate Finance • Volume 18 Number 4

A Morgan Stanley Publication • Fall 2006

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Competition, Fuel Costs, and Consumer Prices Fuel prices are an external factor that airlines cannot control. What can they do to react and minimize the damage? A comparison with other modes of transportation is revealing. Fuel represents a roughly comparable proportion of expenses for railroads and many trucking companies (in the mid-teens percent range), but they have not been hurt by higher fuel prices to nearly the same degree. Part of the difference is due to more active hedging programs by these freight transportation companies, but most is due to the fact that many of their contracts with corporate

maintenance.7 Hedging fuel costs, as the results of our study suggest, can help the airlines manage this potential underinvestment problem while also limiting other costs of financial trouble. Some Background on the Companies We analyzed all publicly held U.S. passenger airline companies (SIC codes 4512 and 4513) for which information was available for at least two years during the period 1992-2003. That fuel price risk is a major risk factor for the airlines is clear from the disclosures about their hedging programs that appear in many of their annual financial statements. At the same time, a number of other airlines that say nothing about hedging future jet fuel purchases draw attention to their use of other risk-management tactics, such as fuel pass-through agreements with major carriers or charter arrangements that allow for fuel costs to be passed along to the organization chartering the flight.8 Table 1 provides descriptive data on our sample of 28 airlines. The second and third columns list the airline classification (major carrier, national carrier, or regional/ commuter) and the years for which information about the airline was available.9 As shown in the fourth column of Table 1, fuel costs averaged about 13.75% of operating expenses for all years, with a range of 8.5% (for Mesaba Holdings) to 18.8% (Airtran Holdings). The last three columns in the table report three pieces of information about the companies’ fuel hedging programs: (1) the calendar years in which fuel hedges were in place at the fiscal year-end; (2) the maximum maturity of the hedge 7. Kenneth Froot, David Scharfstein, and Jeremy Stein, “Risk Management: Coordinating Corporate Investment and Financing Policies,” Journal of Finance 48 (1993), pp. 1629-1658. 8. It should be noted that fuel pass-through and charter agreements do not lock in a price for future jet fuel, as is the case when airlines hedge future fuel purchases. Rather, users of these operational-type hedging mechanisms experience higher fuel costs as fuel prices increase, but have some flexibility to pass some or all of the higher jet fuel cost to another party, such as the partner airline or the chartering client.

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Journal of Applied Corporate Finance • Volume 18 Number 4

customers allow them to pass through higher fuel costs in the form of surcharges. Airlines have tried repeatedly to raise fares in response to high fuel costs, but with little success. [T]he problem comes back to a lack of pricing power in a very competitive market.

philip baggaley, Managing Director, Standard & Poor’s (June 3, 2004), testimony before the U.S. House of Representatives Committee on Transportation and Infrastructure.

(expressed in years); and (3) the percentage of next year’s fuel requirements hedged. The major airlines, as can be seen in the table, are much more likely to hedge future jet fuel purchases than the smaller firms. Only AMR and Southwest Airlines had hedges in place at the end of every year for which we have data. But other fairly regular and extensive hedgers included Continental, Delta, Alaska Air, and JetBlue. Of the 28 airlines, 18 (or 64%) reported hedging jet fuel in at least one year. But among those airlines that hedged, there was considerable variation in the amount of fuel hedged. While the average percentage of next year’s fuel consumption hedged was only about 15%, some airlines—notably Southwest—have often hedged up to 80% of the next year’s fuel requirements. And in an interesting development, a few major airlines such as Southwest and AMR have been increasing the maximum length of hedging horizons in recent years. But, as the case of Delta Air Lines makes clear, fuel hedging is not a panacea. For much of our sample period, Delta maintained fairly high levels of fuel hedging. At the end of 2002, the company had hedged 65% of its fuel requirements for 2003, and this level was fairly representative of its hedging policy from 1998 through 2003. But Delta drastically increased its leverage in the post-9/11 environment, perhaps in the belief the industry downturn would be short-lived. By the end of 2003, Delta’s long-term debt as a percentage of total assets had grown to 48% (up from 27% at the end of 2000), with about $1 billion coming due in 2004. Meanwhile, during the years of 2001–2003, Delta reported 9. Airline carrier classifications are based on the Air Transport Association of America definitions. Major carriers are defined as an airline with annual revenue of more than $1 billion, and national carriers are airlines with annual revenues between $100 million and $1 billion. Regional carriers are airlines with annual revenues of less than $100 million whose service generally is limited to a particular geographic region.

A Morgan Stanley Publication • Fall 2006

Table 1 Fuel Usage and Derivatives Hedging by Sample Airlines (1992-2003)

Airline

Airline Classification

Sample Years

Jet Fuel as a Percentage of Operating Expenses (Average Over Sample Period)

Years Jet Fuel Hedged

Maximum Maturity of Hedge (Years)

Average Percentage of Next Year Hedged

Airtran Holdings

National

1993-2003

18.84%

1999-2003

1.0

14%

Alaska Air Group

Major

1992-2003

13.92%

1992-96, 2000-03

3.0

22%

America West Holdings

Major

1992-2003

13.30%

1997-2003