Analysis on Profitability and Operating Risks

In previous articles we discussed qualitative analytical approaches for a busines's future cash flow. To summarize: 1. Can the company raise prices? 2. What is the outlook for competition? 3.How well is the product or service differentiated from its competition?

4. Can the company increase output? 5. What are its growth prospects? 6. What are its prospects for cutting costs? 7. Can it eliminate inefficient divisions? 8. Does it have many stated “one-time” profits or losses? 9. What does it do with its excess cash? 10. What measures is the company taking to gain competitive advantage?

We will not necessarily answer the above questions in the order that they are presented, and, depending on what information is publicly available, we may not be able to answer all of them.

Prices, Competition and Service Differentiation

The airline industry has been subject to intensifying competition in the past 15 years with many smaller, low-cost chartered airlines coming to the market. It is important to understand specifically that competition effects XJT slightly differently than most airlines companies. The majority of XJT’s business operates over 200 aircraft for Continental Airlines. Only after Continental began cutting XJT from its fleet did the company branch out into other ventures.

XJT cannot raise prices so easily because competition is intense. However, there are certain potential opportunities. XJT has an excellent reputation for customer service and flight reliability, which is crucial in the airlines business. In the Department of Transportation industry survey, XJT was rated as one of the highest performers in the industry. Furthermore, XJT has differentiated itself from other airlines by providing differentiated travel solutions for corporations, aircraft brokers, sports teams and other niche customers. Out of the 69 planes which have been removed by Continental, 15 have been refurbished and reconfigured with redesigned seats for enhanced passenger comfort, and each seat includes complementary satellite radio with over 100 channels. They have also provided a valet carry-on baggage service and complementary meals for longer flights. 

             Given these new variables XJT might be able to either raise prices slightly or keep the same price and increase output. Given the state of XJT’s competition, I would bet on the latter.

Growth and Output

Under the Continental CPA, XJT’s growth is somewhat limited to how much Continental grows as Continental was XJT’s main source of revenue. However, now that Continental is removing planes, XJT has affiliated with Delta. At this stage XJT still depends on Continental as its main source of revenue. XJT’s capacity purchase agreement with Continental can be terminated. The fact that XJT is in arbitration with Continental is not going to improve relations. Continental can remove XJT as its service provider with only 12 months’ notice, which makes XJT’s revenue and growth prospects very risky.

             XJT’s growth prospects outside of Continental are also limited by the fact that, while Continental’s CPA permits XJT to fly under Continental’s known code, there are some major restrictions: At Continental hubs they may only fly for Continental, and, at any other airports where Continental, its subsidiaries, or other Continental-coded aircraft average more than 50 flights daily, XJT may only fly Continental. Continental however is allowed to license other service providers to fly under the Continental name. Page 9 of the 10-K states other reasons that Continental can terminate its agreement with XJT without notice.

             XJT is making great efforts to fly under its own branding and service other carriers. They have acquired smaller companies to improve service where needed. XJT also runs an aviation training centre as well as other aircraft maintenance businesses.

Cost Cutting and Efficiency

The annual report writes that XJT’s cost structure measured on a per seat-mile basis remains highly competitive compared to much larger carriers. According to public data, operating costs on a per available seat-mile basis for maintenance, flight operations, and aircraft ownership are superior to many of the 100+ seat airlines.

             Under the Continental CPA, XJT is entitled payment for each block-hour it flies for Continental. The payment is based on an XJT target margin of 10%, taking into account variations in certain costs that are generally within XJT’s control. Continental will charge XJT or reimburse them if operating margins shift away from the target band.  This method of costs within the margin band and reconciled costs represents 63% and 35% of total operating costs, respectively, which makes XJT’s costs profile very volatile. Furthermore, the cost rate settings for 2007 are under dispute. Continental and ExpressJet have resorted to an arbitration panel to resolve the issue. There could be serious ramifications on XJT’s total costs if they lose the case.  

             XJT has exposure to most labor costs and some general administrative and maintenance expenses if the actual costs are higher than those reflected in XJT’s estimated block hour rates. As an added bonus they are entitled to receive incentive payments from Continental if their controllable cancellations are lower than some historic average.

             XJT’s labor costs are significant. A workers union represents 70% of XJT employees, so XJT remains vulnerable to strikes. In the event of a strike which results in flight cancellations, Continental has the right to remove planes from its lease depending on the severity of the strike. Furthermore, XJT must pay for its own insurance. In the event of an accident XJT’s liability is enormous, because its insurance coverage is limited. Furthermore, Continental has the right to cancel its contract if it feels that XJT has safety failures on its flights. Other costs that XJT could face include additional taxes, higher fuel costs, increased maintenance costs as average age of fleet increases, and increases in insurance rates. An important item to note is that XJT has not had any extraordinary losses or gains since 2002.

After listening to the latest conference calls the CEO said that they do not cut costs necessarily because of competition but rather if the industry environment changes. This is possibly due to the fact that they have a somewhat differentiated product. XJT uses its excess cash to acquire small companies to venture into new businesses.