by Scott Fearon
To be honest, I’ve only seen one person in my three decades of managing money who was willing—even eager—to remake a company whose industry had left it behind. It was during my time at Texas Commerce Bank, way back in the sticky Houston summer of 1984. I was primarily in charge of analyzing energy stocks like Global Marine for the bank’s trust accounts. But I was also responsible for keeping track of companies in the consumer services sector, which included hotels, motels, restaurants, and—most important for me, as it turned out—airlines.
At the time, there was an airline company headquartered in Houston called Texas Air. Its CEO was a fiery native New Yorker named Frank Lorenzo. In 1981, after a grueling takeover bid, he and Texas Air had acquired Continental Airlines, which wound up declaring bankruptcy in the fall of 1983. Continental was still in business as Texas Air’s prime operating subsidiary, but it was only serving a fraction of the routes it had once served. Because of these troubles, shares of Texas Air were very cheap, down around $5. And yet, when I crunched the numbers and plotted out the company’s earnings models, I found something intriguing: of all the airlines in business, Texas Air had the lowest “cost per available seat-mile,” meaning it could charge less for tickets and still make a healthy profit.
I checked and rechecked my calculations to make sure they were correct. When I was satisfied that I hadn’t made a stupid error, I started to go into my boss Geoff Raymond’s office to show him what I had found. But then I figured it was time I tried to fly this one solo, so I sat back down at my desk and looked up the phone number for Texas Air’s offices. A receptionist answered my call and informed me that the company’s director of investor relations was not available, but that he would return my call soon. I thought I might hear back the next day, or maybe sometime the following week. It was around lunchtime so I went downstairs and bought a sandwich at a shop called Antoine’s across the street. Less than an hour later, as I was eating the second half of that sandwich at my desk, my phone rang. I answered it with my mouth half full. A fast-talking man with a thick Queens accent said he was looking for Scott Fearon.
“You’ve found him,” I replied, swallowing the rest of my food. “How can I help you?”
“This is Frank Lorenzo. I heard you were interested in talking about my company.”
I sat up in my chair and frantically tried to dig my file on Texas Air out from beneath my lunch. The only thing I succeeded at doing was dropping the rest of my sandwich on the floor. You have to understand, I had just turned twenty-five years old. I was barely one year out of business school. Frank Lorenzo was, and still is, a legend in the corporate world, and here he was speaking into my ear.
“Yes, Mr. Lorenzo,” I managed to say. “I would very much like to discuss Texas Air with you, but I know you must be a very busy man so I—”
“I’m about to go for a run,” he cut in. “Can you be here in two hours?”
“Yes, sir,” I croaked. “I’ll be there.”
The F***ing Ham in the F***ing Ham Sandwich
Lorenzo’s office was on the twenty-eighth floor of the American General Tower, a sand-colored high-rise a few miles west of downtown on Allen Parkway. He was studying some paperwork behind his desk when I came in. Even though he’d just come back from what I later found out was a daily ten-mile jog in the sweltering midday heat, there wasn’t a drop of sweat on his brow. His dark hair was parted neatly to one side and a bespoke Italian suit hung loosely on his wiry frame. There’s no other way to put it: the man was imposing. Leaning back in his leather chair with the skyline of Houston spread out behind him, he looked like the perfect embodiment of the 1980s corporate raider—which, in many ways, he was. A few years after our meeting, he waged a storied takeover battle for Eastern Airlines with none other than Carl Icahn.
Several scale models of DC-10s were displayed around his office. One of these was painted in Continental’s colors, another had the now-defunct Texas International Air brand on the side of it, and a third had been decorated with the name and logo of Jet Capital, the holding company Lorenzo and a fellow Harvard MBA had started in the late 1960s. I’d done a little research on him in the two hours between our phone call and our meeting, and I’d learned that his nickname at Harvard had been “Frankie Smooth Talk.” He definitely lived up to that nickname in our meeting—at least the “talk” part. I’m not sure a man who used profanity like most people use nouns could be called smooth, though.
When I brought up Continental’s bankruptcy, Lorenzo got particularly, well, frank.
“I’ll tell you a little secret, Mr. Fearon,” he said. “We didn’t have to take Continental chapter when we did. We could have limped along for a while longer. But I said screw it, we’re going to have to do this at some point, so we might as well do it on our terms. The sooner the better.”
“You mean, you chose to go bankrupt?” I asked. I couldn’t mask my surprise. This was a very odd concept back in the early 1980s, especially for a young kid like me. In business school, people talked about bankruptcy a lot like you would expect them to talk about getting arrested for drunk driving. It was something shameful.
“Hell yes, I chose to go bankrupt!” Lorenzo almost shouted. “There was no other way to do what had to be done.” He leaned forward and put both elbows on his desk. “Here’s the thing. Before we went Chapter 11, Continental was the f***ing ham in the f***ing ham sandwich.”
“Excuse me?”
Lorenzo laid one hand on top of another. “Here’s a sandwich, okay? Only it’s not a sandwich. It’s the airline industry. The top slice of bread is the legacy carriers, American, United, Pan Am, those guys. Now, everybody knows their prices are outrageous. They’re way, way overpriced because they’ve got high labor costs. But they get away with it because business travelers use them. They’re flying on a corporate expense account, so they don’t give a damn what a ticket costs. They just want legroom and a decent meal and some good-looking stewardesses who smile and say nice things to them, right?”
He paused and waited for me to show that I was still listening, which I was—very intently. Being in Lorenzo’s company was like attending a weird cross between a Vegas variety show and a graduate seminar in high finance. I didn’t know whether to laugh out loud or take notes, so I just sat there perfectly still and tried my best to keep up.
“Right,” I said.
“Now,” he continued while shaking the hand on the bottom. “Down here on the bottom of the sandwich, you’ve got this new low-fare company called Southwest. They don’t care about frills. They sell you a cheap ticket and they say, ‘Here, have some peanuts, pal, we’ll be landing in an hour, the barf bag is in the seat pocket in front of you if you need it.’ Let me tell you something, Mr. Fearon. Those guys at Southwest are kicking everybody’s butts. They’re completely changing this industry. These guys on top here, American and United and all the other legacy companies? They’re in trouble, they just don’t know it yet. But in a couple years, they’re going to be in the same place Continental was.”
Again he paused to let me demonstrate that I was still with him.
“You mean, they’re going to be the ham in the sandwich?” I offered.
“Exactly!” Lorenzo cried as he rubbed his hands together. “Continental was right in the middle. We had the high labor costs of the legacy guys, but we didn’t offer the same level of service, so business travelers wouldn’t fly with us. But because we had all those labor costs, we had to charge too much to compete with Southwest. So there you go. We were the ham in the sandwich. We were dead meat, unless we did something. So we did. It wasn’t pleasant. A lot of people lost their jobs or took pay cuts. But it worked.”
“It did?” I asked.
“Hell yes! You saw our cost per seat-mile number. It’s incredible! The bankruptcy allowed us to renegotiate all of our labor contracts. We cut our least profitable routes, too. Let me tell you something,
we’re back. Our turnaround is going to shock the world.”
He clapped his hands together triumphantly and sat back contentedly in his chair. I half-expected him to light up a celebratory cigar.
That afternoon, I drove back to my office at Texas Commerce Bank and typed up a two-page summary of my research, including a brief description of my meeting with Frank “Smooth Talk” Lorenzo. I paraphrased his more colorful language and concluded by saying that I thought we should invest heavily in Texas Air. It was my first “strong buy” recommendation at the bank. I hardly slept that night. I was too excited to find out if the higher-ups would follow my advice. The next morning, Geoff Raymond gave me the green light to purchase a million shares, which I did right after leaving his office.
There’s nothing quite like spending $5 million of other people’s money before your second cup of coffee.
As I said, because of Continental’s bankruptcy, Texas Air’s stock price had taken a major hit. It was down to $5 when we bought in. The rest of Wall Street had pretty much written the company off for dead. Then its quarterly earnings report came out, and—true to Lorenzo’s prediction—it freaked people out. Continental was not only still alive, it was suddenly making money, a lot of money. With cheaper labor contracts in place, every ticket it sold was highly profitable. And thanks to newly discounted fares, it was selling out most of its flights.
A few days after the company announced its record-level quarterly earnings, Texas Air’s stock had already doubled. Then it doubled again, and again, and kept going up. By the time I left TCB for GT Capital in San Francisco three years later, it was up around fifty bucks, a full ten times what we had paid for it. It wouldn’t be an exaggeration to say that investment made the early part of my career. It was one of the biggest winners of my time at Texas Commerce. And given the path I’ve chosen since then, it seems fitting that my best-performing investment during my four years in Houston owed its success to bankruptcy.
Shock Therapy
Frank Lorenzo, as many of you may know, is a very controversial figure. If you ever drop his name to a longtime union member in the airline industry, I suggest you duck, or at least cover your ears. The reaction is bound to be forceful, and not very pleasant. I am certainly not trying to make Lorenzo out to be a saint here. As a matter of fact, after Texas Commerce’s big investment in Texas Air came out, I was interviewed by a reporter at the Wall Street Journal, and I said that I was worried that Lorenzo seemed to care more about financial wheeling and dealing than the day-to-day work of managing an airline. The next morning, that quote appeared on the front page of the paper, and I found myself summoned from my cubicle on the fourth floor of the Texas Commerce Tower way up to the sixty-eighth story. Several executives there warned me, with Lorenzo-like frankness, that if I ever spoke to the press again, I would be riding the elevator to the ground floor one last time.
Even though it was stupid of me to talk to a reporter about my concerns, what I said was from the heart. Lorenzo did worry me. I knew he was a brilliant businessman, and his use of bankruptcy as a tool to remake Continental was unprecedented. It was creative destruction in its rawest, most potent form. But in the end, everything just seemed like a game of numbers to him. In fact, the second time I came to see him a few months after our first meeting, he offered me a job analyzing potential takeover targets for Jet Capital and Texas Air. That was plainly where his focus was—making deals and growing his assets, not managing the companies he already owned.
Nosedive
My experience with Texas Air notwithstanding, the airline industry has historically been one of the worst sectors to invest in. The costs of running an airline are astronomical, and cutthroat competition constantly puts downward pressure on prices (and profits). High costs and poor margins: that’s not exactly a lucrative business model. It almost makes the restaurant industry look like a gold mine by comparison. And yet—just like in the restaurant business—one high-profile figure after another, from Donald Trump to Carl Icahn, has poured millions into their own pet airline ventures. In almost every case, these investments have crashed and burned.
Warren Buffett has repeatedly lamented the vast amounts of money airline investors—whom he once jokingly referred to as “aeroholics”—have lost over the decades. “If a capitalist had been present at Kittyhawk back in the early 1900s,” he told the Telegraph newspaper, “he should have shot Orville Wright. He would have saved his progeny a lot of money.”*
*Dominic Lawson, Robert Peston, and Grant Ringshaw, “Buffett: My Elephant Gun Is Loaded,” Telegraph, September 22, 2002.
Lorenzo’s ruthless form of capitalism had its advantages, but it was incredibly risky. Taking Continental into bankruptcy was a kind of corporate shock therapy. In that particular case, the patient lived through the procedure and regained its health. But a few years later, he tried to apply the same technique at Eastern Airlines; this time, the patient died on the operating table. The company imploded and never reemerged from bankruptcy. And Continental itself suffered in the long term under Lorenzo’s leadership. By 1990, shortly after he sold off his stake, it was back in bankruptcy.
For all my reservations about his motives, I have no doubt that Lorenzo made the right decision with Continental in 1983. As he himself pointed out, Southwest had permanently changed the airline business with its discount model. There was no getting around that. Lorenzo knew that Continental had to reinvent itself to stay alive. His methods were drastic. But they were necessary. And just as he predicted that summer afternoon in his office, the other legacy carriers have been forced to adopt them. In the thirty years since Lorenzo willingly took Continental into bankruptcy, every single major US airline except Southwest has filed for bankruptcy at least once. Some, like Continental and United, have even filed multiple times.
Notes
*Aaron Sankin, “How Blockbuster Almost Beat Netflix,” Daily Finance, November 14, 2014.
†Leslie Kaufman and Christine Haughney, “The Last Temptation of Tina Brown,” New York Times, August 4, 2013.
‡Warren Buffett, Chairman’s Letter, Berkshire Hathaway Annual Report, 1980.
Six
The Buck Stops . . . There
Victory has a thousand fathers, but defeat is an orphan.
—John F. Kennedy
What, me worry?
—Alfred E. Neuman
In the summer of 2007, I visited the nicest corporate office I’ve ever been in. Unfortunately, it belonged to the president and CEO of a business fast on its way to bankruptcy.
His name was Rob, and he had a beautifully appointed corner aerie on the thirty-second floor of Embarcadero Center Four in the Financial District of San Francisco. His company, Building Materials Holding Corporation (stock symbol: BMHC), sold construction materials and services to housing developers. It had originally been owned by the old Boise Cascade lumber company in Idaho, but it had moved west to its fancy new digs after a massive acquisition spree in the 1990s had turned it into a billion-dollar concern. I had actually met Rob once before, in 2002, but when he escorted me into his office overlooking San Francisco Bay that second time, the view almost knocked me flat. Unlike my previous visit, and on most summer days in the city, the fog had miraculously held off, and it seemed like it was clear enough to see all the way over the golden brown hills of Marin County to the Oregon border. The bay far below us was as blue as sapphire and as smooth as a sateen bed sheet. Across busy Embarcadero Boulevard, boats the size of toys landed and took off from the Ferry Building. To my right, a container ship eased beneath the silver arch of the Bay Bridge. To my left, the Golden Gate Bridge glowed orange in the late afternoon sunlight.
“How do you like the scenery?” Rob asked in a deadpan as I stared out the floor-to-ceiling windows.
He let me gawk for a little while longer before he invited me to sit down. His
office was large enough to include a polished mahogany conference table in one corner. I fumbled with my notes at first. The gorgeous vista almost made me forget the point of my visit, which was to discuss BMHC’s extremely ugly finances.
At the time, the housing market was just starting to transition from a temporary correction to an epic meltdown, and Building Materials Holding Corporation was starting to look like a major reclamation project because of it. After producing record profits in 2006 at the peak of the boom, its business had eroded faster than Alan Greenspan’s reputation. Year over year, the number of building permits taken out for single-family homes had dropped roughly 30 percent, and BMHC’s profits were falling more than twice as fast. Its net income for the first six months of 2007 was roughly $14.5 million. On paper, that’s not a terrible number, until you compared it to the $62 million the company made in the same period the previous year. Not surprisingly, BMHC’s debts were growing almost as fast as its earnings were dropping. It had always carried a good deal of debt in order to finance its acquisitions, but in those same first six months of 2007, it had taken on an additional $84 million in liabilities, and its total long-term debt stood at a troubling $435.5 million.
Not many businesses can weather such a swift reversal in their core market without making painful reductions in operating expenses, and BMHC was cutting back somewhat. Rob told me the company had laid off a good number of employees and was closing some of its regional offices. He also delivered a standard speech about the cyclical nature of the housing market and how he and most experts believed that it was near its bottom. At the time, I wasn’t fully aware of just how gruesome the crash was going to be (this was more than a year before I visited the doomed Brightwater development in Orange County). For all I knew, Rob was right and the downturn was going to be relatively short-lived. But sitting in his opulent, top-floor office in some of the most expensive commercial real estate in the country—if not the world—I couldn’t help but sense a troubling disconnect between Rob’s reassuring words and reality. There was also the matter of his suit. Rob had the dapper style and quietly confident air of a top-notch lawyer, which is exactly what he was before taking the reins of BMHC. I don’t know men’s fashion well enough to guess the exact brand of his beautifully tailored three-piece or how much it cost, but I’m sure that it was a good deal more expensive than most people’s monthly mortgage payments.