Two weeks ago I pontificated on Buffett's new found appreciation for tech. Another topic that captured my interest from this year's Berkshire annual meeting was the discussion on Buffett's recent investment in the airlines. Berkshire Hathaway now owns a piece of all four of the major US airlines - Southwest Airlines (LUV), Delta Airlines (DAL), United Airlines (UAL) and American Airlines (AAL). We've known about these investments for some time as they were reported back in November 2016 and we've heard others speculate about the reasons behind them but for the first time, we heard the rationale straight from the horse's mouth.
When I first heard about these new investments in the airlines, I was taken aback. Another lifetime ago I was a young buy-side analyst that covered the airlines for the better part of two years and for the life of me, I could not find anything redeeming about the US airlines (at that time circa 2008/2009). Over the long term the US airlines' cost of capital exceeded their return on capital, meaning that they had destroyed billions of dollars of value over the years. Even in the case of Southwest (LUV) which had managed to eke out profits, while some of the other airlines were treading water, did so by being really good at hedging oil instead of being really great at airline operations (although they are better than their peers at the latter). The second reason I was so surprised was that Buffett had long ago sworn off airlines after an investment in US Airways in the 80's didn't go quite as planned. In fact, he has said:
“The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”
And Buffett has made comments very similar to these rebuking the airlines on several occasions-both in person and in his letters. He's been bitter about airlines for the better part of 30 years and now he owns a significant stake in 4 of them. What gives? What changed? Buffett elaborated on this a bit in response to a question from a shareholder at the meeting. Having dipped my own toes into airlines a bit and learned the myriad of acronyms like RASM and RPM that only an airline analyst would know, I also have an additional thought that I didn't hear Buffett discuss, but that I think is also very important to the secular story on airlines and what seems to make them particularly attractive now.
The airline industry is a peculiar industry. To the casual observer, it would seem that it should be a wonderful industry that should benefit from rising passenger demand from now until the end of eternity and high barriers to entry driven by limited slotting at airports, stringent regulatory requirements and large capex outlays for aircraft. However, ever since the airlines were deregulated in the 1970's, the case has been exactly the opposite. The airlines have destroyed tremendous value by competing fiercely in providing an undifferentiated, commodity product. Buffett doesn't think that an investment in the airlines is a cinch, but he thinks a few fundamental things have changed that now make them a decent investment.
Industry consolidation has created an oligopoly that should result in more sensible competition.
Railroads were once a terrible industry until they went bankrupt and consolidated and gained some modicum of pricing power. Similarly, airlines have been guilty of over-competing to the brink of suicide. At even the hint of more passengers, airlines have historically increased capacity to the point where supply far outpaced passenger demand, resulting in downward pressure on pricing. Buffett believes that the airlines will be more sensible and disciplined in increasing capacity going in the future. So far, this has mostly been the case, the airline majors have only increased capacity modestly over the last several years and seem to remain disciplined based on their plans for the upcoming year - flat to modestly up (0-1%) capacity growth- despite record demand. This has resulted in record high load factors (Demand/Supply or Revenue Passenger Miles/Available Seat Miles) approaching the mid-80% versus the low to mid 70% area in years past. Buffett believes that these higher load factors will persist over the next 5-10 years and should drive better industry profitability.
Labor stability
Strikes and contentious labor relations were an issue for the airlines in the past, but Buffett believes that the conditions have improved as it relates to labor because they've been through bankruptcy and restructured a lot of their labor agreements. Part of the airlines' folly was locking in higher pay during the good times that was then unsustainable during times of recession or high fuel prices. Many of the new labor agreements allow for greater comp flexibility by way incentive based comp like profit sharing. However, Buffett notes that there will likely be a shortage of pilots in the future.
Earning decent Returns on Capital
Buffett cites that the airlines are currently earning high returns on capital. Flipping through the financials of the airline majors (see below) proves out Buffett's point - the returns on capital have improved and are pretty solid. Also - it seems like most of the airlines are using ROIC as one of their key KPIs because many have started to report it out to shareholders - this is a good thing when airline management teams act rationally and manage towards a high ROIC.
US Airline Majors Return on Invested Capital % (ROIC) - 2016
Share repurchases should driven returns
All the airline majors have been diverting their free cash flow to buy back shares at a hungry pace and thereby reduce their share count. In 2016, Delta, United, Southwest and American spent $2.6bn, $2.6bn, $1.8bn and $4.5bn respectively on share repurchases and this was following record high share repurchases in 2015. This is a significant sum that represents a considerable portion of the market cap of these companies. Many of the airlines have reduced their float by double digit percentages over the last few years. When companies buy back their stock at low PE multiples, this is a good for the existing shareholders. Buffett makes the important point that they can make a lot of money through share repurchases even if the total value of the companies stays the same (the per share price will go up as the share count is reduced)
An Industry Bet
What hasn't changed is that the airlines are largely still selling an indistinguishable product as it compares to their peer airlines. However, the number of peers has shrunk, thus making it easier to act sensible. But this indistinguishability is also why Berkshire bought all four of the major airlines rather than just one. It's an industry bet and it's really hard to figure out who will do the best, but he believes that Revenue Passenger Miles (RPMs) will be much higher in ten years compared to now - despite some level of increasing competition from the low cost guys like Spirit and Allegiant.
My Theory - An Expectation of Low Oil Prices is Key to the Thesis
One area that Buffett didn't delve into was the price of oil, which is a major cost factor if you are running an airline. Most airline's biggest expense line item after salaries is fuel. It is a major driver of profitability and usually, losses and one that management can't control (other than locking in some price certainty through hedging). For many years, high fuel prices kept profitability in check as airlines had to absorb the high fuel costs but had trouble passing them onto consumers without significantly impacting demand. But fuel prices have come down meaningfully (~$50/barrrel currently) and the thesis of an investment in airlines doesn't make much sense if you believe that fuel prices are going to go up meaningfully in the near term. Essentially, Buffett believes that low oil prices are here to stay for some time. And we are seeing this play out in real time- the US with its new found shale oil has become a swing producer and has been able to offset any cuts made by OPEC to more or less keep oil prices in check. This is a win for the airlines.
All in all, it seems like there have been some fundamental changes to the airline industry that make them a much more attractive investment than they have historically been. Although the numbers do look pretty good, I maintain a healthy dose of skepticism about airline management teams' ability to remain rational, sensible actors and disciplined about capacity growth if passenger demand declines due to the vagaries of the business cycle. While it seems like airlines have learned the lesson that growth is not always a good thing, a change in demand may be the only true test.