In his 2008 letter to shareholders of Berkshire Hathaway, Warren Buffett described the airline industry as follows:
“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.”
On Monday, news arrived that Berkshire Hathaway had made some investments in the airline industry. Specifically, the most recent quarterly filing indicated that Berkshire Hathaway purchased $800 million in American Airlines stock, $250 million in Delta stock, $240 million in United stock, and an undisclosed amount in Southwest Airlines (the undisclosed amount reported through CNBC may indicate that Berkshire’s investment in Southwest was ongoing.)
Did Warren Buffett do this? Almost certainly not. During the 2015 shareholder meeting, he stated that common stock purchases of less than $1 billion would be made by his apprentices Ted Weschler and Todd Combs. The size of the investments, coupled with Buffett’s previous comments regarding airline investing, means that onlooking investors should at least make the assumption that Buffett didn’t make the investment unless we receive information otherwise.
But of course the reason why we care whether or not Buffett himself made the decision is because we want to know whether airline investments are so attractive right now that we should appeal to authority and mimic the decision.
So let’s just ask that question: Are airlines good investments right now?
Well, they are certainly better than they were ten years ago. A loosening of federal regulations has enabled airlines to overbook an extra 6 seats per flight on average than they could in 2005–in any other business operation, this practice would be rightly ridiculed as despicable because it means that you are selling something you don’t have. But because cities like Las Vegas have crazy high 25% flight cancellations, airlines are able to goose revenues by about 5% through this maneuver.
Additionally, the Big Four airlines agreed six years ago to begin doing code sharing arrangements which reduces the traditional investment cost requirements of rolling out your own infrastructure when you expand. Basically, two airlines can share the revenues from the same flight via joint publishing agreements.
The biggest boon to airline investors is the creation of ancillary fees. When gas was high and the industry was in turmoil, airlines started charging $25-$50 per bag to stimulate revenue (attached with the promise to roll back the baggage fees when better days arrived.) Promises like that are never really honored and are instead just used to get a foot in the door by rearranging normalcy expectations, and now that the industry is in better shape, the baggage fees remain and add $3.5 billion in annual revenue to the industry as a whole. In fact, not only is it not being rolled back, but airlines like United are planning on being even more onerous by adding overhead bin fees to their economy fares in the second quarter of 2017.
This “found money” revenue stream has been coupled with a 20% slashing of the airline work force since 2005.
It is contemptible to leverage a captive audience for plucking, but it is also true that the characteristics of an airline investment are much better than they were a decade ago.
Despite this improvement, I still find it wise to avoid the sector entirely. And that is because of the sector’s subservience to fuel prices. This industry cannot withstand high oil prices. If oil costs more than $100 per barrel, this sector loses money. If oil goes up to the $80-$99 range, you have to turn to the bag of tricks featuring cost cuts, gimmicks, and financial engineering to demonstrate an annual profit in the hundreds of millions. If oil remains in the $70s or below for years on end, airline stocks have the possibility of making a great investments.
But that is a term I find unacceptable. Who the heck wants to arrange their affairs that incorporates the risk: “If energy prices go up to rates they’ve seen in the past decade, my investment is screwed.” Moderate to low energy costs are a prerequisite to a successful investment in the industry. Why would you want to own part of an industry that has such little control over its own fate?
Compare it to an asset like Colgate-Palmolive. Sodium carbonate prices could double, and the toothpaste industry could pass that on to its customers by raising the price of toothpaste correspondingly. Colgate isn’t a slave to its input costs because it has a much wider ability to pass its higher costs onto customers.
Right now, if you low fuel prices, a strong economy, and a low unemployment rate. The combination of these elements make airline profits look really, really good. That’s why you can’t perform a P/E ratio analysis on these stocks–the “e” is too fickle and subject to steep drops. Maybe things continue to improve and fuel remains low, but that is entirely speculation. There is no margin of safety in your investment hypothesis if low to moderate commodity prices are a necessary condition for positive investment returns.