What Does Buffett Know About Airlines?

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Includes: AAL, BRK.A, BRK.B, DAL, LUV, UAL
by: Ivan K. Wu

Summary

How would you react if an airline CEO asked you to take a “leap of faith"?

Setting valuations aside, the true test of long term profitability is whether operators have made a permanent transition from price-taker to price-maker (with emphasis on "permanent").

The "airlines had a bad century" argument assumes that pricing power improves at a faster rate than a consumer's ability to identify and exploit systemic weaknesses.

The four most dangerous words in investing are: this time it's different. -Sir John Templeton

I. A Leap of Faith

How would you respond to an airline CEO asking you to "take a leap of faith" in his industry?

American Airlines (NASDAQ:AAL) CEO Doug Parker did just that in his presentation last March at J.P. Morgan's 2016 Aviation, Transportation, and Industrials Conference. Here are the relevant slides (comments are mine):

I see record profits in 2014 and 2015. I also see a comically small sample size. Furthermore, 2016E turned out to be optimistic by about a billion dollars ($5.1B earnings vs. $6.2B in 2015).

Comparing your most profitable year in history to the year your airline was a mismanaged, loss-leading dumpster fire lends new meaning to the word 'cherry-picking.'

The takeaway: You don't get to emerge from Chapter 11 bankruptcy as recently as 2011 and point to two years of record profits (amidst the biggest commodity collapse of the decade) as evidence that your entire industry has changed.

If we were living in ordinary times, I would have dismissed these arguments as baseless and went on my merry way.

Unfortunately, we don't live in ordinary times.

II. Berkshire Hathaway

The timeline of Berkshire Hathaway's (NYSE:BRK.B)(NYSE:BRK.A) $10B airlines investment is as follows:

  • In March 2016, one of Buffett's lieutenants (my bet is on Todd Combs) attended the J.P. Morgan aviation conference mentioned above and shortly thereafter, built a $2B position in the company
  • In Q4 2016, Buffett invested another $8B, building on their AAL stake while adding new stakes in three other major U.S. airlines: Delta (NYSE:DAL), Southwest (NYSE:LUV) and United (NYSE:UAL)
  • According to Berkshire's 2016 shareholder letter, the airlines make up 8% of Berkshire's investment portfolio
  • In February 2017, Buffett goes on CNBC and makes the "every industry has a bad century" argument

As it hasn't been Buffett's m.o. to invest in companies based on short term cheapness, let's put current valuations aside for a moment and consider the long term implications of his argument.

In order for Buffett's "bad century" thesis to play out, the following conditions need to be met:

  • Less competition along the same routes
  • Improved bargaining power with suppliers (labor and lessors)
  • Slower growth in capacity (available seat miles)
  • Improved ability to generate incremental revenue in economy class
  • Deteriorating bargaining power for customers

I think you could make a reasonable case that the first two conditions are being met. The bargaining power of labor has eroded to such a sorry state that airlines can now afford to be magnanimous and focus on building the "best employee relationships."

Furthermore, the U.S. airline industry has been consolidating at a rapid rate since the 08-09 Recession, leading to less competition and a division-of-spoils system emerging around the traditional hubs. However, this improved pricing power arguably extends only to domestic short-haul routes, as low cost European and Asian carriers are taking share in the long haul market on each coast. It's no coincidence Southwest Airlines is the only airline that has remained consistently profitable due to its flexible point-to-point operating model and focus on North America.

Now here's where Berkshire's thesis falls apart.

III. Some things never change

1. Capacity

Since air travel grows at the same rate as GDP (2-3%), it is imperative to the profitability of the entire industry that capacity (or available seat miles) be kept in check.

This is a case where video footage speaks louder than words.

Here's a clip in 2015 (a year of record profits) of Southwest CEO Gary Kelly appearing on CNBC's Mad Money responding to American Airlines CEO Doug Parker's accusation of irresponsible capacity growth within the industry.

When you've got Jim Cramer passing notes for you on live television, it's safe to say the airline industry has about as much chance of maintaining sensible capacity growth as Germany and Greece have in agreeing to fiscal priorities.

2. Incremental Revenues

This depends on whether or not you believe travelers will pay extra for "premium economy" seating. I can speak with some authority on the subject as Asian airlines have been offering premium seats for years. Two observations:

  • Travelers will pay a premium if service is noticeably better (and not "less bad")
  • U.S. airlines will never be able to meet the minimum level of customer service standards demanded by Asian airlines in order to justify the incremental revenue

You only need to fly Japan Airlines or ANA once to know this to be true. When it comes to customer service, the Japanese have as wide and as insurmountable a moat ingrained into their culture as Berkshire Hathaway.

While analysts are banking on incremental revenues like the good capitalists they are, my counterpoint is based on the assumption that travelers are neither blind nor suckers.

IV. Forgetting the Internet

On the other hand, this very morning, I sat down at my library with my daughter-in-law and she picked up round-trip tickets to Europe including taxes for four or five hundred dollars -- and we're buying into the airline business!?

-Charlie Munger, Daily Journal shareholder meeting, Feb 2017

Pop quiz: which side is fighting the losing battle?

a. A legacy airline's ability to integrate cumbersome reservations systems, maintain reliability, while constantly identifying and repricing loss-leading routes

or

b. A guy on a computer's ability to create an algorithm to identify and exploit mispriced routes, and make that information immediately available to the general public on the internet?

In 2015, I bought a roundtrip ticket from Boston to Paris for $250 including tax. Last year, I spent $1,000 on six multi-city international flights (on a major U.S. carrier) by exploiting the most competitive routes and using transferable points (i.e. I didn't earn them through an airline loyalty program).

Such deals are only becoming more prevalent. These days most people I know get a list of flight deals sent directly to their inboxes first thing in morning. The only way this could get any worse for airlines is if Amazon (NASDAQ:AMZN) decides to move into the travel business.

In fact, I believe this might be the only edge I will ever have over Warren Buffett: I've actually booked a commercial flight in the past two decades and consulted for the back offices of major financial institutions - enough to understand that IT back office innovation and response times will always lag the proliferation of digital tools available to the public.

V. Conclusion

I believe Buffett's "bad century for airlines" argument is flawed on its assumptions. My view is that the airline business wasn't as bad thirty years ago as he claimed and it isn't as good today as he says. One can argue that his ill-timed 1989 U.S. Air investment clouded his judgment on the industry as a whole, to the point where he missed the rise of Southwest, whose model took advantage of all the upsides in the business (pricing flexibility along the least competitive routes), while steering clear of the downsides (capacity and scheduling risks inherent in the hub-and-spoke model). A $1 investment in Southwest back in 1989 would have earned him $58 today.

In conclusion, Buffett wouldn't feel the need to hedge his bets on airlines (by buying all of them) if he were fully confident in his "bad century" argument. At 8% of his investment portfolio, only one position needs to pan out on valuation alone for him to do quite well in the long term.

As for the rest of us, airlines have been and will always remain bad bets on the future.

"Of course it's the same old story. Truth usually is the same old story." - Margaret Thatcher

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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