Warren Buffett Is Wrong About The Airlines
- Warren Buffett revealed on Saturday that he had sold all of Berkshire Hathaway's airline stock positions. Airline stocks fell on Monday in response.
- Buffett expects the recovery in travel demand to be extremely slow. As a result, he believes airline fleets are too large and debt levels will become unmanageable.
- The pace of the demand recovery is impossible to predict, but Buffett's other concerns appear misguided.
- Alaska Air Group, Delta Air Lines, JetBlue Airways, and Southwest Airlines shares all appear undervalued.
Airline stocks plunged again on Monday after Warren Buffett revealed at the Berkshire Hathaway (BRK.A) (BRK.B) annual meeting that Berkshire had sold all of its airline shares. Considering that the conglomerate had accumulated major stakes of 8-11% in all four of the largest U.S. airlines over the past few years, this marked a big shift in Buffett's thinking.
At a high level, this decision to exit the airline industry is understandable. For decades, Warren Buffett has prioritized investing in high-quality businesses. Given that airlines are burning cash rapidly in the current environment and it's not clear when they will return to positive cash flow, airlines may no longer meet Buffett's investment criteria.
That said, some of the rationales Buffett gave for selling Berkshire's airline stocks don't hold up to scrutiny. To be sure, some individual airlines face a difficult future. I have previously described how American Airlines (AAL) and United Airlines (UAL) will struggle to adapt to lower demand in the near term due to the former's massive debt load and the latter's high exposure to long-haul international travel and undersized domestic hubs.
However, rivals like Alaska Air (ALK), Delta Air Lines (DAL), JetBlue Airways (JBLU), and Southwest Airlines (LUV) probably won't end up as overleveraged as Buffett fears and have more levers to get back to breakeven than he may appreciate. As a result, their shares represent compelling bargains at their current, marked-down prices.
(Source: Alaska Airlines)
Airlines are not the terrible businesses they once were
In the two months since the COVID-19 pandemic crushed air travel (and caused airlines to start burning cash), many airline bears have reverted to some of the traditional stereotypes about the industry: namely that airlines are eternally doomed to destroy investor wealth.
For many years, Buffett held that view, and with good reason. As he described in Berkshire's 2007 shareholder letter (see p. 8):
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.
The airline industry's demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it.
Berkshire Hathaway's decision to invest in the airline industry (again) in 2016 was justified by a change in the circumstances. Airlines are still capital-intensive businesses and always will be. However, since the Great Recession, management teams have stopped chasing market share and growing for growth's sake, prioritizing profitability instead. The result has been an impressive run of profitability and free cash flow production. Even higher-growth airlines like JetBlue have consistently generated free cash flow in recent years.
In short, airlines have accumulated a solid track record of investing shareholders' capital well. Prior to the black swan event of COVID-19, they had earned good returns on invested capital and generated plenty of free cash flow over a period of many years. While they will never be able to generate high growth with minimal CapEx (like some tech firms), airlines have still demonstrated their potential to be solid investments.
Are fleet sizes unmanageable?
Even if the airline industry is no longer inherently unprofitable, airlines still must survive an environment where demand has collapsed by more than 90% and won't snap back immediately. Many airline CEOs have opined that it could take about three years for demand to fully recover. Buffett appears more pessimistic, saying on Saturday that air traffic could remain below 2019 levels even three or four years from now.
As a result, Buffett said that airlines have too many planes. The implication is that because airplanes are major capital investments for airlines, profitability will suffer.
There's no way to know in advance how quickly traffic will bounce back. To a large extent, it depends on when a safe and effective vaccine becomes widely available. Future GDP growth will also play a big part. Yet, many airlines have ample flexibility to adjust their fleet plans to adapt to a world of temporarily-lower demand.
For example, Delta Air Lines, recently, announced that it will retire all 77 of its MD-88s and MD-90s by June, simplifying its operations. These planes are 27 years old on average and were already on the way out. Between its 757, 767, and A320 fleets, Delta has over 100 additional aircraft built between 1990 and 1996 that would be ripe for retirement soon. Its undersized fleet of 18 Boeing (BA) 777s also may be retired for fleet simplification reasons, despite an average age of just 15 years. In total, Delta could easily shrink its fleet by 20-25% over the next year or two if demand is slow to return.
Alaska Airlines' (ALK) oldest planes were built in 1999 but expiring leases could help it shrink its fleet. The bulk of the leases for the Airbus (OTCPK:EADSY) fleet it inherited from Virgin America expire by 2024 (see slide 94). As a result, Alaska's committed aircraft lease payments fall off from $245 million in 2020 to just $81 million by 2024. Through scheduled lease expirations, Alaska should be able to shrink its fleet to match demand within two years or so.
(Source: Alaska Air Group 2019 SEC Form 10-K, p. 70)
Even JetBlue (which has a similarly young fleet and few near-term lease expirations) has palatable options for shrinking. Most notably, the capital cost of the carrier's E190 fleet was quite low, but operating costs per seat are high due to above-average maintenance and fuel costs. As a result, JetBlue was already planning to phase out this fleet by 2025; it may now accelerate that process.
Buffett underestimates other cost-cutting options
JetBlue isn't the only airline that will save on maintenance expense over the next few years as it retires planes that would have needed significant investments to remain in service. Moreover, maintenance is just one area where airlines can look for savings over the next few years while revenue remains under pressure.
At the moment, airlines are also benefiting from significantly lower jet fuel prices. The Argus U.S. jet fuel index has been hovering between $0.40/gallon and $0.80/gallon since mid-March, down from around $1.65/gallon in mid-February. Fuel is the second-largest expense for most airlines. Furthermore, while oil prices could bounce back in the years ahead, airlines have an opportunity to lock in prices well below 2019 levels for the next several years by hedging in the futures market. Fuel efficiency will also improve from airlines retiring older jets.
As for labor costs (the biggest line item), even highly-unionized airlines like Southwest have been able to save money by offering voluntary temporary leaves to employees. They have also slashed board and executive compensation. Additionally, airlines have some flexibility to reduce employees' hours (including expensive overtime), and if they must, they can furlough staff.
Attrition also represents an important lever for reducing labor costs over time. Delta is especially well-off in this respect. In 2018, it told The Wall Street Journal that half of its pilots would reach the federal mandatory retirement age of 65 within a decade. Pilots represent by far the largest chunk of airlines' labor bills.
(Source: Delta Air Lines)
Finally, most airlines offer generous profit-sharing programs. For example, Delta recorded over $1.6 billion of profit-sharing expense for 2019 (3.5% of revenue); at Southwest, profit-sharing totaled $667 million last year (3% of revenue). This expense will go away until airlines return to profitability.
The balance sheets won't be so terrible
Airlines have issued a ton of debt over the past two months to cover their cash burn. There's no doubt that airline balance sheets will be stretched in the short term. However, Warren Buffett's prediction that the top four airlines will each have to borrow $10 billion to $12 billion to survive seems unduly alarmist.
For example, Delta told investors last month that daily cash burn would recede to around $50 million by May, even with negligible cash inflows from ticket sales. Payroll protection grants will cover the bulk of its cash burn in Q2, with some additional benefit in Q3. Given that cash burn was minimal in Q1 and that Delta has suspended virtually all CapEx, demand would have to remain near zero in the back half of the year for Delta to burn over $10 billion of cash in 2020.
Southwest is in even better position, with average daily cash spending for Q2 estimated at $30 million-$35 million (before the benefit of payroll grants). While Southwest will have added $7 billion to $8 billion of debt by this summer, most of the cash it has raised is sitting on its balance sheet "just in case". Southwest is likely to repay much of this new debt as conditions stabilize over the next year or two.
(Source: Southwest Airlines)
Furthermore, some of the airlines' current cash burn is being driven by the unwinding of their working capital balances. This cash burn represents a temporary headwind: not a permanent loss. Once booking activity rebounds (whenever that may be), airlines will benefit from cash inflows due to bookings being made in advance of travel (when the costs are incurred).
Lastly, airlines that have been cash taxpayers in recent years will benefit from provisions in the CARES Act that allow businesses to carry back 2020 NOLs to claim refunds for amounts paid over the previous five years. This could be a significant source of cash for Alaska Air, JetBlue Airways, and Southwest Airlines after they file their 2020 taxes.
The bottom line
Airline stocks aren't for everyone: especially now. Airlines are burning lots of cash and there's no way to know precisely when conditions will start to improve or how long it will take to get back to breakeven.
But for risk-tolerant investors, the latest airline stock selloff could be a good opportunity to invest in Alaska, Delta, JetBlue, and/or Southwest: four airlines with above-average balance sheets and above-average profitability over the past five years. Southwest Airlines stock, in particular, fell to a new 52-week low on Monday.
There will certainly be more turbulence for airlines in the near future. However, these four companies remain favorably positioned in the sector and have more flexibility to adapt to lower demand in the short term than bears appreciate. That will minimize near-term cash burn, enabling shareholders to capitalize on the upside from a return to normal demand conditions over the next several years.
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Analyst’s Disclosure: I am/we are long ALK, DAL, JBLU, LUV. 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.
I am also long Jan. 2021 $40 calls on LUV and Jan. 2022 $10 calls on JBLU.
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