The Wright brothers’ ingenious invention of the airplane has given man the gift of flight. Since then, aviation has paved the path for international trade and tourism, which have played central roles in global economic prosperity. In 2019, the world’s airlines carried 4.5 billion passengers, while air transport carried 0.5% of the world trading volume that represented 35% in shipment value. It’s a huge industry generating US$704.4 billion per year. In fact, the aviation industry would rank 20th globally in GDP terms with a size close to that of Switzerland’s.
Despite the economic significance of aviation, airlines are not as profitable a business as we think they are. It is a capital-intensive business with little to no profits to show. Billions of dollars, mostly funded by debt, are spent on growing their fleet of aircraft. The airlines then incur high fixed and variable costs, primarily from aircraft maintenance, labour, and fuel costs. Airlines that expanded aggressively during an economic upcycle often experienced difficulties covering their overheads and servicing their debt in future economic downturns, causing their bankruptcy.
The question is, if airlines were such terrible businesses as Warren Buffett described them to be after admitting he made a mistake investing in US Airways in 1989, why did he invest in the four major American airlines (i.e. Delta Air Lines, American Airlines, United Airlines, and Southwest Airlines) again in 2016?
In this article, we will explore Buffett’s relationship with airlines chronologically — when and why did he make those purchases of airlines, and what went wrong?
The 1978 Airline Deregulation Act
To better understand Buffett’s decisions, we need to understand the Airline Deregulation Act of 1978. Prior to the act, airlines were basically guaranteed profitability. The federal government controlled the entry and exit of participants in the airline industry, making the industry an oligopoly. The Civil Aeronautics Board (CAB) would determine the routes and prices of the airlines, and these very generous pricing structures allowed airlines to fly profitably despite filling only about half of the airplane’s capacity. However, in 1978, the Airline Deregulation Act effectively shifted the control of the air travel market from the political to the market sphere. Subsequently, the increased competition in the air travel market lowered air ticket prices, making it more affordable for the average air traveller. This explains why the load factor that airlines require to breakeven today is much higher than before (between 72.5% and 78.9%).
Initially, the act did not have a great bearing on profitability. New entrants to the air travel market were low-cost carriers with small capacities that did not affect legacy airlines such as US Airways. Legacy airlines continued passing down the high costs of operations to consumers. As low-cost carriers gained market share and expanded their operations, legacy airlines were forced to engage in a price war to prevent further loss of their market share. This marked the start of changes that would shape the airline industry for years to come.
Buffet’s first airline investment
In 1989, Warren Buffett purchased US$358 million worth of US Airways’ 9.25% convertible preferred stocks. He believed that legacy airlines would continue to run profitably if they brought their costs down to compete effectively with low-cost carriers. However, he was wrong. US Airways had trouble negotiating contracts with labour unions who were used to inefficient work rules and generous salaries that would not exist in a competitive market. The entrants of new low-cost carriers were largely made up of non-unionized labour that were paid an average of US$22,000 a year, almost half the salary of a unionized employee that received US$39,373 a year.
Consequently, US Airways struggled to reduce costs and lost an aggregate of US$2.4 billion from 1990 to 1994, wiping out its entire shareholders’ equity. The airline had to suspend their preferred dividends for two years (in 1994 and 1995). As a result, Buffett wrote down the value of his investment in US Airways by 75% to US$89.5 million.
However, Buffett was cautious enough to structure his initial deal to include a penalty for preferred dividends that were missed. As stipulated in the contract, US Airways had to pay penalty dividends, the unpaid dividends for the past two years at a compounded annual rate of between 13.5% and 14.0%. US Airways resumed their dividend payments once again in 1996 after they returned to profitability.
By 1998, Buffett managed to profit handsomely from his mistake of investing in US Airways. Benefiting from a cyclical tailwind, US Airways paid back its US$358 million loan with common shares which Buffett sold for US$574 million, yielding Buffett an absolute return of 127% over a period of nine years, including US$216 million in capital gains and US$240 million in dividends.
Why Buffett went in once again…
The next time Buffett invested in airline stocks would be in late 2016. Berkshire investors were puzzled by his move, especially because he stated in his 1992 shareholder letter that, ‘…investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth.’
Despite this, he continued accumulating shares in major U.S. airlines, and by the end of 2019, he had spent US$7-8 billion accumulating an 11% stake in Delta Air Lines, a 10% stake in American Airlines Co., a 10% stake in Southwest Airlines Co., and a 9% stake in United Airlines.
The purchases were not entirely unreasonable. In fact, the four major airlines are back to the days before the 1978 Airline Deregulation Act — an oligopolistic market with a pricing structure to sustain profitability in the long run. After waves of bankruptcies, reorganizations, and mergers, the United States is left with four major airlines. Together – Delta Air Lines, American Airlines, United Airlines, and Southwest Airlines – control 90% of all U.S. domestic air traffic. The consolidation of the industry pushed up the prices of the air fares as travellers have fewer choices. Fueled by low oil prices, the four major airlines have been consistently profitable over the past five years and returning capital to shareholders through dividends and share buybacks.
Unprecedented impact of COVID-19
However, a global pandemic has drastically changed the outlook of the airlines. The four major airlines have had to drastically cut costs as air travel plunged more than 95% due to COVID-19, parking hundreds of jetliners and putting employees on voluntary furlough. The airlines’ earnings call said that these measures reduced the daily cash burn from US$100 million down to US$70 million each day. The U.S. carriers must also raise funds through debt, equity, and billions of dollars in government aid which they are required to pay back in the future.
Buffett sold his stakes in the airlines for a fraction of the US$8 billion he invested because it will take a whole lot more for them to bounce back to pre-crisis levels. The increase in debt and equity will lower profitability and dilute shareholders in the next couple of years. The airlines will also have to deal with excess capacities as demand for travel will trickle in and not go back at the flip of a switch. It takes time for consumers to regain confidence to travel again. On top of that, airlines will have to adhere to social distancing measures by leaving the middle seat empty – hence, flying at two-thirds of the actual capacity. As Michael O’Leary, CEO of Ryanair, said: ‘We can’t make money on 66% load factors. Either the government pays for the middle seat or we won’t fly.‘
Additionally, the digitization of workflow during this period might alter companies’ views on corporate travel, realizing that they might not have to fly down to sign a document to close a deal. This can be done digitally through teleconferencing and electronic documents.
The fifth perspective
As seen, Buffett’s experiences with airlines have been mixed despite an in-depth knowledge about the industry. What I admire about Buffett is his willingness to change his investment thesis according to the facts. He was not wrong about the future of the airlines before the COVID-19 outbreak – no one can prepare for or anticipate black swan events.
Once Buffett realized that the virus altered the outlook of the airline industry, he was quick to follow his own advice – ‘get it right, get it fast, get it out, get it over.’ He cut his losses immediately. It is the right thing to do but also the hardest as losing money is painful; we often wait till the prices of our stocks appreciate a little before selling them.
I also learned from Warren Buffett that making mistakes is part and parcel of an investor’s journey. Our goal is not to aim for an unblemished record by avoiding losses. Instead, we should learn to actively manage our risks through diversification (airlines were about 4% of Berkshire’s portfolio of public stocks) and understanding the business before investing a dime of our hard-earned money in them. We must be sensitive to the economic conditions that affect the businesses we own and quickly react to minimize losses. And we can only achieve that by doing our due diligence on the company. There is no substitute or shortcut.