When it was revealed Warren Buffett (Trades, Portfolio) had decided to build a $10 billion position in the largest airlines in the U.S., many market commentators reacted with surprise. Buffett has always stayed away from the airline industry because it is plagued with problems. Volatile fuel prices, high capital costs, price wars and unpredictable unions all combine to make the industry an extremely uncertain and challenging place to invest. Indeed, at the beginning of the year, Buffett himself noted, “I think there have been almost 100 airline bankruptcies. I mean, that is a lot," he said in an interview with CNBC. "It's been a disaster for capital."
In the same interview, he alluded to the fact he believes the industry has put its bad practices behind it. Specifically, the "Oracle of Omaha" said, "it's true that the airlines had a bad 20th century. They're like the Chicago Cubs. And they got that bad century out of the way, I hope."
It seems the central thesis behind Buffett’s enormous airline investment appears to be airlines now have significantly more pricing power and can extract more money from customers than ever before. Airplanes “may become like cattle cars, but a significant percentage [of passengers] would rather be treated that way and fly for X than have far more legroom…and fly for X plus 25%,” Buffett told CNBC, a nod of approval to managers’ desire to squeeze every dollar possible out of their assets.
Time to sell?
They say actions speak louder than words, and while Buffett may have defended his airline investment during the first few months of 2017, his latest portfolio disposals imply he has had a change of heart about the aviation industry over the past four months.
Berkshire trimmed its position in Delta (DAL, Financial) by 3%, American Airlines (AAL, Financial) by 5% and United Continental (UAL, Financial) by 3% during the second quarter.
The sales do not appear to be standard portfolio rebalancing movements, especially when Buffett has a much reported $100 billion of cash sitting on his balance sheet. Instead, it seems some of the sales were profit-taking. According to Dataroma, the average reported price of Berkshire’s holding in United Continental is $75.30, American Airlines is $50.3 and Delta is $53.7. During the second quarter, United traded as high as $82, American traded up to $54 and Delta traded as high as $56. Since reaching these highs, all of the airlines have lost ground. Year to date, United is down 8.5%, American is up 4.5% and Delta is up 1.8%, all of these figures exclude dividends.
Has the industry really changed?
Of course, Buffett might not be giving up on airlines entirely. This could be a portfolio reorganization even though it does not initially look like it. But what Buffett is doing should not matter particularly to the average investor. If you want to replicate Buffett, it is probably best to buy shares of Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) rather than trying to follow him into positions, as you will never get the same price.
On an individual basis, Delta still looks attractive considering its valuation of around nine times forward earnings. What’s more, management is committed to returning cash to investors. Last year, the company repurchased $2.6 billion of its stock, and further buybacks are likely on the cards if it hits its annual free cash flow targets of $4.5 billion to $5.5 billion.
The airline aims to return 70% of its free cash flow to shareholders. Even though some investors might be put off by the aviation industry’s historical problems, these free cash flow metrics are enough to convince even the most skeptical analyst that Delta has put its problems behind it. Last year, repurchases retired 7% of the company’s outstanding shares. If this trend continues, the company should have no problem posting double-digit earnings growth in the years ahead. If it does, it will not be long before the shares re-rate to a higher multiple. A forward price-earnings (P/E) multiple of less than 10 will not last long with earnings growing at a double-digit percentage.
Disclosure: The author owns no stocks mentioned.
