Warren Buffett (Trades, Portfolio)’s airline adventure has been interesting to watch from the sidelines. After initiating his positions in the industry around this time last year (a great surprise to Buffett watchers who are well aware of his negative view of the industry), the investment community has been struggling to explain why, after years of staying away from the sector, Buffett finally made his move.
Getting to grips with airlines
I have been following Buffett's airline trades since the beginning of this year and have pondered why the billionaire decided now is the time to get into the sector. Initially, I speculated in a previous article the trade is:
“A play on a cyclical upswing in the U.S. economy. Other theories include President Donald Trump’s protectionist rhetoric, which will increase the number of domestic flights made by U.S. consumers; consolidation of the airline industry as the U.S.’s top four carriers now own 84% of the airline market versus 65% in 2015; deregulation, another potential Trump play that will make life much easier and profitable for carriers; and a change in the dynamic between worker unions, airlines’ biggest problem, and the businesses themselves.”
Several months later, Buffett himself spoke about the trade in an interview.
He said the investment is not a bet on a single carrier but the industry as a whole as “[it] has been operating for some time now at 80% or better of capacity – meaning available seat miles – and you can see what delivery is going to be.” He went on to say, “"It is no cinch that the industry will have some more pricing sensibility in the next 10 years than they had in the last 100 years, but the conditions have improved for that.”
In other words, Buffett believes the industry has gotten past its worst times and is now heading, as a whole, toward better, more profitable years, following the same course as the railroad sector:
"It [the railroad industry] was a terrible business for 80 years...but they finally got down to four big railroads, and it was a better business. And something similar is happening in the airline business."
Unfortunately for Buffett, it now looks as if the airline industry is returning to its old ways. After years of price stabilization, Bloomberg reported a battle that started this summer between United (UAL, Financial) and heavy discounters like Spirit (SAVE) and Frontier has since spread to others, including American (AAL, Financial) and Southwest (LUV, Financial).
According to analysts surveyed, this price war will likely lead to additional revenue growth forecasts for the major carriers, following the first wave of downgrades during the first half of the year.
“Some carriers are expected to use a Cowen transportation conference that starts Sept. 6 in Boston to update outlooks for third-quarter revenue for each seat flown a mile, most likely to the low end of earlier guidance, Becker said. Others may include updates on the gauge, known as unit revenue, in monthly traffic reports this week.
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United currently expects unit revenue to be somewhere between down 1% from a year earlier to up 1%, while Southwest sees the measure up 1%. Investors were disappointed by both forecasts, made in July, and by Southwest’s plan to grow more quickly than expected. United President Scott Kirby declined to comment on the unit-revenue outlook in an interview last week, but confirmed the carrier would provide an update this week.
American has said the measure will be up in a range of 0.5% to 2.5% from a year earlier, while Delta (DAL, Financial) expects up 2.5% to 4.5%.”
While it is unlikely this will be a long or particularly damaging price war, it shows the industry is not yet immune from all of the issues that have held it back in the past. Buffett’s view that the industry is changing is right to some degree, although he is also correct that it will not be long before carriers can grow predictably without being hit by competition and other factors (i.e.,higher fuel prices from Hurricane Harvey).
A classic Buffett trade
In many ways, this is a classic Buffett trade. Airlines have never been an attractive industry, and investors still do not trust the sector -- which is why “Standard & Poor’s index of the five biggest U.S. airlines plunged 7.5% in August, wiping out about $10 billion in market value” according to Bloomberg. In the long term, however, these carriers could turn out to be good investments. Using Delta as an example, the company repurchased $2.6 billion of its stock last year. 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 -- few other companiess have such generous cash return policies in place.
Disclosure: The author owns no stocks mentioned.
