Back in April, Warren Buffett (Trades, Portfolio) made an announcement that came as a surprise to many investors at the time. The Oracle of Omaha declared that he'd dumped all of his airline stocks due to the risks and uncertainty facing the industry.
This was a big surprise because only a few weeks before, Buffett was still buying airline stocks and touting the industry's strengths.
Since he completed these deals, the market has been awash with speculation and criticism as to why Buffett made these moves. Recently, though, developments in the sector lead me to believe that this was the right move.
Buffett on airlines
Buffett made his first large airline investment in 1989 in USAir, buying $358 million worth of preferred stock with a 9.25% dividend and a mandatory redemption in 10 years. While the trade did make money for Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) and its investors, it was ultimately a bad deal.
The company's primary issue was cost. Its costs were higher than the rest of the industry, which meant it struggled to compete with more efficient carriers. As Buffett told Berkshire's shareholders in 1994:
"USAir has a cost structure which is non-viable in today's airline business...I think the cost structure could be brought into line, but whether it will be brought into line or not is another question."
This was a problem that all airlines, not just USAir had to deal with. As Buffett later remarked in 2008, the industry's demand for capital has been insatiable since virtually the first flight:
"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."
However, in 2016 and 2017, Buffett's view on airlines shifted. He believed that the sector had changed for the better. Companies had become more aware of their costs and prioritized profit-making over growth. This change in attitude convinced him that the sector was worth investing in again.
We will never really know if Buffett was convinced that the industry had changed for good, or if he'd just run out of alternative ideas in the booming stock market, but as it turns out, Buffett was wrong. The industry has once again reverted to its "bottomless pit" status.
Last weekend, American Airlines (AAL, Financial) announced that it is going to raise $3.5 billion in new financing on top of the company's existing debt load of $34 billion and a $4.8 billion loan from the U.S. government. As part of the financing deal, the company will sell stock worth $750 million, about 12% of the carrier's total number of outstanding shares.
This deal will dilute shareholders significantly, and there's no guarantee it'll be the company's last fundraising. American Airlines is the first to come back to the market for new money after the recent government bailout, and it's unlikely to be the last.
In my opinion, this proves Buffett's decision to sell was correct. At the height of the crisis, it was impossible to tell which companies would survive and which wouldn't. With so much uncertainty, Buffett decided to sell all of his airline holdings rather than gamble on the future. Now we're starting to see the impact of the crisis on these companies' bottom lines. There could be future dilution and pain ahead for shareholders as the crisis rumbles on.
After his sales, Buffett announced that the "world has changed" for airlines. This statement has proven to be correct. Demand might eventually return to previous levels, but the new debt these companies have taken on will prove to be a drag on earnings for many years, with a high opportunity cost for shareholders in the meantime.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
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