When Warren Buffett (Trades, Portfolio)'s Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) published its results for the second quarter of 2018 at the beginning of August, the conglomerate's cash pile became a focal point for many analysts and Buffett watchers.
I reported in an article on GuruFocus at the time that at the end of the period, Berkshire Hathaway had just under $130 billion in cash, after accounting for $12 billion spent on new investments and traded securities for the three months ending June 30.
We had to wait a few weeks longer to find out which companies Buffett was buying during the second quarter. Berkshire does not publish its holdings in quarterly reports. Instead, like all other fund managers with over $100 million in assets under management, the conglomerate has to report its equity positions in the 13F document, filed 45 days after the end of each calendar quarter.
Berkshire's 13F
According to Berkshire Hathaway's 13F, published earlier this week, Buffett and his team at the Berkshire Hathaway head office made several significant changes to the overall portfolio during the second quarter.
The team increased Berkshire's holding in Apple (AAPL, Financial) by 52% to just under 252 million shares and boosted the holding in US Bancorp (USB, Financial) by 11% to just under 11 million shares.
Three companies, however, saw the largest portfolio changes. These included Delta Airlines (DAL, Financial), Goldman Sachs (GS, Financial) and Southwest Airlines (LUV, Financial). Even though these positions are relatively small compared to the $50 billion stake in Apple, the fact that Berkshire Hathaway decided to increase its holding in each one by around a fifth is significant. In fact, the group actually slightly reduced its holdings of other carriers including United Continental (UAL, Financial) and American Airlines (AAL, Financial), which it noted was to keep the positions under a certain size.
The increase to 56.6 million shares in Southwest Airlines has only increased speculation that this company or another airline could be Buffett's next takeover target.
Berkshire buying Southwest?
Only a few weeks ago, analysts at Morgan Stanley put out a detailed research report claiming that Berkshire Hathaway could quite easily swallow Southwest and still achieve an attractive return on investment at current prices.
Analysts speculate in the report the Berkshire Hathaway could be prepared to pay 40% more for the airline than its current market price.
They arrived at this multiple by looking at previous deals completed by the conglomerate, where it has, on average, paid a 20-30% market premium. Right now, the stock is trading at 11 times Morgan Stanley's estimate of 2019 earnings.
At this low multiple, Berkshire would have to pay a sizable premium to get shareholders on its side. But even at a premium of 40% to the prevailing market price, based on the airline's current growth trajectory, analysts at Morgan Stanley believe Berkshire Hathaway can still achieve an 7% annual cash return target.
So Berkshire could afford Southwest, and it could pay a premium for the airline and still achieve an attractive return. The question is, would it?
Well, Morgan argues that the airline has improved significantly over the past 10 years and now generates some of the best returns in the sector. The operating margin is around 14%, the industry's second best. Meanwhile, math suggests Southwest could generate a return on invested capital in the 15-20% range on an after-tax basis, compared to the cost of capital of below 10%.
By being part of Berkshire, Southwest would be able to maintain industry-leading consumer satisfaction scores and margins as well by focusing on long-term value creation rather than quarterly performance numbers. Morgan's report noted that Southwest has been putting off the replacement of its fleet to help improve short-term results. Spending to renew aircraft would be easier and cheaper as part of Berkshire.
What's more, new planes are approximately 20% more efficient than old craft, as well as provide a better passenger experience. Not only would Southwest be able to lower its costs, but it could also generate a competitive advantage by outspending its peers.
Conclusion
If you were to ask me 10 years ago, what is the probability of Warren Buffett (Trades, Portfolio) buying an airline? I would have said zero. However, over the past three years, it is clear his view on the industry has changed. Now, with more than $100 billion in cash to spend, and few targets on the horizon, Southwest looks to be a very attractive target.
Disclosure: The author owns shares in Berkshire Hathaway.
