Valuentum Exclusive Analysis for the Discerning Investor

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Warren Buffett has changed his mind about airline stocks... In this 10-minute podcast, the Valuentum analyst team talks all about the hazards of the airline business model from substantial operating leverage to the risks of volatile jet fuel costs to bankruptcies and beyond. The team also highlights the long-term passenger growth prospects of the sector, and recent consolidation that has brewed a more optimistic tone from industry observers.

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Ticckerized for airline-related equities around the globe.

Brian Nelson, CFA:

The worst sort of business is one that grows rapidly requires significant capital to engender the growth and then earns little or no money. Think airlines. There's a durable competitive advantage that has proven elusive ever since the days of the Wright brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk he would have done his successors a huge favor by shooting Orville down, Warren Buffett’s annual letter to Berkshire Hathaway (BRK.A, BRK.B) shareholders 2008. 

Fast-forward eight years and now Warren Buffett is back into airline stocks. What is he thinking? Joining me today is Mr. Chris Araos and Mr. Kris Rosemann, and we're going to cover the bases on airline stocks. Mr. Kris Rosemann, can you take us through some of the recent trends that you're seeing across the industry? 

Kris Rosemann:

Yeah, so the International Air Transport Association recently came out with their outlook for the next two decades through 2035, and they're expecting air passengers to roughly double to 7.2 billion in 2035 from around 3.8 billion 2016, and that growth represents a 3.7% compound annual growth rate over that 20-year period. This demand is expected to be driven by nations increasing their intercontinental trade, and just on a consumer side, people wanting to explore the world and share the benefits of technological innovations and economic prosperity. 

Brian: 

That's a really good point. I think the proliferation of low-cost carriers making travel much more affordable, the growth of urbanization, the rising middle class in emerging economies, the lure of travel both for business and for pleasure. These are all dynamics that are contributing to this very strong backdrop but what's really interesting is that Warren Buffett isn't really, I guess you could say, a growth investor. 

He's probably one that would say that value and growth--and in fact he has said—that value investing is redundant, that the only way to truly invest is to consider the value of a business; and what's really interesting is the concept of economic value--and for most of the history of the airlines, they have been destroying economic value. 

Since deregulation in 1978, over 160 airlines have declared bankruptcy, and I think the first year ever that airlines were able to generate economic profit was in 2015 (last year), and this took one of the strongest economies and just an outright collapse in jet fuel prices and crude oil, so it really takes a perfect storm for airlines to do well. So why is Warren Buffett, with what he’s said in the past, with his focus on competitive advantages, why is he jumping in this? 

When we look at what Buffett has written, and what others have written about Buffett, when he first made his mistake jumping into airlines in 1989 when he opened a position in US Airways, he called it the equivalent of an unforced error. He went so far as to say that in an unregulated commodity business like air travel, one must, a company, must continue to lower its cost to remain competitive or face extinction, and he even admitted that this principle had been obvious to him, but he still missed it. 

Mr. Araos, I think one of the things that the business models of airlines possess is somewhat an ominous dynamic. Can you talk a little bit more about that aspect of their business? 

Chris Araos: 

Yes. Two thirds of the cost of flying of an airplane is fixed -- that would be the attendants, maintenance, engines. However, one third of it is not fixed and that would (primarily) be the fuel cost of the airplane itself, and that's where most of the bankruptcies would take place when fuel just skyrockets.

As an example in 2008, the price of oil was around $150 per barrel. During that time, (several) airlines ended up going belly-up such as Eos, a business-class only trans-Atlantic carrier, filed for chapter 11 on the 26 of April in 2008. Four months before that, MAXjet also threw in the towel. Aloha Airlines, a regional carrier based in Hawaii for more than 60 years, closed on the 31st of March of that year. So fuel is a very dangerous proposition. 

Brian: 

The interesting thing about jet fuel prices, too, is that many may say that hedging fuel could be a good proposition for a lot of the airlines, but it really cuts both ways. If you hedge at a price that's too high, you end up paying, end up losing money on those hedges, and while over time, for example, a company like Southwest (LUV) that has, at least in the airline business, has been known to be a long-term (successful) hedger fuel of prices, that was really only a benefit during a number of years ago when crude oil prices and jet fuel costs were above their hedging portfolio. 

Airlines, themselves, are not financial companies, per se, so the value behind an airline should not rest in its hedge portfolio, but with respect to its operating dynamics, and as Mr. Araos alluded to, the operating leverage in their business model with their high fixed cost nature is really something that lends itself to boom-and-bust dynamics. For example, labor costs tend to be sticky downward, and that is a very challenging dynamic to overcome during times of weak economic performance. 

When you think about just how many passengers travel on an airline in any given year, if an airline is able to charge a dollar more per ticket, for example, that flows straight to the bottom line because there's no cost attached to that (pricing), so there's substantial amounts of operating leverage from the pricing dynamic -- or even adding one person more per plane a year could have profound implications on the profitability of an airline. 

…and what I find probably most interesting about Buffett’s investment is that he's now investing in an industry where even the executive teams, for example, don't know what the price they're going to charge on a flight is going to be or the (main) costs of their business, whether it be because of the uncertainty of pricing competition and/or the changes in the price of crude oil and jet fuel costs (respectively), so they don't have a good handle for how their future looks on the pricing, on the revenue side, nor do they do on the cost side. 

So this is a very, very hazardous business. 

Another dynamic is the idea that barriers to entry are just so limited in this airline industry, that pretty much anybody with capital can start up a new airline. On Boeing's (BA) website, for example, it has information on it if you're interested in starting an airline, so there's a lot of interesting forces out there that tend to create a very ominous competitive environment for these entities – and Warren Buffett seems to now be embracing a lot of these hazards. 

Kris: 

Yeah -- I just want to get back to something you mentioned there Brian about the uncertainty of the future revenue and the boom-and-bust cycle, and I think that there's a lot of risks associated with the growth rates that I referenced earlier with the IATA expectations for air passengers to double, and a lot of that has to do with some of the things that we're seeing in the political sphere of the developed world. 

Right now, the US (SPY) is the number one aviation market with the UK (EWU) as the third, and in both of those countries we've seen a move towards protectionists ideals in some recent political events in the case of Brexit in the UK and the Trump phenomenon in the United States, so to speak, and the concern there is that some trade restrictions or changes in the current dynamics of global trade agreements could hinder the amount of air travel (growth) we see around the world. 

In addition to that, there's a few other risks including the infrastructure issues that will be required to keep up with the demand. In these developing economies and countries especially, there's going to be a very high need for airports, runways and even airlines themselves are going to need government help. The governments are going to need to get involved to help with the massive infrastructure projects that will be necessary to keep up with these things. So, in addition to the company-specific risks inherent to their business models that you guys are mentioning, there's plenty of risks to the robust top-line forecasts that some of the industry observers are coming out with. 

I think it's just important to keep this in mind as everyone is pointing to Warren Buffett's investment in some major airlines as the industry—all of a sudden—being a highly-investable space. 

Brian: 

Yeah -- there's risk to the secular growth dynamics of their top line and passenger travel, but this industry is notoriously cyclical, too, so while it is resilient as we've seen after the shock of 9/11 and also the global financial crisis -- while it bounces back, it's also very, very cyclical, and that's one area of these businesses that I think a lot of investors may be overlooking during these good times -- that during bad times operating leverage cuts both ways. 

More recently, the bull case or the more positive outlook for airlines has been driven by this thesis behind massive consolidation in the industry. For example, there used to be five or six major carriers, and now we've really cut that down to three or four over the past several years. Delta (DAL) has tied the knot with Northwest, Continental with United (UAL), US Airways with America West, and then subsequently with AMR Corp (AAL), and even Southwest and AirTran have tied the knot. 

So these carriers are getting bigger, and the idea that the industry has turned into an oligopoly may be true, but the challenge with right-sizing capacity to meet demand will always be a concern, and the idea of being able to price in excess of cost increases is always going to be challenging, especially in light of some of the major airlines being accused of price collusion, so there's a lot of challenges to running an airline as many of the executive teams of over the 160 airlines that have declared bankruptcy since 1978 can attest to. 

We're just having a very difficult time--I would say, I guess you could say--balancing the views of Warren Buffett, who is a long-term investor, with him now jumping into the airline space -- but those are our latest thoughts on the airline industry. Thank you very much for joining us. I’m Brian Nelson for Valuentum Securities.