Should I Be Investing In Airlines?


You’ve probably heard that joke about airlines before: “How does one become a millionaire?  You start out a billionaire, and then buy an airline.”  This kind of humour was well deserved given airlines’ tragic history — constantly in bankruptcy and frequently losing money for investors.

That joke used to be all the advice an investor needed to know about airlines…until recently.

You’d have to be living under a financial rock to have missed the big news that Warren Buffett has now sunk over $10 billion into investing in airline stocks, and nobody is betting he’s going to lose it all.

Buffett recently bought into all four of the big U.S. domestic airlines – Southwest, American Airlines, United, and Delta.  Not just a single stock.

This is a huge bet on the airline industry, and perhaps a preview of what’s next for Berkshire Hathaway (more on this later).

So what gives?  Has Buffett completely lost his mind, or has he started to see something in the airline industry that’s fundamentally changed?

 

Lower For Longer

One of the biggest business environment changes that airlines experienced in recent years is drastically lower oil prices coupled with a good domestic economy.

Oil prices mean everything to airlines, because oil is refined into jet fuel… and airlines burn A LOT of jet fuel!  

This sudden windfall (of low oil prices) had a HUGE affect on airline profitability.  They went from having terrible profit margins, to those similar to the very best America’s best companies.  Take a look at this:

Operating margins
Operating Margin % at major U.S. airlines and selected corporations for comparison.

Every single one of the major U.S. airlines now has operating margins in the double digits.  That’s incredible!  Suddenly they look like good businesses!

With OPEC turning down the spigot of cheap oil near the end of 2016, you might have expected oil prices to head upward and airlines to suffer.

Except they haven’t, not really.  Prices are still sitting near $50 a barrel.  Why?  Domestic oil producers have started pumping out more oil, and maintaining this ‘oversupplied’ state.  

The world is awash in cheap oil, and those conditions are not expected to change anytime soon.  Hence the phrase “Lower for Longer”.

Interestingly enough, profits at oil refiners (in 2016) were also some of the worst since the Great Recession.  Just take a look at the Q4 numbers for big oil refiners like Valero or Phillips 66 — Sub 2% profit margins, all the while running their refineries at near 100% of capacity.  Yikes!

All this adds up to profitable times for airlines, and a party that’s not going to stop any time soon.

 

Consolidation

Next up on my list of big changes for the airline industry is domestic consolidation.  Remember Northwest Airlines?  Continental?  US Airways? America West?  How about TWA, AirTran, or ATA?  All gone in the last decade or so.

Aloha from the plane
Anyone remember Aloha Airlines? Yet another domestic airline that disappeared in the last decade.

This level of consolidation brought us down to just 4 large carriers and a handful of regional airlines in the United States.  We now have oligopoly-like conditions in the domestic air market, providing excellent competitive conditions for the remaining carriers.  (Oligopolies tend to be very profitable.)

There also appear to be few new entrants into the domestic airline industry… For a very good reason: Running an airline is really hard.  Even the big 4 airlines are constantly having computer problems, delays, mechanical problems, and dealing with bad weather.  

Not only that, but airplanes are expensive to purchase and operate.  It takes a huge amount of money to start a new airline, and then decades to build significant consumer trust.

Think about it — When you buy that next vacation ticket to Disney World, would you rather fly on Air Bob or Delta Airlines?

Yeah, I thought so.  Air Bob would have to be significantly cheaper than a Delta ticket for most people to even consider a no-name airline.

The last time I used a no-name airline, it was a buy-one get-one-free promotion almost 10 years ago.  Needless to say, I never got to use that second ticket before the airline fell into bankruptcy.

 

Slow Growers

It’s also worth mentioning that airlines are not fast growers.  The industry typically grows in step with the population, and follows GDP growth (or decline).  Usually this is in the 1-3% range.  If there’s a recession, people travel less.  If the economy is good, people travel more.

Yes, airline profitability has improved, but they are not (as an industry) moving significantly more passengers.  The big revenue growth for airlines came from consolidation, NOT from selling tons of new seats on planes.

The Bureau of Transportation statistics provides the necessary data to back up this assertion:

Airline passengers by year
Source: Bureau of Transportation Statistics, Summary 2014 U.S.-Based Airline Traffic Data.

Yep, almost a decade of moving around 800 million to 850 million passengers.

Given those low growth rates, how does Buffett and Co. expect to earn big bucks from their investment?

Well, Berkshire isn’t banking on a population boom.  On the contrary, Buffett is famous for loving companies that are slow growers, but maintain consistent earning power for long periods of time.  Earning power that gets plowed into dividends, share buybacks, and carefully growing the business at a slow and steady pace.  

I think that’s the case here as well.  We can see that after profitability improved in 2014, the big 4 airlines started using the excess cash to buy back shares and increase dividends.  Delta and Southwest provide great examples of this phenomenon at work:

share counts
Dividends are increasing while share counts continue to decline.  That’s a recipe for shareholder success.

This pattern of rewarding shareholders with excess profits looks set to continue into 2017 and beyond … as long as a recession doesn’t hit or a major world event doesn’t shock oil prices sky-high.

 

What I Think It Means

Normally, I wouldn’t touch airlines with a 10-foot pole.  One little economic blip or war in the middle east, and they’re back into bankruptcy…

That said, I think there’s something else going on here.  

Buffett expects profitability to remain strong for airlines as the domestic oil industry continues to pump out cheap oil.  It’s also a big bet on the U.S. economy continuing to do well.

Furthermore, I’m going to suggest that he’s going to buy one of these airlines outright but he doesn’t want to disclose which airline to keep prices lower.  

Instead, he’s buying a basket of airline stocks to confuse the real winner and his real intentions.  

If you’re a Buffett watcher (like I am), you’ve seen this behavior before.  He did the exact same thing before purchasing the Burlington Northern railroad.  

For those of you with fuzzy memories, back in 2009 Buffett was buying shares in multiple railroads — Burlington Northern, Norfolk Southern, and Union Pacific railroads.

Railroads were doing really well after decades of poor results. (sound familiar?)  The 13F filings from 2009 have all the details.  Buffet later sold his remaining railroad shares after the tender offer for Burlington Northern was announced.

I see great parallels between this past purchase, and what’s going on with airlines today — Consolidation into an oligopoly, improved profitability, buying a basket of stocks to mask the real purchase, and significant cash at Berkshire for purchasing an entire company.  The elephant gun is loaded.

If I was to guess, I would say the eventual winner is going to be either Southwest Airlines or Delta.

Maybe I’m wrong about Buffett buying an airline outright, but this looks extremely similar to what he’s done in the past.  If I’m right, we’ll see continued purchases throughout the year, and a winner announced around the end of 2017.

 

Conclusion

So do I think you should go out and buy airline stocks?  No, not really.  Despite improvements to profitability and debt levels, they still aren’t the most durable businesses in the world.

There are still small regional carriers and budget airlines that could take market share from the big 4 by cutting into profit margins.  A war in the middle east could still upset oil prices.  The economy could head into a recession.  All of these things could significantly hurt the airline industry.

I don’t think anyone should divert funds from existing index funds into a basket of airline stocks.  But, if you have spare cash to invest, this could be an opportunity to research further.

Domestic airlines have experienced some of their best years ever because of the pain in the oil and refining industry, but I don’t expect airlines to do significantly better than the general stock market.  Those big gains are already in the past… we have to think about what comes next.

Perhaps airlines will do a few percentage points better than the general market this year due to improving P/E ratios, but not the doubling, tripling or quadrupling of profits we’ve seen in the past few years.  That just doesn’t seem realistic.

Airlines are set to do well regardless of Berkshire Hathaway’s real intentions, and the shares are generally priced at a bargain compared to the high prices of the general stock market.  

As long as oil prices stay low and the domestic economy remains healthy, investors could do OK.

 

[Image Credit: Wikipedia]


14 thoughts on “Should I Be Investing In Airlines?

  • February 22, 2017 at 1:31 AM
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    Interesting read, Mr. Tako! I’ve never paid much attention to airline stocks for many of the same reasons you cited. Through in Buffet’s name, and it’s now intriguing. I don’t know that I’ll be purchasing any Southwest stock, but I don’t mind flying them as an airline. 🙂

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  • February 22, 2017 at 4:43 AM
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    Tricky move for sure if Buffett goes that route – I like it!

    I remember one year I just bought everything he did rather than research myself (hey – he did all the work for me!) and it just so happened to be around that same time before he bought Burlington outright 🙂 I only had like $500 invested but I was feeling pretty smart about it all haha…

    Now? I shake my head at my cockamaimy ideas… It’s all indexing for me 🙂

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    • February 22, 2017 at 12:42 PM
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      For most people that’s the most sensible route for sure! Buffett tends to get a lot press, but I think a lot of what’s reported in his portfolio isn’t of value to most investors. Some of those positions he bought decades ago. Others, like this basket of airline stocks could have different motives.

      Thanks for the comment J. Money!

      Reply
  • February 22, 2017 at 5:44 AM
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    This is some great insight into Buffett’s latest trades. I was curious about his recent airline purchases as well, you did a great job explaining the likely logic behind his purchases but also why they may not be a great investment for most people. I’ll be interested to see if he does indeed purchase one of these airlines outright. Great post!

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  • February 22, 2017 at 6:09 AM
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    Yeah, I would be pretty scared to invest in airlines, myself. I’m not sure why anyone would really want to, unless a particular airline was actually doing something great with R&D and not just making seat sizes smaller.

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    • February 22, 2017 at 12:43 PM
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      Hey, I heard Delta’s bringing back ‘free’ meals on some flights. That sounds like a competitive advantage! 🙂

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  • February 22, 2017 at 8:23 AM
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    Very nice write up! I too will be staying away from the airlines, especially as a European they are just too difficult for me to analyze. And in general too much uncertainty. Personally I am watching coca cola a lot more, another drop toward the 40 USD and it might be interesting again. They have some problems at the moment but still have lots of powerful brands and a logistic/distribution power that is unmatched. Also, management must have pissed off Buffett when they awarded themselfs lots of options for not so great performance. And in general, when it is a good business but not so good management and Buffett has a seizable postion, it is the management that goes: remember Kraft selling their pizaa business and Buffett not being too happy about it? 6 years later he co-controls Kraft-heinz and has clear plans to build it into a powerhouse dwarfing Mondelez …

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  • February 22, 2017 at 3:00 PM
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    Ah good ol’ Buffett, trying to confuse us. Well, he has enough money to play around with, so he can pretty much do whatever he wants. The rest of us? I think I’ll stick to my index funds, thank you very much.

    I do remember Buffett saying he doesn’t care for luxuries (he’d rather the donate the money), with the exception of his private jet. So maybe he has a fetish for planes? Who knows.

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  • February 23, 2017 at 6:20 AM
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    I just can’t get past the industries decades long history of being a money pit. Count me as someone that wouldn’t invest someone else’s money in airlines, let alone my own. I do hold some railroad stock in my play portfolio though.
    Fulltimefinance recently posted…Penny Wise, Pound Foolish

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  • February 24, 2017 at 6:42 AM
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    Thanks for sharing your review of the airlines Mr Tako. I am wary of investing in cyclical companies, as they frequently look cheapest at the top of the cycle, and most overvalued at the bottom of the cycle. Of course, I am not Buffett

    Buffett’s views on airlines are a great example of someone changing their mind, despite saying for 20 – 30 years that he would not invest in one again.

    This is what separates super investors from ordinary ones. That and the ability to think independently.

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  • February 26, 2017 at 7:23 AM
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    Lacking Buffett’s resources and deep patience to stay invested in a position for a very long time, there is no way I could copy this move of his and still SWAN. Despite the recent structural advantages of the industry – mainly fuel efficient planes and lower fuel prices and leaner operations after years of cost cutting – airlines fundamentally remain a low ROCE business. That’s why some of the best airline operators in the world are state-owned who see this as an essential national brand (think Emirates, Etihad, Singapore Airlines etc). Sovereign nations have deeper pockets and possibly even more patience than Buffett!
    Ten Factorial Rocks recently posted…Hacking The Retirement Calculators

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