Why the Airline Industry Is Finally Buffett-Worthy After 80 Years of Red Ink

Berkshire Hathaway (BRK.A -0.59%) (BRK.B -0.53%) surprised the market last month by announcing it had invested in four of the largest airline companies -- seemingly counter to CEO Warren Buffett's long-standing and well-documented distaste for the industry.

In this clip from Industry Focus: Industrials, Sean O'Reilly and Adam Levine-Weinberg explain what changed in the airline industry that made Berkshire Hathaway want to invest in it, what individual investors should make of the firm's decision, and how individual investors might want to buy into the industry in light of Buffett's investments. Lastly, they also name a few smaller companies with exciting potential for growth that investors might want to take a look at.

A full transcript follows the video.

This podcast was recorded on Dec. 1, 2016.

Sean O'Reilly: Talk to me about valuations. I'm a return on capital equity guy. Talk to me about that stuff.

Adam Levine-Weinberg: In the past few years, you've seen a lot of focus in the airline industry on return on invested capital as a key metric that airlines should be thinking about. All the airlines have different targets, different definitions of return on invested capital, but they're basically attempting to keep that at about 15%, which is a really strong number, and something you'd never seen before in the airline industry. And so far so good. They've basically managed to do that, across most of the major airlines, for several years running.

O'Reilly: Yeah, I've always been amazed. I'll occasionally check in on Southwest because I'm a regular customer. Southwest Airlines, if you're listening, I love you. What is it? It's good to be loved? Something. Anyway. But, I'm always like, wow, they actually make money. And it's just because I have that bias from reading about Buffett for 15 years, where I wonder, what is this? Free cash flow? What's going on? So, where are these guys trading? It might be that the industry is improving, it's just profile. What's going on?

Levine-Weinberg: One of the important things for investors to realize is that airline stocks are still relatively cheap compared to the rest of the market. But they're not trading at such a big discount that you can't explain it by the higher risk of the airline industry. If you look back to 2010 and 2011, a lot of airline stocks were literally trading it 4X earnings.

O'Reilly: Which is when Tepper got in.

Levine-Weinberg: And that's when Tepper got in, and that's why he made so much money. Not only did you have some multiple expansion since then --

O'Reilly: But profits went up.

Levine-Weinberg: -- but the earnings went up by a lot. Some of that was related to oil prices falling in 2014 and 2015, but it wasn't all just oil. Even before the oil prices fell in 2014, industry profits were on the rise. Right now, if you look at American Airlines and United Continental, two of the stocks that Berkshire Hathaway bought, they're trading at 10-11X forward earnings. It's less than the market, but not a lot less. Delta is a little bit under that. Southwest is a little bit above that. But that's after huge rallies in the past few months. So, we don't really know exactly when in the past five months Berkshire Hathaway bought these stocks. If you just look back to the beginning of July, since then, some of these stocks have rallied by more than 50%. So, just because Berkshire was interested four or five months ago, it doesn't mean that they would go and do the same thing today.

O'Reilly: That's a good point.

Levine-Weinberg: That's why you as an investor shouldn't necessarily run out and say, "Warren Buffett bought a bunch of airline stocks, I should too!"

O'Reilly: Right. Really quick, Buffett likes monopolies. Not literal monopolies, but consumer monopolies. And this isn't a monopolistic situation, but it feels a little bit like, possibly, an oligopolistic, just like, there's three or four big players that are really crushing it and actually making money finally. Is that part of his thinking? "They deregulated in '78, it's been an absolute massacre in terms of competition for 30 years. Is it now finally time for ... " I'm not comparing American Airlines and Southwest and US Airways to Coke and Pepsi, but, is it a little bit like that?

Levine-Weinberg: I think that's part of the story. I think that's probably why more investors are getting interested, because they see there's now four companies that can, together, control more than 80% of the domestic market, and a good chunk of the international market, as well, out of the U.S. So, they each have a stake in making sure the industry is profitable, because they know if they go out and grow 7%, everybody else is going to do the same thing, and it's going to hurt industry health profitability by quite a bit. So, consolidation has, in that way, helped the airlines to take a more balanced approach to capacity growth, and not grow when they're not making enough money to justify it.

O'Reilly: Got it. Taking a step back, happy December. We got this news recently, it was extremely jarring, at least for me, that Buffett invested in airlines, or, his company did. What do you think of where the stocks are now? Which is your favorite carrier? Help our listeners out.

Levine-Weinberg: Right now, I would say that, I've actually, in the last two months, myself, sold my personal positions in both American Airlines and United Continental. I thought they looked like really good buys when I bought them, that was quite some time ago. With the stocks having risen so much in the last few months, I didn't really see enough upside to justify the risk of holding on to that. I also personally had a lot of money invested in the airline industry, and I wanted to diversify. That said, I actually think, if I were in Buffett's shoes, I would not have gone and invested in the four largest airlines in the industry. I think some of the smaller carriers out there actually have better prospects for investors right now. If you look at companies like Spirit Airlines (SAVE -7.08%) and JetBlue (JBLU -3.39%), they are trading for very similar earnings multiples compared to these much larger companies, but they have, due to their smaller size, vastly more growth potential. If you look at Spirit Airlines, the whole ultra low-cost segment right now is about 5% of the market. In Europe, it's at least 20%. This is just a movement toward cheaper fares, more fees for add-ons, that has really succeeded in other places, and it's just getting started in the United States. That's a company that has a huge runway for growth. I think in 10-15 years, Spirit Airlines is going to be 3-5X its current size, and making a lot of money. So that's one stock that I think is really compelling right now. And, JetBlue Airways is another example. They have done really well in the U.S. --

O'Reilly: And they're only -- sorry to interrupt -- 15 or 20 years old, correct?

Levine-Weinberg: Yeah. JetBlue's first flight was in February, 2000. In the grand scheme of things, they haven't been around that long. They're actually already the fifth largest airline in the U.S. But they're way behind the top four. Some of the big initiatives they're working on right now are growing in Boston, where they have actually now become the largest airline. That's the only metro area where they really have a leadership position like that. So, they're starting to attract business traffic, which was never really their thing. They'd always primarily been a leisure carrier. They've been moving even further into the business market with their new Mint product, which came out a couple years ago. This is a new aircraft configuration that they use just on transcontinental flights, mostly out of New York and Boston right now, but they're also going to be adding some other cities. They've found that fares, on average, go up about 20% when they put these planes on their new route, because the 16 seats in the front convert into fully flat beds that are 6.5 feet long. So, you have business travelers who would never fly JetBlue for a transcontinental flight because they want more space, like you could get on some other airlines. And now that JetBlue is offering this at a lower cost, they're having huge success, and they see a lot of room for growth in that market over the next three or four years.

O'Reilly: So, JetBlue is having a lot of success with letting people fly the red-eye to sleep. (laughs)

Levine-Weinberg: Yeah! And this is even popular during the daytime. People just want more space if they can get it at a reasonable price. It's certainly not as cheap as your typical ticket. But some of these are going for as little as $600 one-way, which, when you can sometimes pay $300-400 for a coach seat, that's a pretty good deal, to get that much space, and great meals and top-notch service.