Warren Buffett has gone on record numerous times as being adamantly against investing in airline companies, yet last month Berkshire Hathaway (NYSE:BRK-A) (NYSE: BRK-B) disclosed that it had invested in four of the world's largest airline companies: American Airlines (NASDAQ:AAL), Delta Air Lines (NYSE:DAL), United Continental (NYSE:UAL), and Southwest Airlines (NYSE:LUV).
In this clip, Motley Fool analyst Sean O'Reilly and contributor Adam Levine-Weinberg explain why Buffett had despised airlines in the past, what's changed in the past few years to make these airline companies compelling investments for Berkshire, and how macro-trends in the airline industry will affect consumers and companies going forward.
A full transcript follows the video.
This podcast was recorded on Dec. 1, 2016.
Sean O'Reilly: This is a slightly older story than I would prefer, we had the holidays and everything, but I immediately messaged you on Slack when this news hit the wires. Berkshire Hathaway owns shares of the four largest airlines. I recently turned 30, sorry to say --
Adam Levine-Weinberg: It happens to all of us.
O'Reilly: Yeah, it happens to the best of us. I've been reading about Warren Buffett and investing for half of my life now. I wander into the library and I see these books, "Warren Buffett Way," and all that stuff, and all of them talk about, Buffett does invest in airlines. He's done it before, he gets burned. He did the preferred shares in US Airways. He always gets burned, and it is the quintessential example of a Warren Buffett mistake in that it's a commodity business. Then this hits the wires, and I just give up. I'm done. I'm just going to go quit and live on an island. What did you think? Give us some context, what's going on here?
Levine-Weinberg: I'd say, this news was much more surprising to me than the OPEC production cut.
O'Reilly: Boom, yeah. (laughs)
Levine-Weinberg: Yeah. (laughs) Because, Warren Buffett really has, for a good 20 years now, warned off investors at every opportunity from airline stocks. Even when airlines have been profitable, he said forget it, they're not sustainable businesses, stay away.
O'Reilly: What's that quote? Had a capitalist who wanted to make money been at Kitty Hawk with Wilbur and Orville Wright --
Levine-Weinberg: He would have shot down the plane to stop the airlines.
O'Reilly: (laughs) That's kind of harsh, man.
Levine-Weinberg: It's harsh. What he was saying was basically, investors have found this allure in airline stocks for decades, and they have poured billions and billions and billions of dollars into the industry, and that's just money that's been lost, not money that has been invested. You look over the whole history of the airline industry, it has been unprofitable.
O'Reilly: And you're talking about the 90-year history.
Levine-Weinberg: Yeah. That's decades and decades. So, it's not a bad industry cycle, that's just been the business, for history. So, it was definitely surprising to see Berkshire Hathaway buy these airline stocks. Now, it's important to recognize that at this point, Berkshire is a really big conglomerate, Buffett does not control all of the investing. He has two lieutenants who invest most of the excess money that Berkshire Hathaway has. It's most likely that one of those two guys bought the first three airline stock --
O'Reilly: What's the position sizes of these things?
Levine-Weinberg: It's not that big. In total, the investment seems to be under $1 billion. That's a lot of money for you and I, but for Berkshire Hathaway that's small change.
O'Reilly: What do you mean, Adam? What are you saying? (laughs)
Levine-Weinberg: (laughs) The first investments were in American Airlines, which is the largest position, then Delta Air Lines and United Continental. Those are the three biggest carriers, the remains of the legacy airline business. Those were probably not made by Buffett himself. According to Buffett, at least, he was at a conference or something, and Herb Kelleher, who's the founder of Southwest Airlines, was there, and they're old friends, so they got to talking, and Buffett got back and kind of felt bad that they'd invested in three out of four and not Southwest Airlines, so he was like, "Let's buy some Southwest Airlines, too."
O'Reilly: Oh, no. Is that what Buffett's doing? Has he been doing this for the last fifty years, and I just don't know it?
Levine-Weinberg: Hopefully not.
O'Reilly: Is that what he's been doing, and he's just been really lucky?
Levine-Weinberg: I just think, in this case, it was a small amount of money and he felt like --
O'Reilly: He didn't care, yeah.
Levine-Weinberg: -- if his guys thought the other three were good investments, he figured, why not Southwest as well.
O'Reilly: Really quick side note, I want to get your thoughts, I'm sure you're aware that another brilliant investment manager, David Tepper, he runs Appaloosa Management, he's personally worth $10 [billion] to $11 billion. Not bad. He made a bunch of money buying the airlines right after the Great Recession, but not immediately --
Levine-Weinberg: He was really early.
O'Reilly: Like 2010. He made almost three times his money on American, at least. I wanted to know what you thought about that, and why is Buffett late to the game on this, what's going on?
Levine-Weinberg: I think, Buffett obviously was late to the game because he had this long-standing position.
O'Reilly: Bias, we'll call it bias for now. (laughs)
Levine-Weinberg: All right, let's call it a bias, against airlines. He'd said, several years ago ... I'll get the quote here, this is from the 2007 Berkshire Hathaway investor letter. "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."
So, he just saw these businesses as constantly wanting to grow, growing so fast that they need to buy lots of planes. Planes cost tens of millions of dollars, in some cases, over $100 million apiece. And after they spent all this money to get started, they wouldn't actually make money in the long run.
O'Reilly: You're subject to the vagaries of ticket prices --
Levine-Weinberg: And OPEC.
O'Reilly: Or OPEC, yeah.
Levine-Weinberg: Yeah. It's demand, it's oil prices, it's whether you have labor troubles, almost all of these airlines have a high percentage of their workers that unionize, and every time you start to make money, the unions say, "We want a bigger share of the profits." And to some extent, the airlines have to give in. They're customer service businesses. For a couple years, they can push back, but they can't have dissatisfied workers for a really long time or it's going to start to have a major impact on their profit, either way that they go. Anyway, I think Tepper obviously saw much earlier than Buffett that there have been some changes in the airline industry that are really promising. What it really comes down to is, airlines aren't trying to just pursue growth, especially the larger airlines. They recognize that they need to be businesses, and they need to make a reasonable return for their investors. So, what you've seen is, when they're doing really well, they'll grow at a 4% to 5% rate, among these larger airlines. As soon as their profits start to take a hit, they pull back on capacity. You're seeing right now, during the second half of 2016, airline profits are starting to pull back up a bit, and most airlines have already announced that for 2017, they're going to grow 1% to 2%. That slower growth means you don't need to spend as much money on new planes.
O'Reilly: For our listeners, when you say growth, do you mean expanding routes? Buying new planes? Capex? What do you mean?
Levine-Weinberg: That's a good point. By growth I mean capacity growth.
O'Reilly: So, seats. (laughs)
Levine-Weinberg: Seats, and also distance. Sending one seat from New York to Beijing, obviously a lot more capacity than sending one seat from New York to Miami.
O'Reilly: This is an important airline industry term, like with restaurants, same-store sales growth?
Levine-Weinberg: Yeah. So, in terms of this capacity growth, the technical term is available seat miles.
O'Reilly: Insert eye roll.
Levine-Weinberg: Yeah. How many miles you send each seat, and add that up across the cross all the seats in your fleet. So, you have about a 2% growth rate or less for the three biggest airlines -- American, Delta, and United. And those are stocks that Tepper, I believe, has invested in in the past, made a lot of money there, and that's where Buffett's lieutenants made their first investments during the third quarter. With that slower growth, you have a better ability to keep fares higher, that you can earn double-digit margins or close to it, which is something that the airline industry never really did, looking back into previous cycles.
O'Reilly: With everything you've been saying, they're finally realizing they need to make money. Is the airline industry, after 80 to 90 years, finally maturing? What does this mean?
Levine-Weinberg: Yeah, I think it is maturing. Certainly, a lot of the problems that you saw back in the '90s and 2000s was, the U.S. airline industry was regulated up until the late '70s. So, after 1978, you had all of these airlines whose fares had previously been set by the government, essentially. Their costs were really high, they didn't have to compete on cost, so they didn't. So it's taken this long for the whole industry to shake itself out.
O'Reilly: That's a big deal, yeah.
Levine-Weinberg: And the thing is, you've had Southwest Airlines competing for a long time, but even as recently as 2000, they had something like $5 billion of revenue, which was less than 5% of the industry. Even with a company like Southwest Airlines -- a vigorous competitor, very low costs -- they didn't have the ability to completely overturn industry pricing at that point in time. Now, you have enough of these smaller airlines in addition to Southwest. You have the ultra low-cost carriers like Spirit Airlines and Frontier Airlines, you have people in the middle like JetBlue or Virgin America. With all of these companies, they forced the legacy carriers to get their costs to the point where they're not at parity, but they have a reasonable cost structure where they can make money year-in and year-out.
O'Reilly: Got it. Really quick, do any of the smaller carriers charge money for oxygen?
Levine-Weinberg: (laughs) Not yet.
O'Reilly: Not yet? OK, we'll find out.
Adam Levine-Weinberg owns shares of JetBlue Airways and Spirit Airlines. Adam Levine-Weinberg has the following options: long January 2017 $17 calls on JetBlue Airways, long January 2017 $40 calls on Delta Air Lines, and long December 2016 $30 calls on Spirit Airlines. Sean O'Reilly has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool recommends JetBlue Airways and Spirit Airlines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.