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).
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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.
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This podcast was recorded on Dec. 1, 2016.
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Sean O'Reilly: This is aslightly 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:Ithappens to all of us.
O'Reilly:Yeah,it happens to the best of us. I've been reading about Warren Buffett and investing forhalf 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'sdone it before, he gets burned. He did the preferred shares inUS 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.
Levine-Weinberg:Yeah.(laughs) Because, Warren Buffett really has, for a good 20 years now, warned off investors atevery opportunity from airline stocks. Even when airlines have beenprofitable, he said forget it, they're not sustainable businesses, stay away.
O'Reilly:What's that quote? Had a capitalist whowanted to make money been at Kitty Hawk with Wilbur and OrvilleWright --
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 fordecades, and they have poured billionsand 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'retalking 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, Buffettdoes not control all of the investing. He has two lieutenants who invest most of the excess money thatBerkshire 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 firstinvestments were inAmerican Airlines, which is the largest position, thenDelta Air LinesandUnited 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'sthe founder ofSouthwest 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 beendoing this for the last fifty years, and I just don't know it?
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:Reallyquick side note, I want to get your thoughts,I'm sure you're aware that another brilliant investment manager,David Tepper, he runsAppaloosa 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, andwhy is Buffett late to the game on this, what's going on?
Levine-Weinberg:I think, Buffettobviously 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 asconstantly 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. Andafter they spent all this money to get started,they wouldn't actually make money in the long run.
O'Reilly:You'resubject to the vagaries of ticket prices --
O'Reilly:Or OPEC, yeah.
Levine-Weinberg:Yeah. It's demand, it's oil prices, it's whether you have labor troubles, almostall of these airlines have ahigh 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." Andto some extent, the airlines have to give in. They'recustomer 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 Tepperobviously saw much earlier than Buffett thatthere have been some changes in the airline industrythat are really promising. What it really comes down to is, airlinesaren'ttrying to just pursue growth, especially the larger airlines. They recognize that they need to be businesses, and they need to makea 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 theirprofits start to take a hit, they pull back oncapacity. You're seeing right now,during the second half of 2016, airlineprofits are starting to pull back up a bit, and most airlines havealready 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.
Levine-Weinberg:Seats, and also distance. Sending one seat fromNew York to Beijing, obviously a lot more capacity thansending one seat fromNew York to Miami.
O'Reilly:This is animportant 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, andadd that up across the cross all the seats in your fleet. So, you have about a 2% growth rate or lessfor 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'slieutenants made their firstinvestments during the third quarter. With that slower growth,you have a better ability to keep fares higher, that you can earn double-digitmargins or close to it,which is something that the airline industry never really did, looking back into previous cycles.
O'Reilly:Witheverything you've been saying, they'refinally 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 regulatedup until the late '70s. So, after 1978,you had all of these airlines whose fares hadpreviously been set by the government,essentially. Their costs were really high,they didn't have to compete on cost,so they didn't. Soit'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 hadSouthwest Airlines competing for a long time, but even as recently as 2000, they had something like $5 billion ofrevenue, which was less than 5% of the industry. Even with a company like Southwest Airlines --a vigorous competitor, very low costs -- theydidn't have the ability to completely overturn industry pricing at that point in time. Now,you have enough of these smaller airlinesin addition to Southwest. You have the ultra low-cost carriers likeSpirit AirlinesandFrontier Airlines, you havepeople in the middle likeJetBlueorVirgin America. Withall of these companies, they forced the legacycarriers 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.