MIAMI — Warren Buffett has long been a critic of investing in airline stocks. He is famous for saying that a “far-sighted capitalist” would have benefitted his successors by “shooting down Orville” at Kitty Hawk.
In a recent regulatory filing, however, the influential investor appears to have changed his long-standing bearish position on the airlines. Buffett’s Berkshire Hathaway was revealed to have purchased a significant number of shares in some major airline companies in the United States. Berkshire Hathaway made varying degrees of investments in each of the “Big Four” airlines: American Airlines, Delta Air Lines, Southwest Airlines, and United Airlines.
Shares for each of the four airlines gained altitude in trading following the news.
Other terms that Buffett has thrown the airline industry’s way over the years are “bottomless pit” and “death trap for investors.” Buffett’s apparent reversal of his formerly pessimistic stance comes as a welcome seal of approval for the industry. Historically one of the most cyclical and financially-challenging businesses, the airlines have recorded record profits over the past few years.
Buffett’s blessing seems promising for a traditionally beleaguered industry. Looking forward, what do the mega-investor’s moves suggest about the future of the airline industry? Are there any implications for what he may believe is in store?
The Airline Industry is Finally Becoming More Stable
Warren Buffett’s recent investments are more than just airline shares trading hands to the tune of many millions of dollars. More broadly, they are a sign that the airline industry is back on track.
The airline industry has traditionally been a very tough one, squeaking by on razor thin profit margins and enduring wild swings with the turn of the business cycle. Former American Airlines CEO Bob Crandall said it best: “this is a nasty, rotten business.” Both 9/11 and the 2008 took an especially hard toll on the airline industry, precipitating a wave of consolidation that has trimmed the playing field down to four major carriers.
In each of the airline mergers to date, the argument has been trotted out that consolidation would benefit the combining firms by taking two financially instable companies and turning them into a single stronger entity, one that is positioned to forcefully compete with its rivals. On an industry level, the result has been four rejuvenated airlines that are now more financially fit than ever and less prone to shocks.
Low oil prices have certainly helped to lift airline profits. Fuel composes one of an airline’s largest individual operating expenses, translating into a significant bottom line benefit given the current oil prices. However, low oil is not the sole driver of the airlines’ recent success. The industry has also adopted a new mentality of capacity discipline, starkly different than anything we’ve seen in recent memory.
Gone are the days of chasing market share off a cliff. Gone are the days of cutthroat fare wars. This is a fundamentally different industry today, which Buffett’s recent investments recognize.
The airline industry is well positioned to keep flying high even once oil prices inevitably regain some altitude. Given their nature as more of a luxury good than a staple good, the airlines will always be a cyclical business to some degree. However, consolidation paired with limited capacity growth should buffer the impact of downturns in the future.
These downturns have always been one of the most grueling parts for investors in the airline industry. Buffett’s big dollar investment is a sign, in broad strokes, that clearer skies are to come for the airlines.
Airlines are Likely Nearing Positive Unit Revenue Growth
Buffett’s investments seems to be a vote of confidence for the prospects of the airline industry as a whole. More specifically, his large purchase of airline shares is likely rooted in the belief that the airlines are on the verge of achieving positive unit revenue growth again in an upcoming quarter.
The airlines have come under fire from Wall Street regarding their performance in one key metric: passenger revenue per available seat mile, otherwise known as PRASM. If we’ve learned anything, it’s that Wall Street loves its PRASM.
A softening revenue environment has led to declining unit revenues in recent quarters, keeping a lid on airline stocks. Each of the “Big Four” turned in year-over-year declines in PRASM in their third quarter earnings. However, there is the belief that the airlines are moving closer to busting that downward trend and moving toward positive unit revenue growth again.
Wall Street is likely to welcome upward-moving unit revenues by increasing their valuation of airline stocks. Granted, the anticipated arrival of positive unit revenues has already been factored into current stock prices to some extent; but more growth is probably on the way.
If Buffett does believe that the airlines are set to turn around their slipping unit revenues in the near future, it would certainly seem logical for him to make an investment in airline stocks at this time.
Unbundling Is All the Rage, and Is Set to Continue
While Buffett created some waves with his buy-up of airline stocks, this news was largely overwhelmed in recent days by United’s unveiling of a new Basic Economy product, set to hit the skies in the spring of 2017. In other words, United is further unbundling its product, stripping out more items from the price of a ticket in order to offer a more discounted fare for price-sensitive customers.
Buffett may have once again been ahead of the game on this one. The trend of unbundling has gained considerable steam ever since the airlines implemented fees for checked baggage, and Buffett’s investments may signal more unbundling ahead in the airline industry.
Unbundling has tremendously benefited the airlines, allowing them to capture more economic value by better matching a customer’s willingness to pay with a product suited to each price level. The cabin has become more segmented, which makes for a positive impact to the bottom line for the airlines.
American Airlines has already announced intentions to roll out its own Basic Economy product sometime in 2017. The legacy airlines may seek to continue pulling more items from the base ticket to better compete head-to-head with ultra-low-cost carriers (ULCC’s), such as Spirit and Frontier. United notably removed carry-ons from the base fare for Basic Economy customers, and other elements of the travel experience may soon be turned into ancillary revenue opportunities.
The reversal of stance from one of the airline industry’s biggest critics is not to be taken lightly. Once one of the most turbulent businesses in which to be involved, the airlines are now poised for clear skies ahead. We won’t know Buffett’s precise rationale until if and when he chooses to comment. Nonetheless, it seems clear that Buffett’s backing speaks volumes for the stability of the industry, the forecast for unit revenues, and the future of unbundling as an industry trend.
Buffett has been successfully calling the shots across his entire career, and investors should take notice now that he’s officially in the airlines’ corner.