Disclosure – We here own various airlines (including the big four discussed) with different strategies.
"I have an 800 number now that I call if I get the urge to buy an airline stock. I call at 2 in the morning and I say, 'Hi my name is Warren and I'm an aeroholic,' and they talk me down." – Warren Buffett, 2002 interview with The Telegraph
Airlines – That glamorous industry that has been a notorious money loser. An industry burdened with high fixed costs, high capital costs, and a marginal customer cost next to zero. Airlines have been making lives of North Americans better since 1914, but from an investment standpoint they have been terrible. The graveyard of defunct airlines includes memorable names like Bonanza Air Lines, Slick Airways, and the unforgettable USAfrica Airways (providing non-stop service from Washington D.C. to Johannesburg for a grand total of 9 months).
Yet, in spite of all of this, Warren Buffett of Berkshire Hathaway fame bought ~$10 billion worth of airline stock in late 2016. In the last few months there has been a pullback in airline stocks and we thought this would be a great opportunity to see if we could understand the thought process behind the investment… and possibly copy it. For those that haven’t read our article on cloning investments this would be a good time to read it! http://www.canadianvalueinvestors.com/cloning-investments-101/
Why have airlines been bad business?
Before we get started, we want to be clear about the scope of this article. This article (and Berkshire’s investment) is focused on U.S. airlines only. The world is still full of a lot of crazy airlines like state-sponsored flag waiving airlines meant to promote their nation. But in the U.S. foreign airlines are not allowed to fly between two U.S. cities leading to interesting dynamics once you start digging.
Anyway, why have airlines been so bad anyway?
The primary costs of airlines are all fixed and the cost of filling another seat is near zero. And there has historically been poor discipline in the unfriendly skies.
To understand costs, let’s take a look at Southwest Airlines – The following table shows Southwest Airlines’ cost per available seat mile (this is the average cost to fly an aircraft seat (empty or full) one mile, which is a measure of cost efficiencies).
The aircraft is leased or financed at a fixed rate, or if owned it’s still a big expensive thing to leave on the ground in a yard. If you fly the plane the same pilots and flight attendants are on it regardless of whether anyone else is or not. The engine still needs to be maintained based on miles, and the airline still needs to pay for the gate and other airport costs. Even the marginal cost of extra fuel for even the largest of passengers isn’t much. So what you are left with is the pretzels and cokes…
“I think that [airlines] is more competitive than other industries. And one of the reasons for that is that our principal capital assets, the airplanes, move at 540 miles an hour. If you have a shoe factory that fails in Seattle as an example, you can’t within hours transport that shoe factory to Chattanooga Tennessee. But if your Seattle air service fails you can have your airplanes in San Antonio or Chattanooga in a matter of hours. So the very mobility of your capital assets breeds a lot of competition.” – Herb Kelleher – Founder of Southwest Airlines
A bit of history - U.S. airlines pre-deregulation of 1979
It should be noted that the U.S. airline industry has a clear bifurcation date of when the times really changed. Prior to deregulation, airlines were subject to the federal 1938 Civil Aeronautics Act, which brought railroad regulations and mentality to the airline industry. There were originally 16 trunk airlines – i.e. airlines that were allowed to fly nationally and internationally. Others could fly within a state and in that case were regulated by the state, which actually led to a few pretty large airlines in places like California.
But interstate flight routes and prices were regulated. Airlines were guaranteed a 12% return on investment and the assumption that airlines would fill 55% of seats (i.e. the load factor). This of course led to high costs and airlines to compete on service and not price, and prices getting stuck at unaffordable levels for the common folk. A fun and bizarre fact of regulation is that load factors were based on seats the plane was supposed to have but the seats didn’t actually need to be there, leading to fun ideas like piano bars in planes.
By 1978, there were only 10 of the original 16 left and no new ones were allowed to come into existence. High costs, subsidized flight corridors, and fears that the airlines were going to start causing real taxpayer problems like the railroads did (such as the creation of Conrail by the federal government, which consolidated bankrupt Northeastern U.S. railroads).
Post-deregulation - What has changed?
People forget that flying used to be very expensive, reserved for business and the rich.
The end of fixed prices, routes, and restrictions on new airlines led to a chaotic period of upstarts, mergers, and failures. By the 1990s starting an airline was the lasted cool thing to do if you were a billionaire, with 88 new airlines being founded in the decade. Unfortunately it was something no one seemed to know how to do profitably and 106 over the same period. For example, the Trump Shuttle airline (of Donald Trump fame of course) was founded in 1989 and subsequently failed in 1992. A great read about this story can be found here: The Crash of Trump Air - https://www.thedailybeast.com/the-crash-of-trump-air
There were just too many planes, too many airlines, and too little capital diligence to make the industry work. Beginning in the late 1990s, all of this began to take its toll on the industry. The combination of cost pressures and regulatory pressures, significantly amplified by the September 11th terrorist attack in 2001, led to many failures, mergers, with airline failures (bankruptcies/being acquired/etc) exceeding foundings in almost every year since 1996.
Where we are today
The combination of deregulation, friendly merger reviews, and time is the key. The U.S. government did not want to create liabilities for itself like what happened with the railroads. In turn, the regulators’ have had a merger/failure friendly attitude that, combined with cut throat competition, led to this wave of bankruptcies and mergers. While there have been many mergers, the pace accelerated in the 2000s with several very large significant ones going through. Examples include Delta’s 2008 merger with Northwest Airlines (then the largest airline in the U.S.), United merging with Continental Airlines (also the largest airline at the time) in 2012, and American Airlines merging with US Airways in 2013.
After the dust settled left the U.S. with four large airlines controlling over 80% of U.S. domestic air travel based on passengers and fleet size (see table below).
But how are the airlines acting? – The factors of change
Just because you have a few players does not mean there will be profits. A duopoly of two can have terrible prospects and returns if all they do is try to kill each other.
We conclude that the success of the airlines is not due to any one factor but a lollapalooza of many factors combining, key ones including:
1) Scale and concentration
Scale has numerous benefits in the airline industry. Better ability to negotiate with suppliers, lower cost of financing, increased value of loyalty and partnership programs vs a smaller operator, etc, etc.
They are also able to and have been taking on major capital programs beyond planes to improve their service. For example, American Airlines (market cap of ~$20 billion) “announced a commitment for more than $1.6 billion for improvements of LAX Terminals 4 and 5, setting the stage for us to receive additional gate space and strengthen our Pacific gateway.” For context, the market cap of Alaska Airlines, airline #5, is ~$7.5 billion. All the airlines have taken time to already upgrade or start major upgrades to their ordering systems.
2) Capital allocation diligence
The overall number of flights taken per year in the U.S. continues to grow. Yet at the same time the major airlines have grown their fleets at a reasonable pace and at the same time have been able to maintain high load factors for roughly a decade as a low load factor is just disastrous for airline sustainability. This contrasts with the “if you build it, they will fly” attitude of the 1980s and 90s and is definitely different than the pre-deregulation piano bar era.
Instead of overbuilding capacity, airlines have redirected cash flow towards 1) dividends and share repurchases, 2) improving other parts of the business like order systems and terminals, and 3) upgrading their fleets.
American Airlines has repurchased $10 billion of shares since 2014. Delta has returned $10 billion to shareholders and reduced its share count by 18% since 2013. United repurchased $1.8 billion of shares in 2017 and authorized the repurchase of up to another $3 billion in December 2017. And finally, Southwest purchased $1.6 billion in 2017.
3) Airline ticket pricing diligence and cost diligence
Although costs per available seat mile has been increasing over time, the airlines have demonstrated an ability to pass these costs on. Beginning in 2010 or so, the operating efficiency comparison shows that as a group they have been able to maintain margins. However, it’s likely that this is artificially/temporarily strong given the significant decline in oil prices over the 2015-2017 period. As prices increase it will be interesting to see if and how quickly airlines pass on their increased costs.
It should be noted that the big four are impacted by rising costs in similar ways (e.g. industry-wide tight market for pilots, rising interest rates) but these airlines are better off than smaller airlines in handling rising costs.
4) The web of marketing and partner agreements
Capacity Purchase Agreements, Joint Business Agreements, and Marketing Relationships... The big four airlines all have similar approaches to collaborating to compete in ways that new/small operators cannot replicate. In fact, you get sucked in. The point of these is to help keep utilization high and add new destinations, connections, and frequencies without having to simply buy more planes, helping to minimize industry-wide over-capacity. Their international partnerships also help given foreign airlines cannot fly between American cities but their customers can book their full-rout through a codeshare agreement (letting you get from Beijing to Omaha with ease).
For example, to see how extensive these partnerships are let’s take a look at American Airlines:
- Capacity Purchase Agreements – American Airlines has several airlines that feed traffic into its major hubs (with a strategy used by certain big fours is to actually own a feeding regional carrier). “Regional carriers provide scheduled air transportation under the brand name “American Eagle.” The American Eagle carriers include our wholly- owned regional carriers, Envoy, PSA and Piedmont, as well as third- party regional carriers including Republic Airline Inc. (Republic), Mesa Airlines, Inc. (Mesa), Compass Airlines, LLC (Compass), ExpressJet Airlines, Inc. (ExpressJet), SkyWest Airlines, Inc. (SkyWest) and Trans States Airlines, Inc. (Trans States).”
- Joint Business Agreements – “American has established antitrust- immunized JBAs with British Airways, Iberia and Finnair, and separately with Japan Airlines [and they’re working on others], that enable the carriers to cooperate on flights between particular destinations and allow pooling and sharing of certain revenues and costs, enhanced loyalty program reciprocity and cooperation in other areas. American and its joint business partners received regulatory approval to enter into these JBAs and cooperation agreements.”
- Marketing Relationships – “American currently has marketing relationships with Air Tahiti Nui, Alaska Airlines, British Airways, Cape Air, Cathay Dragon, Cathay Pacific, China Southern Airlines, EL AL, Etihad Airways, Fiji Airways, Finnair, Gulf Air, Hainan Airlines, Hawaiian Airlines, Iberia, Interjet, Japan Airlines, Jetstar Group (includes Jetstar Airways and Jetstar Japan), Korean Air, LATAM (includes LATAM Airlines, LATAM Argentina, LATAM Brasil, LATAM Colombia, LATAM Ecuador, LATAM Paraguay, LATAM Peru), Malaysia Airlines, Qantas Airways, Qatar Airways, Royal Jordanian, S7 Airlines, Seaborne Airlines, Sri Lankan Airlines and WestJet.”
Quite the web. Some have even gone a step further and are actually buying pieces of other airlines. For example, Delta has bought 49% of Aeromexico, 10% of Air France, and a piece of Virgin Atlantic.
5) Regulatory burdens maintaining the landscape and also leveling the playing field (making it harder for ultra low cost carriers)
There are a lot of rules and regulations in the airline business. Funny enough, some of these rules are taking advantages away from the nimbleness of smaller airlines, with other industry dynamics (like cost of capital advantage) increasingly benefiting the large players.
Let’s take a look at a specific example and how it has impacted Spirit Airlines (viewed as a nimble fast growing no-frills airline):
“[Federal Aviation Regulations] 117 which became effective on January 4, 2014, impacts the required amount and timing of rest periods for pilots between work assignments, and modifies duty and rest requirements based on the time of day, number of scheduled segments, flight types, time zones and other factors. FAR 117 has resulted in increased pilot costs as we were required to hire more pilots in order to comply with the regulations.”
To contrast this, when Southwest was getting going in the 1970s they instituted ten minute turns where the goal was to get a plane in and out of a gate in ten minutes. The idea is that the same model of plane could be flown an extra flight more per day than their slow moving competitors, leading to an asset utilization advantage. It is simply getting harder than ever to do more with less than the big four and overcome the structural advantages they have.
6) The big four are starting to compete better with ultra low cost carriers
Again, we look at Spirit Airlines and how they are viewing competition:
“Many other airlines have begun to unbundle services by charging separately for services such as baggage and advance seat selection. This unbundling and other cost reducing measures could enable competitor airlines to reduce fares on routes that we serve. Beginning in 2015, and continuing through 2016, the availability of low priced fares coupled with an increase in domestic capacity led to dramatic changes in pricing behavior in many U.S. markets. Many domestic carriers began matching lower cost airline pricing, either with limited or unlimited inventory.”
The success of the big four has not gone unnoticed – Wildcard
The success of the big four has ruffled a few feathers. As per American Airline’s Annual Report:
“Private Party Antitrust Action. Subsequent to announcement of the delivery of CIDs by the DOJ, we, along with Delta Air Lines, Inc., Southwest Airlines Co., United Airlines, Inc. and, in the case of litigation filed in Canada, Air Canada, have been named as defendants in approximately 100 putative class action lawsuits alleging unlawful agreements with respect to air passenger capacity, although Southwest has entered into a settlement with the plaintiffs that is pending approval by the court. The U.S. lawsuits have been consolidated in the Federal District Court for the District of Columbia. On October 28, 2016, the Court denied a motion by the airline defendants to dismiss all claims in the class actions. These lawsuits are in their relatively early stages and we intend to defend these matters vigorously.”
The Berkshire Hathaway Strategy
Berkshire Hathaway started buying shares in each of the big four in the second half of 2016 and had their full positions in Delta, United, and American by their December 31, 2016, 13F filing, and Southwest by Q1 2017. They bought roughly equal parts in each totaling approximately $10 billion.
As we note in Cloning 101 http://www.canadianvalueinvestors.com/cloning-investments-101/ - If you are copying an idea it should meet four criteria – We will go through them here:
- The idea should be from a fund manager with a long history of success – Warren Buffett + Tedd + Todd, the three capital allocators at Berkshire, meet this criteria. In this case, the idea is big enough that Warren Buffett was involved, separately confirmed by various interviews.
- The idea represents high conviction (demonstrated by being large vs other investments) – Check. Combined (being all bought at the same time as one idea) the airlines represent the 7th largest stock position of Berkshire.
- The idea can be bought for a similar price – Your call. At the current price level, the airlines are as a group about 25% above where Berkshire bought one and a half years ago.
- The idea is in your circle of competence – Your call.
We also believe BRK is fully exposed in airlines as much as they can be as they don’t want to trip the 10% ownership regulatory hurdle. This seems to be confirmed by their Q1 2018 13F. They sold a bit of United and bought a bit of Delta as they would trip the 10% ownership hurdle in United shortly due to its share buyback plan.
Interestingly, they’re limited on United and American (nearly 10% and maintaining it below) but short of the percentage threshold on Southwest/Delta (8.2% and 7.7%) as we believe it is because these positions have been and remain larger on a dollar amount basis. In turn, it seems to be that they want an even-ish dollar exposure to the big four without a strong preference.
It also reminds us of the railroad scenario, where Berkshire owned holdings BNSF, Union Pacific, and Norfolk Southern stock where Buffett ultimately bought BNSF and sold holdings in the other two.
Exiting times in the airline industry – Let us know what you think: http://www.canadianvalueinvestors.com/contact/
A very fun NPR interview of Herb Kelleher – He is the chain smoking wild turkey drinking lawyer who founded Southwest Airlines in 1967. However, competing airlines tried to stop Southwest from operating. After four years of court battles, including the Texas Supreme Court twice and the U.S. Supreme Court. https://www.youtube.com/watch?v=lx8az5F17Ww
American Railroads – This book provides some good context to the history of airlines through railroads as early regulations were ultimately driven by the railroads (including the fun fact that airline union labor relations are governed by the Railway Labor Act) - https://books.google.ca/books?id=aPNQXN9Onv4C&pg=PA234&redir_esc=y#v=onepage&q&f=true
What prompted deregulation – This is an excellent talk by John Barnum, General Counsel, Undersecretary and Deputy Secretary of the Department of Transportation (1971-1978) from 1998 on the history of U.S. airline regulation and deregulation - https://corporate.findlaw.com/law-library/what-prompted-airline-deregulation-20-years-ago-what-were-the.html
The actual deregulation act - https://www.gpo.gov/fdsys/pkg/STATUTE-92/pdf/STATUTE-92-Pg1705.pdf
The Crash of Trump Air - https://www.thedailybeast.com/the-crash-of-trump-air