There was a lot of press on late Friday, April 3rd, about Berkshire Hathaway reducing their stakes in Delta and Southwest Airlines. At the time of this writing, Delta was trading (in after-hours) down 11% and Southwest down 5% following this news. Is Berkshire throwing in the towel due to COIVD-19 or is there something else going on?
We think that, as usual, the headline does not tell the full story.
For those just joining us – we wrote a piece on Warren Buffett’s purchases of the big four airlines. After having a very negative view on the industry for decades Buffett turned around and bought roughly 10% of Delta, Southwest, United, and American. We cover the Why of the thesis here - http://www.canadianvalueinvestors.com/home/2018/6/4/investing-in-north-american-airlines-why-did-berkshire-hathaway-buy-airlines-anyway
We also just wrote about Air Canada and its fight against COVID-19 - Will it Survive? http://www.canadianvalueinvestors.com/home/2020/3/24/will-air-canada-survive-covid-19
Berkshire’s Airline Holdings
Now, Berkshire owns approximately 10% of each of the big four. However, the interesting thing is that Berkshire only owned more than 10% in two of the four, Southwest and Delta, and under SEC rules if you own more than 10%, even a smidgen, you are considered an insider. It should be noted that Buffett accidentally ended up owning more than 10% of Delta after they made significant share buybacks (where he affectionately referred to this event as like losing his virginity). After the disclosed sales they now own 9.2% of Delta and 9.9% of Southwest.
Is Berkshire selling these stakes now to get below the 10% ownership level (and thereby no longer be considered an “insider/affiliate”), or is this the beginning of them selling down their positions more materially along United and American?
We find it also helps to look at the actual filings and reports that the media refers to. In this case, you can see the day trading fun by day that Berkshire had last week.
But First…Why It Matters If You’re a 10% “Insider/Affiliate” Owner
Basically, once you own more than 10% of a company, the SEC classifies you as an “insider,” not too different from being an officer of the company. There are a couple considerations:
Short-swing profits: Within a 6-month period, if you buy and sell shares at a profit, OR if you sell and buy shares at a lower price, you must repay that profit or avoided loss.
Acquisitions/Other Material Transactions: If you acquire a company after reaching this threshold, you would be subject to a judicial review over whether this transaction was “fair” (given your significant voting influence). Under this review, there is more risk of shareholder litigation.
Other Regulatory Considerations: The U.S. and especially the airline industry is heavily regulated. Owning more than 10% complicates Berkshire’s reporting and also makes it more difficult to do transactions in the space. For example, doing a preferred share/convertible debt deal with airline A likely involves more lawyers than less if you are an insider of airline B…What does Buffett think?
The Recent History of Berkshire’s Airline Adventures
Berkshire/Buffett became interested in the airlines perhaps through Ted Weschler, who had a previous rapport with American Airlines CEO, Doug Parker, as described in this article: https://www.dallasnews.com/business/local-companies/2017/02/06/berkshires-airline-bet-said-to-stem-from-faith-in-american-airlines-ceo-doug-parkers-call/
On February 24, 2020, Buffett had his annual CNBC interview following the shareholder letter. In that interview, he mentioned “three of the four [airlines] positions are mine; one of the positions is one of the other fellow’s (being Ted or Todd)”. We think that “fellow” is probably Ted Weschler!
Here is the rest of the exchange between Becky Quick and Buffett:
Quick: Some of the questions that came in over this weekend were questions about those airlines. [People were] wondering if you would buy any of them outright. Have you considered buying any of those companies?
Buffett: It'd be very unlikely we would do that. I'm not saying it's impossible but it's complicated. For one thing they're regulated, and there's an interplay. I'll just give you an example – not that we’d be doing it – but with Delta [Air Lines] we own 18% of American Express which is a bank holding company and bank holding companies have limits as to what they can do and we're a passive holder of a bank holding company with American Express but if we owned an airline that was tied up with them [through the large Delta-AmEx loyalty program arrangements] there's a lot of complications because it's a regulated industry.
Anytime you get in a regulated industry you have more complications in transactions.
Quick: So is it fair so say you like these stocks and you would own more if it didn't if it wasn't complicated?
Buffett: Well…[pause]…if we go beyond 15% [ownership] in any company we would have to go in on Hart-Scott-Rodino [Antitrust Improvements Act]. I mean there's a lot of rules as you increase your ownership.
Obviously, almost anything we own we'd like to own more of [and anything we own, we like].
Three days after this interview it was disclosed via a Form 4 filing that Buffett marginally increased his Delta Air Lines holdings by 1.4%.
About two weeks later in early March, Buffett gave another interview with Yahoo Finance’s Andy Serwer, and briefly talked about the ongoing pandemic and its effects on the long-term economy and the airlines. Here is the brief exchange when asked about the airlines and economic outlook:
Buffett: Well it's gonna be terrible, but I've always felt a pandemic would happen at some time. I've actually used that term (pandemic) in describing things that can interrupt the progress of, not only this country, but the world. It won't stop the progress of the country, or the world, [but] this is a terrible event that's occurring.
We don't know how terrible, and it may not turn out to be that big a deal when we get through, but it may turn out to be a very big deal. We just don't know, and I certainly don't know, and nobody knows. But there will be other things that happen in the world in the next 5, 10, 20 years [that can interrupt progress] – that's the way the world works.
[Human progress] is not a totally even course. The progress of mankind has been incredible, and that won't stop…but there will be interruptions and I don't know when they will occur and I don't know how deep they will occur. I do know they will occur from time to time and I also know that it’ll come out better on the other end.
Serwer: So it doesn't sound like you're selling airline stocks today.
Buffett: [Laughs] I won't be selling airlines.”
So How Does This All Tie In With The Recent DAL/LUV Sales?
Here are our thoughts on a few questions:
1) Did Buffett underestimate the impact of a pandemic on the airline business?
To us, this is an unequivocal “no”. Buffett has many times talked about how pandemics and bio or nuclear terrorist/rogue-state attacks (ie, stuff that can bring society to a halt) can happen. We’d guess he has been thinking about these probabilities and impacts for many decades, on at least a weekly basis, through Berkshire’s reinsurance operations.
2) What could Berkshire do with their airline investments now?
It is clear the airlines need additional capital, which is why they are applying to the recently-approved $50bn loan/grant package (priority applications were due on April 3).
It’s possible Buffett might be a white knight to an airline, but this will likely require some regulatory flexibility since he would likely want increased equity (either buying an airline outright, or doing his typical preferred share + warrant deals). Perhaps this is why he sold down his Delta/Southwest stakes (on April 1 and 2) to <10% - to avoid the judicial review that we described earlier. This also ties into the April 3 deadline for the loan/grant applications, which stated airlines must submit evidence they do not have access to other credit financing.
Berkshire has done these types of quick deals in heavily-regulated industries before, such as MidAmerican’s 2002 purchase of the Northern Natural Gas pipeline network from Dynegy – this deal open and closed over a weekend, with MidAmerican/Berkshire obtaining regulatory approval by basically agreeing to do whatever the regulator required of them.
3) Why else might Buffett want to sell?
It is also possible Buffett may think the risk to existing equity holders is getting untenable and is selling down his equity stakes. We are certainly a bit surprised the Canadian airlines have furloughed most of their employees to reduce cash burn, while the US airlines have not (and in effect allowing debt levels to more materially increase, which gives creditors a greater stake in the enterprise vs equity).
One thing is clear: airlines as an industry will survive and eventually thrive…but just remember the current bondholders may replace you as an owner along the way.
4) What’s the game plan for 13-F copycats?
We personally think there is enough evidence that Buffett is actually looking to increase his airline(s) investment. Not that our US airline stakes are a large part of our portfolio (and seemingly decreasing every week without us lifting a finger!), but we are waiting for the next 13-F filing (May 15th – don’t bother us that day, because we’ll be studying all the 13-Fs!!!!) to see if Berkshire’s other United or American airline position changes imply a negative view on those companies/the industry. For now, we generally do not view the recent Delta and Southwest sell downs necessarily as a negative.
We think Buffett (1) is not surprised by industry’s revenue falloff given the pandemic-environment, (2) is unlikely to have changed his mind so drastically from his interviews in late February and early March, and (3) sold his Delta and Southwest stakes on April 1 and 2 to <10% in case some financing/acquisition opportunity came up during what will be intense negotiations for the airline bailout package.
…but we might also be wrong.