When Richard Branson was asked how to become a millionaire, he retorted:
‘There’s really nothing to it. Start as a billionaire and then buy an airline.’
Investing in the “bottomless pit”
And everybody’s favourite go-to quote machine on anything stock market related, Warren Buffett, once said:
“The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it.”
That’s not to say he has avoided the sector.
Investorplace.com reports that until recently Buffett owned “11.2% of Delta, 10.4% of Southwest Airlines (NYSE:LUV), 8.8% of United Airlines (NASDAQ:UAL), and 10% of American Airlines (NASDAQ:AAL).”
The ultimate contrarian bet?
In fact, on 27 February, he took advantage of the Covid-19 “dip” to buy almost 1 million shares in Delta Air Lines (NYSE:DAL) at an average price of $46.40 per share.
You know Buffett’s creed as well as I do:
“Be greedy when everyone is fearful.”
But he hasn’t become one of the world’s richest men and arguably the greatest investor of all time by taking rash punts.
So, it must have been a carefully calculated risk.
And I was genuinely curious to know what the Great Sage thought he knows that other investors are missing.
Why was he buying shares in an industry that’s notoriously tough – at a time when it’s facing an existential threat in the form of the Covid-19 pandemic?
Was Buffett placing the ultimate contrarian bet? And should we be closing our eyes and following him in?
With stock markets trading at levels almost 30% below the recent peak, it’s only right that we should be sniffing out potential opportunities.
And I’m NOT saying that because I think we’ve seen the market bottom yet. I believe there could be further to go.
But I do want to be ready to pull the trigger on shares that I like.
And with that in mind, I’ll be looking at various industries in the coming weeks… and trying to get a feel for whether they should be ones to look at.
The airline sector caught my attention… so let’s take a look…
The world’s toughest industry
It’s tough to make money in the airline business at the best of times.
Think about the huge fixed costs airline companies face.
A new commercial aircraft typically costs hundreds of millions of dollars to buy.
That means if they borrow the money to buy a plane, they have huge loan repayments to make…
And that’s whether business is booming… or facing a potentially game-changing bust.
Then the company faces another hit of millions of dollars a year in terms of depreciation of the aircraft, engine parts and other flight equipment.
Depreciation hits the value of any asset you buy.
A car is the obvious one.
When you buy a brand-new car from a dealer, it loses between 10%-30% of its value as soon as you leave the showroom.
So, say you bought a brand-new Lexus NX Hybrid for £35,000 from a local dealer two miles away.
By the time you get home, it’s worth, say £25,000.
Imagine that kind of loss of value on an Airbus passenger jet costing $250m.
Airlines must account for this and write it off in their accounts each year as a fixed cost of being in the business.
Again, whether the climate for travel is good or bad, this doesn’t go away.
So, the high initial cost combined with the cost of depreciation is the reason airlines don’t buy all their aircraft from new.
They will also lease some, which can reduce total fixed costs across their fleet.
But still, even for leased aircraft we’re talking millions of dollars a year.
Spending millions to protect against risk
Then, another major cost for these companies is insurance.
Insurance to cover damage to multi-million-dollar planes doesn’t come cheap.
Nor does insurance to cover damage to third-party property…
I mean other planes in the air, houses on the ground below the flight route, cars, crops and airport facilities.
These are all at risk, some more than others – so the airline needs to pay insurance to cover it in case the worst happens.
Add all these things up, and it costs many millions of dollars in fixed costs per plane to keep it in the air for a year.
And that’s before you think about the variable costs – ones that fluctuate depending on market forces like demand, seasonality, etc.
So, the cost of fuel is clearly a big one.
Even after the recent rout in the oil market, an airline must fork out hundreds of millions of dollars a year to ‘fill up the tank’.
Then you’ve got the costs of all the maintenance and replacement of parts to keep the fleet airworthy.
That might vary year to year, but it’s always going to be a big cost to the business.
And labour costs is another major variable cost to the industry that will go up and down according to market forces.
From pilots, to flight crew, to instructors, engineers, ground staff and head office staff, airlines have huge wage bills.
The point is, costs across the board are high in the airline business. Capital expenditure is large. And regulation and taxation are a major burden, too.
Razor thin margins and a worldwide virus attack
And these huge cost burdens mean that airlines end up with what has often been called “razor thin margins”.
The International Air Travel Association (IATA) once described profits per passenger as being “less than the price of a sandwich”!
That was before more airlines caught on to the trick pioneered by Virgin Atlantic in the 1990s of creating the lucrative “premium economy”.
Here the airlines can charge as much as double the price of a normal economy seat… for a few more inches of legroom and a few other perks.
It’s a money-spinner for the airlines.
But only if they have lots of flights… and lots of passengers.
And, of course, right now, they have neither.
Airlines are important because of this idea that they “shrink the planet”. Air travel in the 21st century means that it’s easy to get anywhere we want to go.
As a research paper from McGill University in Montreal puts it:
“Aviation is a principal means of intermingling and integrating disparate economies and cultures, stimulating social and cultural cross fertilization, economic growth and diversity in an increasingly interdependent global environment.”
That’s great for international business and great for recreational travel, too.
But demand takes a hit if people don’t want to fly – or are not allowed to.
Airlines took a massive hit following the 9/11 terror attacks, for example.
For a while, no one wanted to get in a plane.
That caused big problems for some time for the industry, as the Guardian notes:
“Globally, airlines took five years to return to profit after the 2001 terror attacks, losing more than $40bn (£30.7bn), mainly in the US, in that time. The industry plunged back into negative territory in 2008, losing an aggregate $8bn as the financial crisis struck.”
The industry took another big hit in 2003 when the SARS outbreak struck.
The impact of that disease epidemic cost airlines in the Asia Pacific region some $6 billion. And North American carriers lost $1 billion.
According to IATA, it took nine months for international passenger travel to get back to normal levels.
And SARS wasn’t a pandemic. It didn’t affect the whole world. In fact, European air travel was largely unaffected.
“Aviation’s Darkest Hour”
Well, what we’re seeing now with Covid-19 is clearly going to hurt the industry far worse.
Its market has been absolutely smashed by the pandemic.
“Global air traffic demand fell 14% in February, the most since the 9/11 terrorist attacks, as airlines were “hit by a sledgehammer called COVID-19,” the International Air Transport Association said.
“The decline reflects a record collapse in travel in China that month and a 41% tumble in demand in the Asia-Pacific region, IATA said, warning that the situation has only grown worse.
“This is the biggest crisis that the industry has ever faced,” IATA’s Director General Alexandre de Juniac said in a statement. “The impact on aviation has left airlines with little to do except cut costs and take emergency measures in an attempt to survive in these extraordinary circumstances.
De Juniac says: “This is aviation’s darkest hour and it is difficult to see a sunrise ahead.”
And if those February figures sound bad, I dread to think what March numbers will be like.
It was only in March when many countries started restricting travel.
Most of the flights coming into UK airports in March were for repatriation purposes, for example.
Numbers are starting to come through.
This morning, Scandinavian budget airline, Norwegian, reported a 61% drop in March passenger traffic compared to last year.
That’s a trend we can expect to see continuing as the major international carries start reporting their March figures.
And that will cost the industry huge sums, as Bloomberg explains:
“IATA, which represents some 290 carriers, said last month that airlines worldwide could lose $252 billion in revenue this year and burn through as much as $61 billion in the second quarter as travel slumps.”
With no passengers, there is no money coming in.
So, it’s a case of seeing how long these companies can survive on their cash reserves.
Can they keep going until the threat of the virus has gone?
Well, the airline companies have been slashing the variable costs where they can.
With no planes in the sky, they’re not spending on fuel.
And they’ve furloughed most of their labour force, so governments are picking up the tab for crew, ground staff and so on.
But they still have a bunch of sky-high fixed costs that must be covered, whether or not they have planes in the sky.
According to a report in The Independent, most airlines only have enough cash reserves to cover a few months of these fixed costs.
How will they survive if this crisis continues?
The reality is many of the smaller carriers probably won’t.
Perhaps even some of the bigger international airline companies won’t either.
Unless they’re bailed out by the taxpayer, that is.
Or maybe there will be a lot consolidation in the sector, with big players picking over the bones of the weaker companies.
We’ll have to wait and see.
Cheap, but could get cheaper
As it is, most of these companies have seen their share price slashed by 50% or more since Covid-19 took hold.
|Airline company||Country||Loss YTD|
From that point of view, they may start looking ‘cheap’.
But they’re only cheap at this price if they survive and things start to look better – or at least stop getting worse.
Otherwise, they could get a lot cheaper yet.
Or even go bust.
So, what about old Warren Buffett?
Well, reports out on Friday show he’s had a rethink.
Investor Business Daily this morning:
“Airline stocks are due to fall sharply Monday after Warren Buffett’s Berkshire Hathaway (BRKB) disclosed late Friday that it sold millions of shares of Delta Air Lines (DAL) and Southwest Airlines (LUV). Less than a month ago, Buffett had said he wouldn’t sell airline stakes. Airline stocks sold off hard late Friday on the news.”
He’s not out of the sector entirely.
According to the IBD, Buffett still owns some 59 million shares of Delta following last week’s disposals and 51.3 million Southwest.
At the current price, that’s around $1.3 billion worth of Delta and $1.5 billion of Southwest.
That’s a substantial amount of skin still in the game.
UK value legend could be interested
Meanwhile, another investing legend looks like he might be sniffing around the airline industry.
Anthony Bolton, like Buffett, is a value investor. He looks for businesses that are trading at a big discount to what they’re worth.
For almost 30 years, he averaged 19.5% annual returns for investors in his Fidelity Special Situations Fund.
He seems to be suggesting that major airlines will survive… and could become interesting investments.
Citywire quotes the FT:
“Bolton predicted a wave of government bailouts for companies following the ‘extraordinary measures’ to protect businesses and workers. ‘There’s almost an element of governments competing. If we save the [UK] airlines, the Germans are not going to let Lufthansa go bust,’ he said.
“He believed such bailouts would be less punitive to investors than the bank rescues of 2008-09 which saw shareholders’ equity written off in return for taxpayers’ money. ‘I think it is slightly different this time. If we do see some sort of rescue for BA, I’ll be very interested to see on what sort of terms it will be.”
True, he’s not giving much away.
But it sounds to me like he’s interested in the world’s current most hated industry.
I think it’s worth keeping an eye on this – and on what the directors at these companies are doing.
If they all start loading up on shares at these depressed prices, it could be a sign of confidence that they believe things are going to move from bad to less bad.
And that could mark a significant turning point for the shares.
But it looks a bit early for that just yet.
I’ll be interested to see what the passenger numbers across the industry look like for March first.
And I’d also like to see further signs that the pandemic is under control.
If things don’t improve on that front markedly, I can’t see anything other than a deepening slump for the airline business.
When these things start looking better, then perhaps the biggest international players like the UK’s IAG, Germany’s Lufthansa and American Airlines will be great long-term investments.