By Bill McGilton
Buffett is currently seventh on the Bloomberg Billionaires Index – a daily ranking of the world’s richest people. The index lists his net worth at roughly $73 billion… and he earned it all through investing.
The “Oracle of Omaha” invests through his conglomerate holding company Berkshire Hathaway (BRK-B), which he took over in 1965. Since then, Buffett has generated a compound annual return of around 20% per year on average while managing Berkshire’s investments. Every $10,000 investment in Berkshire Hathaway at the start of 1965 was worth $274 million at the end of 2019.
While he’s widely recognized as one of the greatest investors of all time, not every investment turns out well for Buffett. When the COVID-19 pandemic cropped up earlier this year, it crushed one of his biggest investment ideas.
You see, Buffett has a problem… He’s a self-admitted “aeroholic.” As he told British newspaper The Telegraph in a September 2002 interview…
If a capitalist had been present at Kittyhawk back in the early 1900s, he should have shot Orville Wright. He would have saved his progeny money.
But seriously, the airline business has been extraordinary. It has eaten up capital over the past century like almost no other business because people seem to keep coming back to it and putting fresh money in. You’ve got huge fixed costs, you’ve got strong labor unions, and you’ve got commodity pricing. That is not a great recipe for success.
I have an 800 number now that I call if I get the urge to buy an airline stock. I call at two in the morning and I say: “My name is Warren, and I’m an aeroholic.” And then they talk me down.
At the time of the interview, Buffett was referring to Berkshire Hathaway’s 1989 $358 million investment in convertible preferred stock of USAir – later renamed US Airways and now a part of American Airlines. (Convertible preferred stock are shares that can be converted into common stock under certain conditions.)
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Buffett wrote in a 2007 letter that US Airways tanked and stopped paying the preferred dividend soon after Berkshire’s investment. By 1994, Berkshire wrote down 75% of its investment.
Ten years after the initial investment, Berkshire ended up getting the dividends it was owed in arrears before converting the shares to common stock and selling its position. Altogether, Buffett did make money on the investment, but he still considered it a mistake.
In a 1994 letter, Buffett told shareholders that he “failed to focus on the problems that would inevitably beset a carrier whose costs were both high and extremely difficult to lower.”
By 2016, Buffett relapsed. He once again found circumstances across the airline industry too tempting to refuse. And he invested between $7 billion and $8 billion in the four largest U.S. airlines… taking an 11% stake in Delta Air Lines (DAL)… a 10% stake in American Airlines (AAL)… a 10% stake in Southwest Airlines (LUV)… and a 9% stake in United Airlines (UAL).
At the time, Brent crude oil – the international standard – had crashed from around $115 per barrel in 2014 to less than $30 per barrel. As a result, the price of jet fuel also plummeted. And Buffett knew cheap fuel would be a boon for the airlines in a strong economy.
Buffett’s bold bet on this group of major airlines looked good for a while. But that all changed with the onset of COVID-19 in the U.S. at the beginning of this year. Air travel – like pretty much everything else in the country – came to a halt. Airline passenger volume was down 96% in the first week of April, compared to the year earlier.
In April, Buffett finally threw in the towel and liquidated all of Berkshire’s airline holdings. All told, he took a total loss of around $2 billion on the four positions in the airlines.
Some critics believed the Oracle was losing his touch. But I’d argue to the contrary…
A smart investor like Buffett knows when it’s time to preserve capital and move on. More often than not, he can see what’s coming.
A smart investor like Buffett knows when it’s time to preserve capital and move on. More often than not, he can see what’s coming. And in this case, he knows airlines are in trouble for at least the next few years. As Buffett told Berkshire Hathaway shareholders in early May…
I don’t know that three, four years from now if people will fly as many passenger miles as they did last year.
Buffett went on to say that even if 70% or 80% of the airlines’ business returns, the industry still has “too many planes.” That type of overcapacity will lead to lower ticket prices and billions of dollars in unsustainable operating losses.
And today, these airlines are nowhere close to 70% or 80% of their business returning – which Buffett said would still cause an overcapacity problem.
Don’t Expect a V-Shaped Recovery
Folks are scared to death of COVID-19… We saw that firsthand when various states started easing their quarantine restrictions in recent weeks and months. Malls, department stores, and restaurants that reopened still remained deserted in many places.
And in most people’s minds, the confined space of an airplane heightens the risk of getting COVID-19. Just think of all the times you’ve been near someone who sneezed for an entire flight.
And in most people’s minds, the confined space of an airplane heightens the risk of getting COVID-19. Just think of all the times you’ve been near someone who sneezed for an entire flight.
According to data from trade group Airlines for America (“A4A”) – whose members include the four largest U.S. airlines – U.S. passengers were down nearly 75% in the week ending July 19, as compared to a year ago. You can see the massive drop starting in early March…
The A4A data also showed that U.S. airlines averaged just 55 passengers per domestic flight and 71 passengers per international flight in the week ending July 19. International passengers were down 90% in the week ending July 19, as compared to a year ago.
As a result, almost 2,000 U.S. passenger planes were sitting idle… That’s 32% of the country’s passenger airline fleet, as of July 19. And it’s after the major airlines already started the retirement process for hundreds of planes in recent months.
A big part of the problem is the lack of business travel. With many companies instituting “work from home” policies, people don’t even need to leave the comfort of their own living rooms anymore… let alone go to another part of the country.
Technology platforms like Zoom Video Communications (ZM) make it possible to hold essential meetings with colleagues… without the risk of getting infected with COVID-19.
Delta CEO Ed Bastian best described the situation on the airline’s July 14 earnings call…
Business travel, which typically provides 50% of our revenue, has not yet returned in any meaningful way with corporate offices slow to reopen.
Bastian acknowledged that the airline industry’s recovery has “stalled.” Delta is now forecasting passenger traffic in September at levels 75% to 80% lower than last year. Bastian doesn’t expect the industry to return to normal for at least two years.
And he isn’t the only airline CEO expecting tough sledding ahead. United CEO Scott Kirby said in a July 22 interview on CNBC that he expects flight revenue to peak at 50% of 2019 levels until a COVID-19 vaccine is developed.
Still, a vaccine might not be widely available until sometime in 2021 or maybe even 2022. And a lot of folks likely won’t take a perceived “rushed” vaccine even if one is available. According to a mid-May poll from the Associated Press, only 49% of those surveyed plan to take a COVID-19 vaccine when it’s available. And 20% said they’ll refuse to take it.
So a lot of people will stay away from vaccines – and planes – even when one is available.
So a lot of people will stay away from vaccines – and planes – even when one is available.
That’s why it will likely take far longer for airlines to recover than even Bastian and Kirby expect.
According to A4A CEO Nicholas Calio, “Air transport demand has never experienced a V-shaped recovery from a downturn.” It took passenger volume three years to recover from the September 11 terrorist attacks… and more than seven years from the 2008 financial crisis.
COVID-19 is the worst crisis ever for the airline industry. The industry has never experienced anything so drastic. We’re still in the early innings of this ordeal, too… It will take several years before passenger traffic gets anywhere close to 2019 levels.
Meanwhile, the planes that do fly won’t be full – far from it.
I experienced this a few weeks ago on a United flight from Germany to San Francisco. As you can see in the following picture, I had most of the plane to myself. It was at least 80% empty…
And here’s what the San Francisco airport looked like at 5 p.m. Pacific time that day…
In 2019, airlines needed an average of 76% of their seats filled just to break even. So how do they break even with capacity limitations while passengers mostly stay off planes?
They don’t.
The U.S. airline industry is burning through roughly $6 billion in cash per month. According to A4A, that number will ease to about $4 billion per month by the end of the year. But the thing is… airlines can’t keep losing billions of dollars every month forever.
Expect a Major Bankruptcy Soon
The airline bankruptcies have already started. Smaller carriers like Compass Airlines, Miami Air International, RavnAir Group, and Trans States Airlines have all gone bankrupt due to the COVID-19 backlash. And at least 13 carriers outside the country have filed for bankruptcy or shut down this year as well.
This is just the beginning. In addition to burning through boatloads of cash, the major carriers are taking on massive amounts of debt as they try to wait out the pandemic. A4A projects that total U.S. airline debt will jump 50% this year – from $105 billion in 2019 to $158 billion by the end of 2020.
The airline industry is a capital-intensive business that requires costly planes. It’s prone to labor, economic, and fuel price disruptions. And the industry is known for brutal, cutthroat competition.
Airlines tend to “fix” the problems by taking on more debt… but that only works for so long. That’s why almost 90 U.S. airlines have gone bankrupt since 1979. Around 75% of the time, they restructure… Existing shareholders get wiped out, and the debt gets adjusted to an amount the new entity can handle. So the planes keep flying – just with new owners.
Three of the four major U.S. airlines have restructured in bankruptcy over the past 14 years… United completed its restructuring in 2006, Delta in 2007, and American in 2013.
Bankruptcy is nothing new in the airline industry… And if this current situation doesn’t improve soon – which seems unlikely – we can expect major airlines to go bankrupt as well.
Dave Calhoun, the CEO of aircraft maker Boeing (BA), said earlier this year that he believes we may see a major U.S. carrier go out of business as early as September.
And the federal government is unlikely to come to the rescue this time…
Since March, the federal government has approved around $3 trillion worth of funding in the Coronavirus Aid, Relief, and Economic Security (“CARES”) Act and other stimulus bills. The CARES Act provides U.S. airlines with up to $25 billion in “payroll support” cash grants for agreeing not to lay off workers through September 30… and another $25 billion in loans.
But this isn’t an industry savior. It’s nothing more than a stopgap measure to keep the airline industry in place for now. The fall in traffic and the resulting cash burn is too great.
The government doesn’t need zombie airlines… the same way it didn’t need a zombie automaker in 2009.
By the time General Motors (GM) declared bankruptcy in June 2009, it had received more than $50 billion in loans from the government. Ultimately, $42 billion of those loans were converted in the bankruptcy restructuring to 60% of the stock in the “new” General Motors (the current company). And $8 billion of the loans stayed on the books of the new entity.
Besides the grants to keep workers employed, the loans that the airlines are receiving from the government must be paid back. They’re not free.
The more loans the airlines take… the more likely they’ll be overwhelmed by debt and go bankrupt. And if they go bankrupt – as with GM – the loans will be converted to debt or equity in the new entity.
If we see a new round of relief programs and the government lends an airline more money, then it will just take a larger stake in the new entity once it restructures. Either way, we can be absolutely certain of one thing… The government will get its money back.
The government’s only goal is to keep the U.S. passenger airline fleet operational. When the dust settles, it could care less who owns it… as long as people can get around as needed.
Folks who think the government will save existing airline shareholders are sorely mistaken. The government can only delay the inevitable…
So if you own airline stocks right now because they seem cheap – think again…
Most of these companies are racking up debt and burning through cash. Soon, they’re going to run out of assets to borrow against. Sure, they’ll mostly keep flying… But they’ll have a reshuffled deck of owners. And for current shareholders, that means you’ll be left holding the bag when it happens.
Warren Buffett got out in April… and he still booked a $2 billion loss. If you’re holding airline stocks today, don’t waste any more time before you follow his lead.
The clock is ticking… Which major airline will be the first to go bankrupt? And will they be the last?
Bill McGilton is the editor for Stansberry’s Big Trade – a speculative options trading service aimed at profiting from the worst corporate credit and companies with broken business models in America. Bill has been a lawyer for the past 19 years, with experience in corporate litigation research, including securities, contracts, anti-trust, options backdating, foreign-exchange fixing, and trademark and patent infringement.
