Invest in Airlines that Buy on the Cheap
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Charlie Munger, partner of Warren Buffett, once noted that "The net amount of money that's been made by the shareholders of airlines since Kitty Hawk is now a negative figure."
Buttressing this assertion was an expensive and painful lesson that Berkshire Hathawy (NYSE: BRK-A) suffered from an investment in US Airways (NYSE: LCC). In a shareholder letter about this, Buffett wrote, "I liked and admired Ed Colodny, the company’s then-CEO, and I still do. But my analysis of USAir’s business was both superficial and wrong. I was so beguiled by the company’s long history of profitable operations, and by the protection that ownership of a senior security seemingly offered me, that I overlooked the crucial point: USAir’s revenues would increasingly feel the effects of an unregulated, fiercely-competitive market whereas its cost structure was a holdover from the days when regulation protected profits. These costs, if left unchecked, portended disaster, however reassuring the airline’s past record might be."
The leveraged buyout firm of Kohlberg Kravis & Roberts was fortunate enough to avoid heavy losses with airlines investments. In the book, "Merchants of Debt," Kohlberg, Kravis & Roberts passed on the United Airlines leveraged buyout back in 1989. From the book about the advisability of investing in airlines, "If ever a business was badly suited for leveraged buyouts - veering up and down depending on fuel prices, the economic cycle and event threats of terrorism. Capital spending needs for new planes were sizable every year, and they couldn't easily be postponed just to help service debt. A high-debt airline could be vulnerable to a cash squeeze or a loss of consumer confidence."
Despite this advice from some of the most successful investors in history, airline mergers appear to be as frequent as bankruptcies in the industry, more than 200 since deregulation in 1978, and negative profit margins. United-Continental (NYSE: UAL) is the result of a recent merger of United Airlines and Continental. Brazil's Latam Airlines SA (UNKNOWN: TAM.DL) just merged with China's LAN Airlines.
When airlines merge, it is often times as equals. That means that the stock prices are robust. There is no better scenario for a falling share price in the future than to overpay for the costs and difficulties of combining two airlines. Due to the vagaries of the industry and the intense competition, the share prices will eventually fall.
In May 2005, US Airways merged with American West. The share price was over $65 in late 2006 for US Airways. Its low over the past 52 weeks of trading is $3.96. In terms of of being a "high-debt airline," KKR meet US Airways: the debt-to-equity ratio is 22.19. That means that for every dollar of equity for US Airlines required more than $22 of borrowing.
United-Continental has a debt-to-equity ratio of 8.24. Southwest Airlines (NYSE: LUV), which does not merge but buys rivals on the cheap after they have crash landed, has a debt-to-equity ratio of just 0.47. TAM SA has a debt-to-equity ratio of 4.08.
Forget about dividend income from airlines that overpay in mergers. United-Continental does not offer one. Neither does US Airways. By contrast, Southwest Airlines has a dividend yield of 0.43%. The payout ratio, at 5.17%, is also extremely low. As such, there is plenty of cash flow for dividend increases in the future or share buybacks to increase the total return for shareholders.
Every legacy carrier in the United States has filed for bankruptcy at least once. US Airways has entered Chancery Court in Delaware twice for Chapter 11 proceedings. A huge reason why is the burdensome costs from foolish mergers. By contrast, Southwest Airlines is the only US air carrier that has been profitable every year for almost four consecutive decades, 39 in all. A major factor is that Southwest Airlines avoids debt by buying on the cheap, not overpaying for an acquisition and having to incur a burdensome debt load by merging with an equal.
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