It is fair to say that Warren Buffett’s decision to start buying US airline stocks has been met with lots of surprise around the world. Warren Buffett has never been a fan of airlines and barring the one unsuccessful investment in American Airlines back in the early 90s; he has steered clear of the sector altogether.
So, when Berkshire Hathaway announced that it had acquired stakes in three airlines during the third quarter of last year, it took Buffett watchers by surprise. Buffett didn’t stop there, according to Berkshire Hathaway’s most recent 13F filing with the SEC, Buffett, and team continue to acquire airline stocks throughout the fourth quarter of 2016 and now is the #1 or #2 holder for each of the big four US carriers with a total position value of around $10 billion.
A new research note from Morgan Stanley speculates that Buffett’s airline stakes could be the precursor to an acquisition by the conglomerate.
The authors of the report, a team of Morgan’s equity analysts led by Rajeev Lalwani, CFA note that Buffett’s airline stakes mimic those Berkshire placed before the acquisition of BNSF:
“An interest in industries with structural improvement and the gradually growing stakes are fairly consistent with Berkshire's approach to acquiring Burlington Northern Santa Fe (BNSF) in 2009 for ~$26.3B. First, the Rails had also seen an improved…industry structure resulting in a supply-demand balance and pricing power following a period of capacity cuts and consolidation. Second, the BNSF acquisition was preceded by positions in peers, NSC and UNP”
Considering the similarities, between the Berkshire rail and air movements, Morgan’s equity strategists conclude “a full-scale acquisition of an airline by Berkshire as a possibility and not worth dismissing.”
To try and add some more meat to its analysis, Morgan turned to the crowd to try and gauge what the likelihood is of Buffett making a move on an airline. The equity team asked a selection of Morgan’s investors the question:
“Considering Berkshire Hathaway's large stake in the Big 4, do you believe it would consider a full-scale acquisition of: (A) AAL, (B) DAL, (C) LUV, (D) UAL, or (E) None of them?”
All those that responded, 60% said they do not expect Berkshire’s airline stakes to be a step towards a full-scale acquisition considering the strong multi-year stock returns of these companies and the possible purchase price, which is likely to be up to $50 billion. However, 40% of respondents hold the view that Buffett’s airline stakes are a precursor to a full-on acquisition and believe Southwest Airlines Co. is the most likely candidate.
Still, the question remains, what does Buffett see in the airlines? Morgan’s equity analysts speculate that even though Buffett has long held the stance that airlines are an investment "trap" underpinned by a history littered with bankruptcies, boom-and-bust performance, and unsustainable profitability, in recent years the shape of the industry has changed dramatically. Consolidation means that the four leading carriers now account for 80% of domestic supply, significant revenue sources from credit cards deals and bag fees have improved margins, and a focus on establishing a reasonable cost structure has helped stabilize industry profitability. Furthermore, a focus on reducing debt during the past few years means balance sheets are well past leverage peaks.