Warren Buffett has a problem. His business, Berkshire Hathaway, is drowning in cash.
At the last count, Berkshire Hathaway had $64.56 billion in cash and equivalents and $46.54 billion in short-term investments in US Treasury bills on its balance sheet, for a total cash cache of $111.1 billion.
After deducting the $20 billion, Buffett likes to keep on hand to cover any unforeseen expenses stemming from Berkshire’s insurance business; the conglomerate has $91.1 billion of unused capital to deploy.
This is a nice problem to have, but it is still a problem. With interest rates where they are today, Berkshire is earning less than 2% per annum on average from its cash hoard. To put it another way, nearly one-fifth of Berkshire Hathaway's market capitalization is earning a near zero return.
Berkshire's capital as built up over the past few years because Buffett has been unable to find any large acquisitions to target with his elephant gun.
The last significant business purchase came in 2015 when the conglomerate added Precision Castparts to its empire.
Ever since Buffett completed his last significant deal in 2015, Wall Street has been trying to guess his next target. Until recently, it was widely believed that Berkshire would continue to avoid the airline sector, as it has done for decades. But this changed in 2017, when the Oracle of Omaha splashed out on airline stocks, gobbling up $5.5 billion of stock in American Airlines, Delta Air, and United. Berkshire also initiated a $2.4 billion position in Southwest Airlines.
Buffett's new found love of airlines has taken many Buffett watchers by surprise. Apart from several small select investments, the chairman of Berkshire Hathaway has avoided the industry for much of his career because carriers lack the competitive advantage he likes to see in a business. Indeed, earlier this year when talking about the airline holdings on CNBC Buffett said, "It's a business that’s always subject to someone doing something very dumb competitively, and they have done it a lot in the past...The industry was suicidally competitive for decades."
Now, however, Buffett seems to believe that the industry has changed. In the same interview, he went on to say that, following Berkshire's significant purchases of airline stock throughout 2017, he "wouldn’t rule out owning an entire airline."
Since Buffett made this statement, Wall Street analysts have been trying to guess which business would make the best fit for Berkshire. After evaluating all the possible options, a new report from Morgan Stanley speculates Southwest Airlines might be the perfect fit for Berkshire Hathaway.
Berkshire buys Southwest?
Following comments from Buffett about buying an airline, Morgan's analysts set out to try and discover which companies would make the best fit for the Berkshire group. They use the acquisition criteria set out in Berkshire's 2018 annual report, where Buffett lays out his broad acquisition criteria as follows:
"(1) a large purchase, (2) consistent earnings power, (3) good return with little or no debt, (4) management in place, (5) simple business, and (6) an offering price."
Of all the airlines, Southwest is the only one to meet all of the above criteria. The report estimates that Berkshire could pay a 20% to 40% premium for the airline and still achieve a 6% to 7% annual cash return. A deal, which would cost approximately $45 billion could be as much as 8% accreditive to 2019 Berkshire earnings per share.
Southwest could be convinced to sell to Buffett because there are a number of key advantages to be had by moving away from the public eye. These factors include, "1) moving away from monthly/quarterly unit revenue reporting; 2) taking further advantage of its financial strength; 3) less focus on supporting industry capacity discipline; 4) accelerating fleet investment; and 5) rewarding management for growth," according to Morgan Stanley's report on the matter.
Even though the company is one of the most profitable in the airline industry already, with an operating margin of 14% forecast for 2018, almost double American Airlines' expected margin of 8%, the scrutiny that comes with being a publicly traded company is holding back further operational improvements. Morgan notes that the group has been "measured" in its approach to replacing old aircraft "as to manage its capital structure and cash flow profile." The gradual replacement program means that within the next four years, around 60% of its fleet will be over 15 years old, the age at which most carriers begin to replace aircraft.
Morgan argues that as part of Berkshire, Southwest would be able to accelerate its replacement programme, lowering costs further with more fuel-efficient planes without having to worry about market sentiment. The investment bank's research report goes on to argue that under Berkshire ownership, the carrier will also be able to accelerate growth plans:
"We, and investors broadly, support the idea that companies with cost advantages, superior profitability, and healthy credit positions within an expanding end market should prioritize growth. This, in our opinion, could be done relatively easily within the Berkshire family as a hypothetical airline could continue to generate outsized returns moving forward. In fact, for LUV we estimate that with adding 4-5% of supply each year it would be able to hold margins steady, and potentially expand them, per flat to up unit revenues and flat to down unit costs. Our math suggests that ROIC could be in the 15-20% range on after-tax basis, which compares to a cost of capital of sub-10%. The net of this could be an annual total return of 10-20% a year, split between profit growth and capital returns."
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Disclosure: The author owns shares in Berkshire Hathaway.