For years, the airline industry was the butt of Warren Buffett's jokes.
In his 2007 letter to Berkshire Hathaway shareholders, Buffett laid out examples of great, good and terrible businesses.
The airline industry played the part of terrible.
Here is exactly what Buffett wrote:
“Now let's move to the gruesome. The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money.
Think airlines.
Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.”
Keep in mind, this was not Buffett's take on one bad airline company.
This was his opinion about the entire industry. Buffett viewed airlines as a gruesome place to invest money into.
At least, that WAS his view...
As of December 31, 2017, Mr. Buffett's company, Berkshire Hathaway, owned the following:
47.7 million shares of Southwest Airlines (LUV) worth $3.1 billion53.1 million shares of Delta Airlines (DAL) worth $3.0 billion46.0 million shares of American Airlines (AAL) worth $2.4 billion28.2 million shares of United Continental (UAL) worth $1.9 billionThat is a combined $10.4 billion investment. Even for Warren Buffett that is real money.
His investments represent just under 10% ownership stakes in each of these companies.
Buffett didn't just buy one particularly standout airline, he bought significant stakes in four major airlines after describing the industry as gruesome not very long ago.
With this major investment into the four main U.S. airlines, Buffett clearly believes that something has changed to not just make them less gruesome, but to make them companies he wants to own.
Remember, this is a man who has always run a very concentrated portfolio. He only pulls the trigger when he feels certain that he is looking at a great opportunity.
And something clearly has changed, these airlines are now making a lot of money. Over the nine years ending in 2009, the industry lost $54 billion. Since then, the industry has made $66 billion.
The driver of this improvement has been the huge amount of consolidation throughout the industry.
For decades, this industry was fragmented and undisciplined. That repeatedly let to periods where the industry became dangerously competitive on rates and everyone lost money.
Consolidation has ended the boom-and-bust pricing cyclicality that ran rampant - the worst operators are gone.
Today, the consolidated airline industry is much more efficient and focused on return on capital rather than senselessly chasing market share.
The industry now resembles other profitable American industries that are dominated by a few major operators - think cable companies and grocery stores.
And given Buffett's legendary preference for being a long term investor, clearly he believes that this rational operating approach to doing business is not a temporary change for the airline industry.
The advantage that Buffett has as an investor is that giant, rational brain that is constantly working inside of his head.
His disadvantage is that he has so much money to invest that he is restricted to investing in only large cap companies.
This caused him to miss out on a smaller company that represents an even better way to play the airline boom - Alaska Airlines (ALK).
This company has what Buffett most desperately covets in a business - wide profit margins.
In 2017, the legacy airlines that Buffett purchased generated pre-tax profit margins of close to 10%. The low cost carriers (excluding Alaska Air) did a bit better, with profit margins coming in at 16%.
But Alaska Air's pre-tax profit margins of 19% were far better than the legacy carriers that Buffett owns and even significantly better than the low cost carrier group.
Not only is Alaska Air more profitable, the stock is also inexplicably cheaper, currently trading at just 7 times earnings and offering a 2.01% (and growing) dividend yield.
Better still, Alaska Air was just ranked as the #1 airline in the annual Airline Quality Report. That means this company is the most profitable, cheapest (stock valuation) and boasts the title of best quality airline in the business.
If Alaska Air was large enough for Buffett to own, I'm sure he would. But good news for him, if the company continues to grow, someday he just might be able to.
Here's to looking through the windshield,
Jody Chudley
Financial Analyst, The Daily Edge
EdgeFeedback@AgoraFinancial.com