Airline Returns Refute Buffett Aversion to U.S. CarriersMary Schlangenstein and Mary Jane Credeur
U.S. airlines, shunned by Warren Buffett for almost 25 years, are now rewarding investors with the biggest returns in more than a decade.
The Bloomberg U.S. Airlines Index of 10 carriers surged 35 percent in the first quarter, the best start to a year since at least 1999. Wall Street projects that gains are just beginning for Delta Air Lines Inc. and US Airways Group Inc., with both rated higher on average by analysts than 92 percent of U.S. companies, according to data compiled by Bloomberg.
After more than $58 billion in losses from 2001 to 2009 amid two recessions and rising fuel bills, carriers are heading for a fourth straight annual profit as they match seat supply to demand and fly planes fuller than any time since 1945. That’s drawing new investors such as Snow Capital Management LP and Leuthold Group while hedge funds are adding to their holdings.
“The same factors that made airlines uninvestable for years -- too much capacity, too much debt -- are the opposite now and make them attractive,” said Simon Rosenberg, a co-portfolio manager at Snow Capital, which has $3 billion in assets. “I’m not going to shy away from an industry just because it has a bad history.”
Founded in 2001, Snow Capital didn’t make its first airline investment until last year, when the Sewickley, Pennsylvania-based firm began buying a Southwest Airlines Co. stake totaling 192,570 shares as of Dec. 31, data compiled by Bloomberg show.
Airlines cemented their reputation of being a “terrible business,” as Buffett dubbed them in March, with equity-erasing bankruptcies at four major carriers during the last decade. The Berkshire Hathaway Inc. chairman has sworn them off since a 1989 US Airways investment he called a “mistake.”
“The cyclicality was stomach-churning at best,” said Mark Luschini, chief investment strategist at Philadelphia-based Janney Montgomery Scott LLC, which manages $55 billion and holds Delta and Southwest. “With what’s taken place in the industry over the last couple years, that gives us a reason to take another look.”
Planes flew with a record 83 percent of seats filled on average in 2012, according to the U.S. Bureau of Transportation Statistics. A decade earlier, the figure was 72 percent.
By shedding their old habits of piling on flights and then having to discount ticket prices, airlines have been able to bolster fares and post profits even with jet fuel, carriers’ largest expense, soaring almost threefold since a 2009 low.
The $460.50 average U.S. domestic fare in February was an 18 percent jump over the same month three years earlier, based on data compiled by Bloomberg from Airline Reporting Corp.
Consolidation has accelerated the culling of money-losing routes. The merger announced Feb. 14 between US Airways and bankrupt American Airlines will shrink the number of full-service carriers with international networks to three, down from seven in 2000.
That deal was the fourth major tie-up since Delta acquired Northwest Airlines Corp. in 2008. UAL Corp. and Continental Airlines Inc. combined to form United Continental Holdings Inc. in 2010, and Southwest bought AirTran Holdings Inc. in 2011.
Hedge funds were among those betting on US Airways’ takeover bid for American, as their collective stake peaked at more than 30 percent in October, according to data compiled by Bloomberg based on publicly reported holdings.
The funds increased their stakes in US Airways in the past year by about 12 percentage points, the most among all ownership classes, to 24.7 percent, the data show. They boosted their Delta stake by 9.3 percentage points to 22.4 percent.
All but two of 15 analysts tracked by Bloomberg recommend buying US Airways, and project on average that the stock will rise 23 percent in the next 12 months. For Delta, 15 analysts say buy, two rate the stock as a hold and one says sell. The average forecast is for a 16 percent rally. Both carriers fell today as the Bloomberg airlines index slid 2 percent amid broader declines in transportation stocks.
The industry’s revival began after 2008, when jet-fuel prices climbed to a record $4.36 a gallon in July, then tumbled to $1.51 by year end. The worst U.S. economic slump since the Great Depression sapped travel demand and dragged the industry to a $23.8 billion net loss, its second biggest, according to data compiled by the Airlines for America trade group.
“That event fundamentally altered the way management teams look at their jobs,” said Rob Pickels, senior equity analyst at Fairport, New York-based Manning & Napier Inc., which managed $1.1 billion in U.S. airline investments at the end of 2012.
In 2009, the industry made it deepest cuts in available seating since World War II, and has curbed growth since then. Second-quarter capacity in the U.S. industry is 1 percent less than two years ago, Dan McKenzie, a New York-based analyst for Buckingham Research Group, said in a March 26 note.
Leuthold put 5 percent of its Select Industries portfolio into airlines in November, and has since raised the allocation to 8 percent because the shares performed so well, said Kristen Hendrickson, an analyst at the Minneapolis-based firm, which has $1.8 billion under management. The holding included United, Delta and US Airways.
“Airlines have been attractive for a year now, but we waited a bit” to be sure the rally continued, Hendrickson said.
Industry skeptics say there’s still plenty of truth in the old joke that the best way to make a small fortune in the airline business is to start with a large fortune.
Stockholders lost out last decade when United, Delta, US Airways and Northwest all restructured in court and shares became worthless. American parent AMR Corp. sought Chapter 11 protection in November 2011.
Buffett told CNBC last month that he still views U.S. airlines as a poor investment, even with the mergers, and that they might tempt him only if consolidation thinned their ranks to just one or two carriers. He has said he looks to buy stock in companies with lasting competitive advantages. He didn’t respond to a request for comment sent to an assistant last week.
“I’m quite comfortable sitting on the sidelines,” said Matt McCormick, who helps oversee $7.5 billion as a money manager at Bahl & Gaynor Investment Counsel Inc. in Cincinnati. “I have a deep dislike of them. That bias has been so rewarded over the years it’s going to take a lot to change my mind.”
So far this year, investors who are still bearish on airlines would have been better off buying their stocks.
Berkshire’s industrial holdings, for example, lagged behind industrial companies in the Standard & Poor’s 500 Index by 10 percentage points through March 28. If Buffett had allocated 5 percent of his portfolio to Delta, United and US Airways by the end of 2012, his industrial holdings would have outperformed by 13 percentage points, according to data compiled by Bloomberg.
US Airways executives sense a change in attitudes, as prospective first-time shareholders request meetings at conferences and at the airline’s headquarters in Tempe, Arizona, President Scott Kirby said in an interview.
“Many of them say, ‘I work for a long-term, value-oriented firm and we’ve never even looked at airlines before. Now we’re starting to look,’” Kirby said. “It feels like there is a larger pool of investors today than there has been historically.”
Airlines cite balance-sheet-scrubbing steps such as debt reduction, including $5 billion at Atlanta-based Delta and $2.7 billion at United during the past three years.
Delta is also reviewing ways to return cash to shareholders this year, a step that may include the first buyback since 2000. Dallas-based Southwest returned $422 million to shareholders in 2012 through stock repurchases and dividends, the only major U.S. carrier to do so.
“Managers understand that it’s all about generating a profit and a return, and you have a more mature industry and a different behavioral set,” Southwest CEO Gary Kelly said in an interview. “The industry is trying not to repeat the mistakes of the past.”
Delta produced an 11 percent return on invested capital last year, while Chicago-based United’s tally was 8 percent. Southwest, with a 7 percent ROIC last year, says it won’t grow its fleet until it hits 15 percent.
“I would expect airlines to continue to do well as long as they continue to do the things that got them to this point,” said Andrew Davis, an analyst at Baltimore-based T. Rowe Price Group Inc., which became United’s biggest investor after buying more than 40 million shares last year. T. Rowe Price also holds Southwest, JetBlue Airways Corp. and Alaska Air Group Inc.
Some investors project the pending $11 billion merger between US Airways and Fort Worth, Texas-based American to bolster the industry further. The new American will be the world’s biggest airline by passenger traffic.
Tom Claugus, president of GMT Capital Corp. in Atlanta with $5 billion under management, started buying United and Delta two years ago on the assumption that combinations would strengthen the survivors. The firm now owns about 10.5 million shares of United -- its biggest holding -- and 9.9 million Delta shares.
Lately he’s been buying US Airways, too.
“If we’re right about this being a significant structural change in the industry,” the rally will continue, Claugus said. “We’re holding onto all our shares, and adding more.”