Don't Do It, Buffett

GuruFocus.com
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- By Jonathan Poland

On Wednesday, Morgan Stanley analysts said Berkshire Hathaway's (NYSE:BRK.A)(NYSE:BRK.B) full-scale acquisition of an airline is a possibility, especially if the stocks weaken.

Last week, Charlie Munger (Trades, Portfolio) spoke about airlines in terms of the railroad industry.



"It [railroads] was a terrible business for about 80 years, but finally they got down to four big railroads and it was a better business. And something similar is happening in the airline business."



What?

Warren Buffett (Trades, Portfolio) paid more than $26 billion in 2010 to purchase Burlington Northern Santa Fe. Berkshire had previously purchased minority stakes in BNSF, Union Pacific Corp. (UNP) and Norfolk Southern Corp. (NSC) - all sold after the deal closed.

It is easy to see the comparison, as Berkshire bought American Airlines (AAL), United Continental (UAL), Delta Air Lines (DAL) and Southwest (LUV). Buffett shunned the industry for decades following a volatile investment he made in U.S. Airways back in 1989, when Berkshire bought $358 million in preferred shares and almost lost the entire investment. Berkshire eventually made $250 million on the deal, despite the roller coster ride.

Here is what happened.

  • In 1989, Buffett told shareholders Berkshire "purchased $358 million of USAir Group Inc. preferred stock with mandatory redemption in 10 years, a dividend of 9.25% and the right to convert into common at $60 per share."

  • In 1990, "making the USAir purchase, your Chairman displayed exquisite timing: I plunged into the business at almost the exact moment that it ran into severe problems. (No one pushed me; in tennis parlance, I committed an 'unforced error.') The company's troubles were brought on both by industry conditions and by the post-merger difficulties it encountered in integrating Piedmont, an affliction I should have expected since almost all airline mergers have been followed by operational turmoil."

  • In 1991, "I told you that our USAir investment 'should work out all right unless the industry is decimated during the next few years.' Unfortunately, 1991 was a decimating period for the industry, as Midway, Pan Am and America West all entered bankruptcy. There is no tougher job in corporate America than running an airline: Despite the huge amounts of equity capital that have been injected into it, the industry, in aggregate, has posted a net loss since its birth after Kitty Hawk."

  • In 1992, "the case of our commitment to USAir, industry economics had soured before the ink dried on our check. As I've previously mentioned, it was I who happily jumped into the pool; no one pushed me. Yes, I knew the industry would be ruggedly competitive, but I did not expect its leaders to engage in prolonged kamikaze behavior. In the last two years, airline companies have acted as if they are members of a competitive tontine, which they wish to bring to its conclusion as rapidly as possible.

  • In 1994, "we wrote our USAir investment down to $89.5 million, 25 cents on the dollar at year-end 1994. This valuation reflects both a possibility that our preferred will have its value fully or largely restored and an opposite possibility that the stock will eventually become worthless. Whatever the outcome, we will heed a prime rule of investing: You don't have to make it back the way that you lost it."

  • In 1995, "the company's results improved... but it still faces significant problems. On the plus side for us is the fact that our preferred is structurally well-designed: For example, though we have not been paid dividends since June 1994, the amounts owed us are compounding at 5% over the prime rate. On the minus side is the fact that we are dealing with a weak credit. We feel much better about our USAir preferred than we did a year ago, but your guess is as good as mine as to its ultimate value."

  • In 1996, "the prices of USAir's publicly traded securities tell us that our preferred stock is now probably worth its par value of $358 million, give or take a little. In addition, we have over the years collected an aggregate of $240.5 million in dividends." And "in the second half of 1996, when USAir turned profitable, it indeed began to pay, giving us $47.9 million."



A big lesson was that built into the preferred contract was a stipulation of penalty dividends, which ran at 500 basis points over prime and would be accrued on any arrearages. This brilliant clause meant that when Berkshire's 9.25% dividend was omitted for two years, the unpaid amounts compounded at rates ranging between 13.25% and 14%.

Buffett is really hard on himself, even if an investment makes money. That is something all investors could learn from.

Sir Richard Branson had a funny response when asked how to become a millionaire: "There's really nothing to it. Start as a billionaire and buy an airline."

Yet, his Virgin Atlantic is one of the best airlines to fly with. Maybe there is a future for this industry after all. One thing that I would not do is bet against Buffett. He (or his managaers) is betting the industry as a whole right now with positions in four different airline stocks.

The six biggest carriers benefited from lower jet fuel prices and years of deal-making that consolidated the industry and have posted five straight year of profits. This netted about $14 billion in earnings, which followed more than $50 billion of losses from the previous decade. Consistency is still an issue here. Airlines make up approximately 6% of Berkshire's investment portfolio right now, with Delta the top holding of the group. I would not be surprised if he has a change of heart and liquidates the holdings in 2017.

Buffett, please vote no on airlines.

Disclosure: I have no positions in any of the stocks mentioned in this article.

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