airlineinvestor wrote: LogicandIntertia
Not sure if you posted this on the Air Canada board in error since it involves the U.S. airlines and Buffett’s investment in them. I follow the U.S. industry and can assist in helping you gain a better understanding of what has been happening with our Southern neighbours.
First of all, Buffett’s decision to sell his shares in the four airlines needs to be viewed within the broader context of his operating empire. Here are a couple excerpts from the WSJ and Financial Times:
- Berkshire’s been hurt by the pandemic, suffering a $49.7bn loss in the first quarter after its stock portfolio was hammered alongside a broad market sell-off. Berkshire’s sprawling group of subsidiaries was hampered by government lockdowns and a decline in consumption.
- Moreover, in the past few weeks, Geico joined many other insurers by giving customers premium refunds in response to fewer drivers on the road and fewer accidents. Meanwhile, the broader insurance industry, lawmakers and business owners are debating how much insurers will be on the hook for claims related to the coronavirus pandemic.
Buffet has sold out of all his positions in the US Airlines, as announced at the Berkshire Hathaway meeting today. Whether you are bullish or bearish, no doubting this will make refinancing debt harder for airlines, not easier... Here are recent excerpts from the WSJ and Financial Times that should help you gain some perspective on the leverage component. As I’m sure you’re aware, the U.S. airlines were able to negotiate favourable terms from the U.S. Government, and were successful in pushing back on the gov’t taking large equity stakes in their companies. Since then, a couple airlines issued more equity, while others obtained additional cash from other sources, including selling and leasing back aircraft. From these excerpts, it’s clear that U.S. airline CEOs would have balked at a Buffett solution, given his typical terms.
London Financial Times (U.S. Airlines Rescue: April 15, 2020) “Late on Tuesday, the US Treasury finalised its support package for US carriers. The terms were relatively generous to companies, with equity stakes for the US taxpayer essentially limited to 1 per cent. Most airlines took grants and a smaller proportion of loans.”
Cash-Hungry Companies Reach for Lifeline in Convertible Bonds (WSJ April 30, 2020)
“Companies in need of cash during this crisis could also try to strike deals with private-equity firms or big investors like Warren Buffett, but those tend to come with strings attached. When Mr. Buffett’s company,
Berkshire Hathaway Inc., provided rescue financing to
General Electric Co. during the financial crisis, the firm received $300 million in annual dividends on the $3 billion in preferred shares it bought, but Berkshire also received the right to buy $3 billion of GE common stock over the next five years for less than where it traded when the deal was struck.”
From today’s London Financial Times:
“Mr. Buffett said corporate chieftains and financiers owed policymakers at the US central bank a thank-you note for the speed and ferocity at which they responded to the credit market freeze in March, which at the time sidelined companies from raising needed cash. The Fed moved swiftly to help thaw capital markets, agreeing to buy investment grade corporate bonds and exchange traded funds invested in junk credit at the same time it worked to backstop money market funds and the commercial paper market. Those actions, Mr Buffett added, meant companies that would have in the past needed to tap Berkshire for funding have been able to secure it elsewhere. Yields on both investment grade and high yield corporate bonds have fallen from peaks hit in March when the recent market drop was at its most severe. “We were starting to get calls,” he said, referring to companies seeking out investment. “A number of them were able to get money in the public market frankly at terms we wouldn’t have given to them.””
We’ll never know what the outcome might have been – it may not have been any different – had one or more airlines approached Buffet for financing. The one thing to keep in mind about Berkshire’s investment in airlines is that they didn’t stick to their typical songsheet of buying when others are fearful. Buffett’s decision to buy into the U.S. airlines occurred well into the bull market (fall 2016), rather than early on, following the financial crisis. In the case of Delta, buying say in 2011-2012, shares could have been purchased in the $8-$10 range rather than in the $35-$40 dollar range in the fall of 2016. Would this had made a difference in his decision to sell?
The other error Buffett made (in my opinion) was buying shares in all four of the major airlines, something other large institutional investors such as Blackrock, Vanguard and State street were doing, a strategy viewed by many academics as anti-competitive in nature. Buffett’s concern with the airline industry was its past failure to manage capacity, which led to fare wars and significant losses. The thinking behind common ownership it that it ‘encourages’ airline CEOs to keep capacity tight and fares high – focus on profitability rather than gaining market share. A better approach for Berkshire would have been to focus on a couple airlines that were very well-managed.
Hedge funds that have a deep knowledge base in the airline industry took a more focused approached investing in only one or two airlines and investing early in the recovery when it was still ‘ugly in the moment.’ Two hedge funds (Altimeter and PAR Capital) even became more ‘activist’, forcing changes to the United Board in 2016, which brought about improved performance at that airline.
As it stands, it’s a false equivalency to compare what is occurring in the U.S. industry with what is happening at Air Canada. First, Air Canada entered into the crisis with significantly higher liquidity and lower net debt than its U.S. counterparts. (This was addressed in a previous response to one of your concerns.) Second, unlike U.S. carriers, Air Canada is at the end of its major CAPEX program and will not require any major financing. Third, Air Canada still has about 9 percent of its fleet grounded and recently reached a settlement with Boeing estimated in excess of $1 billion. Fourth, the Canadian government is responding differently, in terms of financial support, the latest being the provision of bridge financing based on each company’s needs. They are not seeking equity ownership.
“The airline business has the problem that if the business comes back 70% or 80%, the aircraft don't disappear. So you've got - you've got too many planes....I just made a mistake" - Warren Buffet May 2,2020 Somewhat true. However, this is typical in any airline business cycle. New aircraft are purchased to replace older aircraft. But when the new aircraft arrive and if demand warrants, the older aircraft remain in the fleet, until the next recession at which time, the older less efficient aircraft are sent to the desert, or returned to the lessor.
Consider Delta: According to Wikipedia, Delta has 864 aircraft in its fleet. However, of these aircraft, upwards of 200 aircraft are over 25 years in age, and some aircraft under 25 years (e.g., the 91-B717 gaz guzzlers purchased at a deep discount from Southwest following its merger with Air Tran), are prime targets for grounding. Expect most of these aircraft to be retired and new aircraft orders delayed. The story is the same for Southwest, American and United. In fact this past week, United advised their pilots to expect lay-offs exceeding 30% of its workforce.
Unlike previous recessions, the problem with the current crisis is that airline executives really don’t know what the demand is going to be twelve months for now (typical planning period) so they’re likely going to be prudent and err on the side of having too little, rather than too much, capacity in the market. This will no doubt drive fares higher in the recovery especially if demand comes back more quickly than expected.
Likewise, Air Canada is in a position to significantly reduce capacity. As mentioned, the Airline was already operating with nine percent of its fleet grounded (B737 MAX8), having only 24 in the fleet now instead of the expected 50. Orders for eleven B737 MAX stretched versions were cancelled earlier this year (before the virus), and 2020 Capex spend has been pushed into 2021. Other planned reductions this year included removing Embraer E190s, Airbus A320s and Boeing B767s. The current crisis will undoubtedly accelerate these as well as additional removals. More than half of Air Canada’s fleet is now owned, and this percentage will continue to increase when the Boeing MAX returns to service, replacing older leased aircraft. Having a high percentage of unencumbered aircraft makes an airline much more resilient in an economic downturn, as it is able to park these aircraft at little cost to the airline.
So Buffett is wrong in saying that airplanes don’t disappear if business comes back to 70% or 80%. Old inefficient aircraft do disappear (to the desert) as airlines rejuvenate their fleets and adjust capacity to a new reality.
Looking forward to the middle of May to see who the new owners of Air Canada are.