The basic framework Warren Buffett uses to examine companies can help us understand why he sold Berkshire’s investments in airlines. That framework is rooted in economics and can be expressed as an equation:
Investment Return = Capital Intensity x Profit Margin x Dilution
Let’s take each component in turn:
1. Capital intensity: Airlines are capital intensive. They require a lot of capital to generate each dollar of revenue. That means revenues have a big impact on the return on capital equation. We are already seeing the immediate effects of the pandemic with flights taking off with very few passengers. But the long-term is very likely to be affected too. What happens if airlines are forced to fly planes with empty seats, either through laws/regulations, or through the changed behaviors of passengers demanding more space? Revenues go gown and the economics worsen. Capital intensity increases.
2. Profit margins: The degree to which a plane is utilized is called the load factor. Profitability falls off a cliff when load factors dip below 80% or thereaboouts. A flight costs about the same to operate whether it has one passenger onboard or one hundred. Airlines turn a profit when flights are full since the marginal cost of adding an additional passenger is very low. The first passengers must cover the fixed costs before the airline makes any profit.
The curse of airlines (and related businesses) is that industry capacity creates incentives to compete aggressively for customers. Every airline wants to have a full flight so they reduce ticket prices to try and win customers. But it’s hard to distinguish the marginal passenger from the regular one. So in cutting ticket prices airlines reduce their overall revenues and therefore reduce their profit margins. If passenger traffic remains below historical levels (which it very likely will) airlines will have more planes than the need and will very likely compete aggressively against each other for passengers.
Profit margins decrease across the board.
3. Dilution: The first two factors, capital intensity and profit margins, determine the return on capital a company earns. An investor would earn the company’s return on capital if they owned the entire company. That would hold true if the share count remained stable. But the rescue packages proposed by the US government included warrants to issue additional shares. To make matters worse the strike prices are at depressed levels. That means an investor’s claim on the future earnings of the airlines will go down, even if they recover.
There’s another level of dilution that comes into play too. A company’s capital structure is made up of equity and debt. If the airlines must borrow money to pay for losses and not to expand their operations then the level of equity capital goes down. That means the equity is worth less than before. So if an investor places the same value on the equity as before the result is a higher implied valuation for the entire enterprise. In reality the equity valuation must go down to allow the enterprise value to stay the same (which is the best case scenario because the enterprise value likely went down).
The end result of either dilution by an increased share count or more debt is a smaller claim on the future earnings of the enterprise by equity holders.
Putting It All Together
The three factors above point to no good result for owners of airlines. We concluded the likely result would be:
- -Higher capital intensity
- -Lower profit margins
- -Dilution of claim on future earning power
Any one of the above factors might be enough to call for caution. All three combined is a recipe for disaster.
The Oracle of Omaha might have gotten himself into trouble buying airlines (again). But he was smart enough to recognize when it was time to get out.