Warren Buffett’s dislike of the airlines business is legendary. But the Sage of Omaha has recently changed his tune, significantly. He now believes that today’s carriers are less likely to go bankrupt.
He thinks that conditions for airlines are so different today that he has even invested in several US carriers. He has put billions into a quartet of US carriers. They are United, American, Southwest and Delta.
So, what’s changed?
In one sense, nothing much has changed. Airlines still face the same risks as before. They still have high operational gearing. Aircraft are still very expensive pieces of equipment to buy. And external events can still hamper their businesses….
…. it only takes a volcano to erupt in a remote part of the world to send flight schedules into disarray and compensations through the roof. And airlines are now even more susceptible to reputational damage than before because of social media.
Same but different
But in other ways, things have changed for the better.
Industry consolidation has reduced the number of operators who are now more focussed on bottom-line profits than national pride.
Careful yield management has also enabled airlines to adjust prices promptly to improve cash flows. Put another way, prudent management has turned many airlines into viable businesses with a focus on containing cost rather than flying at any cost. And it shows.
Over the last decade, the return on equity for airlines have shown signs of improvements. In the last three years, airlines have started to generate reasonable profits on every dollar of shareholder equity.
Some airlines have even been able to deliver double-digit returns on equity for investors. In some cases, this has been due to better net income margins.
The improved return on equity can also be attributed to a more efficient use of assets….
…. In 2007, airlines, on average, generated $74 of sales on every $100 of assets employed. That’s quite respectable, given that airlines use very expensive assets. In 2017, the median asset turnover had crept up to $78 on every $100 of assets. A move in the right direction.
Leverages is something else that airlines use extensively to boost their return on equity. On average, total liabilities can be around 75% of total assets.
Gemstones to millstones
In some instances, total liabilities can be as much as total assets, which is worrying. That’s because borrowings can be a double-edged sword. It lets a company use other people’s money, instead of its own, to run the business.
But loans can quickly go from gemstones to millstones, if they can’t be serviced. The demise of many airlines in the past has been due to debts that spiralled out of control. The result was bankruptcy.
So, airlines’ heavy reliance on borrowings means that loans should be considered when we value those businesses. A useful measure is to compare their enterprise value against earnings before interest, taxes, depreciation, amortisation and rent (EBITDAR).
Earnings before everything
Earnings are similar to, but more useful than, the price-to-earnings ratio, when valuing heavily-indebted companies. It excludes those hefty non-cash items that helps to paint a more realistic picture.
On that measure, airlines look reasonably priced.
Three of Buffett’s quartet of airline investments, for example, are clustered around the median EV/EBITDAR of 4.2. It means that investors are paying $4.20 for every dollar of operating profit.
Singapore Airlines (SGX: C6L) also sports an attractive EV/EBITDAR of around 3.9. In other words, someone looking to acquire the national carrier, lock, stock and barrel, would be paying, $3.90 for every dollar of operating profit.
Since 2015, airlines have, on average, generated $6 of profit on every $100 of sales, compared to net income margins of about 2% a decade ago. But those Margins are still quite thin.
Cash is king
Whilst EBITDAR can be useful as a measure of profit, it is not the same as cash. And cash in the bank is crucial for a company’s long-term survival.
So, free cash flow is another way to value airlines. It is the amount of cash left over after a company has paid all its expenses plus capital expenditures. A positive free cash flow means that a company is generating more cash than it needs to run the business. A negative free cash flow could mean trouble.
Not all airlines are free cash flow positive. So, investors should tread carefully, given that the airline industry is closely tied to the state of the economy.
When the economy is doing well, consumers could have higher discretionary income. Consequently, they might splash out on travel. But when the economy is softer, cash-strapped consumers are less likely to travel.
It is during those lean times when airlines’ high operational gearings can bring down even the best. Only time will tell whether Buffett has been right to place his faith in those magnificent men in their flying machines.
A version of this article first appeared in the Business Times.
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