Buffet’s Letter and Airlines

Last weekend I spent some time reading Warren Buffet’s letter to shareholders. One of the things that struck me was his investment in airline companies. In August 2015, I added some shares of Southwest Airlines (LUV) to my fund at around $36.50. I noted this investment in my Caps page as well.

It looks like oil prices will stay down for longer than initially projected. Southwest will be a huge beneficiary of this. Many recent investments and expansions are nearing completion, their fleet is underutilized, and they have completed some recent fleet upgrades. Capex should be limited in the near to intermediate term, allowing for more route expansion or return of capital to shareholders.

Growth in earnings should be significant, pushing above 20% for the next five years. Look for the P/E multiple to expand. On a DCF basis, I see this valued at about $45 using a 15% discount rate. With a current price of just under $37, this stock will outperform the market over the next 5-10 years.

What was true for Southwest in 2015 remains true today. Airlines have built their infrastructure, they have consolidated and optimized their expense structure, and, most importantly, fuel costs have stabilized with little chance of a strong surge in fuel costs. Southwest is up over 60% since my purchase in 2015. Today it is a little over 16x earnings with analysts projecting 10% growth over the next 5 years. This seems like a fair valuation given the risks in the industry and the track record of this airline.

However, Buffet is investing more broadly than Southwest. An airline that grabbed my attention is Delta (DAL). I began reading more about the company. They are very focused on improving the customer experience and doing what is right for shareholders. Management is saying the right things.

Beyond management, the company is well-positioned and looks very cheap. In 2016, they had operating cash flow of $7.2 billion and free cash flow of $3.8 billion. Yet the company is priced at around $36 billion today. To put that in perspective, they are priced at 5x operating cash flow and 9.5x free cash flow. Earnings growth will be somewhat limited in the next year, but cash flow should be about the same.

Airlines are mostly near full capacity across the board. Southwest has begun to expand capacity and Delta is looking to make small improvements in capacity as well. The key to growth for these companies is how they allocate their strong cash flow. Meanwhile, fuel prices could pose a risk as could a drop in demand. Delta in particular looks like it is priced at a discount in excess of the risks to their business.

Buffet seems to be on to something with his purchase of airline stocks. I am following his lead by adding Delta shares. When the master moves, it is best to pay attention.

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