If Warren Buffett’s Berkshire Hathaway Inc. uses its considerable cash pile to buy an airline, as recent investments suggest it could, Morgan Stanley analysts believe Southwest Airlines Co. would make the most sense.
In 2007, Buffett had suggested in Berkshire’s annual letter to shareholders that airlines were among the “worst sort” of businesses, as they grew rapidly, required significant capital to generate that growth and earned little or no money.
Since then, he’s done an about-face. Berkshire BRK.B, -1.18% BRK.A, -0.98% went from holding zero airline stocks to amassing Top-3 shareholder stakes in four airlines for a total value of about $9.76 billion, based on recent filings and current share prices:
Berkshire Hathaway airline holdings Company (ticker) Shares held % shares outstanding (shareholder rank) Value at Aug. 8 closing prices American Airlines (AAL) 44,240,200 9.99 (3rd) $1.70 billion Delta Air Lines (DAL) 53,599,357 7.75 (1st) $2.96 billion Southwest Airlines (LUV) 47,659,456 8.22 (2nd) $2.80 billion United Continental (UAL) 27,705,963 10.16 (2nd) $2.29 billion Holdings as of March 31, 2018, according to latest 13F filing with SEC; shares outstanding/rank data from FactSet“Over the past few years, Berkshire has exhibited a notable shift in tone on the U.S. airlines industry, which we believe could result in a more permanent relationship,” Morgan Stanley analysts wrote in a research note for clients.
The question: If Buffett bought an airline, which one would he buy?
The analysts said that they have no knowledge of any merger and acquisition discussions, and the airlines have not commented. “That said, our screen of potential airline acquisitions by Berkshire suggests Southwest LUV, +0.00% could fit well into Berkshire’s family given its acquisition criteria, ownership of capital-intensive businesses and deployable $100+ billion cash balance,” the analysts wrote.
Berkshire did not immediately respond to a MarketWatch call for comment.
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Buffett appears to have become more open to deploying Berkshire’s excess cash, which J.P. Morgan said has acted as a “large drag on returns.” Last month, Berkshire’s stock rallied after the company changed its share repurchase policy, suggesting buybacks may finally be on the horizon. Read more about the policy change, and the stock’s reaction.
The analysts said based on historical M&A metrics, they estimate that if Berkshire were to buy Southwest it could pay $70 to $80 a share, or roughly a 20% to 40% premium. In return, the acquisition could potentially boost Berkshire’s earnings per share by 7% to 8% and provide a cash return of 6% to 7%.
For Southwest, Morgan Stanley believes there are five reasons that becoming part of the Berkshire family would help create long-term value for the airline:
• Remove near-term “noise” of monthly and quarterly unit revenue reporting
• Take further advantage of its financial strength
• Reduce focus on supporting industry capacity discipline
• Accelerate fleet investment
• Reward management for growth
Southwest shares rose 1.3% on Wednesday to close at the highest level since March 20.
Among shares of Berkshire’s other airline holdings, Delta Air Lines’s DAL, -1.14% climbed 1.0%, United Continental’s UAL, -1.24% rose 0.6% and American Airlines’s AAL, -1.74% gained 0.3%.
Morgan Stanley cautioned, however, that Buffett buying Southwest wouldn’t be an all-clear sign to buy other airline stocks.
On the plus side, it would put a “stamp of approval” on the industry and investor flows out of Southwest could support shares of other airlines. But on the downside, history suggests that if Berkshire were to buy Southwest, it would divest its current holdings in other airlines, which would present a near-term overhang. Increased competition could also be a concern, as Southwest would likely emphasize growth over near-term unit revenue performance.
The analysts cited previous examples, in which Berkshire sold its other railroad holdings after its buyout of Burlington Northern Santa Fe, and how low-cost insurer Geico has more than tripled its market share since the 1996 acquisition at the expense of larger rivals.
“Over time, the [airline] industry could be more competitive,” as Southwest prioritizes long-term growth over short-term performance, the analysts wrote. But has a “disciplined” operator, “Berkshire is unlikely to suppress the competition via irrational activities.”
Southwest’s stock has lost 10.1% year to date, while the Dow Jones Transportation Average DJT, -0.45% has advanced 5.3%, the NYSE Arca Airline Index XAL, -1.22% has lost 8.6% and the Dow Jones Industrial Average DJIA, -0.77% has tacked on 3.5%. Berkshire Hathaway’s Class B shares have gained 5.4% so far this year.
