Airlines are among the worst affected stocks by the coronavirus pandemic. After surprising the market by taking sizable stakes in the major U.S. carriers, renowned investor Warren Buffett recently dumped his entire holding. The initial investment caught markets off-guard because as far back as 2007 Buffett had an aversion for airlines.
In 2013 he described the business as a bottomless pit for capital and a “death trap” for investors. It is for these reasons that pundits were surprised by Buffett’s sizable investment in Southwest Airlines, Delta Airlines (NYSE:DAL), American Airlines and United Airlines.
Are airlines a poor investment?
At the start of 2020, Buffett’s investment was worth almost US$9.5 billion after the industry experienced a strong year. In another move that stunned the market, Buffett sold his entire airline investment at a considerable loss. That caused the value of those carriers to decline sharply, saw Buffett incur a substantial loss and spark considerable speculation that airlines are to be avoided.
Buffett justified his decision stating, “The world has changed for the airlines” — alluding to the considerable impact of the coronavirus pandemic on air travel. The Oracle of Omaha’s latest move could be correct.
Canada’s flagship carrier, Air Canada (TSX:AC) believes it will take the airline industry three years to recover from the disastrous impact of the coronavirus. The sharp decline in sales coupled with carriers grounding most of their fleets sees many burning cash at an extraordinary rate.
In early April, Delta’s CEO advised that the airline was burning through US$60 million a day and that things would worsen before they got better. Sharply reduced capacity, cuts to executive remuneration, the furloughing of employees and significantly weaker oil has done little to alleviate spending in what is a very capital-intensive industry.
Airlines posting poor results
Delta reported a US$534 million first-quarter 2020 net loss and loaded up on debt. Extremely high overheads and larger capital spending requirements have forced airlines to tap debt and equity markets to bolster their financial position to survive the current crisis.
The largest U.S. carrier by revenue’s long-term debt and leases ballooned out by 43% compared to the end of 2019 to almost US$13 billion. Delta has drawn down US$3 billion from existing credit facilities, and announced it would tap debt markets for US$1.5 billion and raise another US$1.5 billion through a new credit facility.
While that may bolster Delta’s chances of surviving the difficult operating environment, it will weigh heavily on its future performance.
Air Canada is in a superior position
Air Canada has yet to tap debt markets or raise equity to secure capital to survive. By the end of the first quarter, Air Canada’s debt had risen 20% compared to the end of 2019 to just under $10 billion.
That can be attributed to the airline drawing $1 billion from existing facilities. At the end of April, Air Canada also finalized a US$600 million facility and a $788 million bridging loan secured against 18 Airbus aircraft.
The measures undertaken by Air Canada to survive the impact of the pandemic on tourism and travel has seen it reduce spending by around $1 billion. These events combined with Air Canada’s $6 billion pile of cash at the end of the first quarter, means that it should emerge in good shape.
Air Canada has additional levers at its disposal to raise capital, including the potential for a bailout from Ottawa.
The national carrier has a wider economic moat that its U.S. peers. Combined with Air Canada being the dominant player in a smaller market bodes well for it to grow earnings.
Foolish takeaway
Over the last decade, even after the latest pullback, Air Canada has delivered an impressive 774%, equating to a notable compound annual growth rate (CAGR) of almost 24%. While past returns are no guarantee of future performance, Air Canada will emerge from the crisis and unlock long-term value.
Nevertheless, airlines are a risk investment in the current environment. That makes Air Canada a speculative contrarian play for investors with a high-risk tolerance.
