Back in April, when the Oracle of Omaha Warren Buffett exited his entire position in the airline industry, it created an uproar in the market. The airline stocks had already lost more than 60% of their values. Rarely does Buffett sell stocks in haste. He is a long-term investor who buys stocks that he stays invested in for decades. Then why did he sell it when the stocks bottomed out?
It is because the reason he bought the airline stocks was gone and was unlikely to return in the coming 10 years.
Buffett: The world has changed for the airlines
Buffett invested in airline stocks when they were growing. Airlines were making profits and earning positive cash flows for over three consecutive years. He expected that more people would fly and airlines would continue to repurchase shares to maintain their stock valuations.
But when the COVID-19 pandemic disrupted air travel and grounded 90% of airlines’ capacities, all his expectations came crashing down. Warren Buffett said, “The world has changed for the airlines.” The surge in air travel demand came to a screeching halt, with no way to predict what lies ahead. The international borders were closed for three months. The U.S.-Canada border is closed for six months.
The pandemic has changed people’s habits. Buffett always looks at a business from the angle of whether or not people will use those products or services. With the pandemic, he wasn’t sure whether or not people would fly frequently. Uncertainty is something that investors hate. They invest in the future, and they want to be sure that there is a sizable amount of growth.
Is Air Canada a value trap?
When Air Canada (TSX:AC) stock lost 75% of its valuation in less than a month, some investors believed it to be an attractive point to buy a value stock. The airline had strengthened its fundamentals over its growth years (2013-2019). At the end of 2019, it had $1.48 billion in net income, 19% in adjusted EBITDA margin, $2 billion in free cash flows, and $2.84 billion in net debt.
Hence, when the AC stock dropped by 75% in the March sell-off, its valuation fell from 8.1 times its earnings per share to 2.3 times. This was the biggest value trap, and Buffett identified it. This was just a momentary valuation, as the airline’s fundamentals nosedived by the time it reported its first-quarter earnings. It reported a net loss of $1 billion in just 15 days of lockdown. Its net debt widened to $4.1 billion, as the airline raised debt to meet its operating expenses.
In a matter of 15 days, the airline lost almost its whole year of profit. And this was just the beginning. The AC stock valuation, which looked pretty attractive in March and April, suddenly became unattractive. Although the stock was trading between $14 and $20 post-pandemic, it was 58 times its earnings per share.
AC’s stock valuation will remain unattractive for the next few years, as its losses will only widen. In the first half, its net loss was $2.8 billion, and this could grow to $4 billion by year-end. AC took 10 years and one bankruptcy to return to profit after the 2002-2003 SARS epidemic. Even though the airline has improved its fundamentals, the pandemic crisis is way bigger than SARS.
Buffett finds value in the transmission
If AC succeeds in averting bankruptcy in the next three years through restructuring and $9 billion liquidity, it will still take five to seven years to see profit again. That is a long time in the investing world. During that time, you can convert $1,000 into $2,600, growing at an average annual rate of 10%. Hence, he escaped the airline value trap and calmly looked for other value stocks. In July, he invested in the natural gas transmission business — a good defensive business.
In the Toronto Stock Exchange, Enbridge is the largest natural gas transmission business. Its cash flows and revenue were not much impacted by the pandemic. Its fundamentals continue to remain strong and dividends high. You can get a 7.5% dividend yield and earn incremental dividends every year.
