Investing in airline stocks has been one of the most debatable topics last year. While traditional value investor Warren Buffett jumped out of airline stocks in April 2020, growth investor Bill Miller stuck to his airline investments. They both have different views on airlines such as Air Canada (TSX:AC).
Bill Miller and Warren Buffett differ on airlines
Miller Value Partners founder Bill Miller has been bullish on airline stocks for a long time, while Buffett has always criticized airlines after burning his hands in U.S. Air preferred stock in 1989. But in 2017, Buffett went against his ideologies and purchased airline stocks, as they generated good cash flows, even in a weak economy. Airlines benefitted as air travel surged and oil prices fell.
To explain the fundamentals of commercial airlines in one sentence, they need substantial capital to produce commoditized services that are sold at competitive prices. That’s quite a heavy sentence. Let me break it down for you.
The market dynamics of airlines
Air travel has become a commodity service where the price is the major differentiator. If you have to travel from Toronto to New York, you will opt for the cheapest ticket that is available for the date and time of your travel. Amid the competitive prices of air tickets, business travel comes as a relief. Business travelers are willing to pay a higher price for last-minute bookings. Hence, airlines earn around 60% of their revenue from business travelers that comprise just 12% of passengers.
With globalization, people are flying more. Air travel has become a necessity than a luxury. But air travel demand is volatile and impacted by macroeconomic factors. For instance, air travel demand plunged after the 9/11 attack. However, supply is capital intensive and not flexible.
Airlines pay a huge sum to buy planes and maintain them. They also have a high operating expense of jet fuel. When oil prices fell in 2016, airlines were the biggest beneficiaries as their fuel expense reduced. While demand is volatile, supply isn’t. This imbalance is what makes commercial airlines risky.
How the pandemic impacted the fundamentals of airlines
The pandemic has vanished more than 90% demand. It is not that people don’t want to travel, but the world governments imposed travel restrictions. Airlines grounded their planes and canceled flights to certain routes. The future demand for air travel is clouded. It is on this topic that Miller and Buffett differ.
Miller said, “People love flying. If there is a vaccine, that will eliminate all the issues people have about flying & these will come back very, very quickly.” Whereas Buffett said, “I don’t know that three, four years from now people will fly as many passenger miles as they did last year .”
Bill Miller’s and Warren Buffett’s vision for airlines
Both are correct in their stance. Air Canada stock surged 80% in November 2020 when the vaccine news came. Then it fell as oil prices surged, and the second wave of the pandemic re-imposed travel restrictions. AC has survived 10 months of travel restrictions. Now, the government says that it will be until September for the vaccine to be available to everyone. This means another three to four months of restrictions or maybe more.
Even if Miller is right and people return to flying as soon as the restrictions are lifted, will business travelers return? Microsoft founder Bill Gates and airline bosses believe business travel won’t return to the pre-pandemic level. One reason is, virtual offices and meetings have reduced the need for business travel in many scenarios. What Buffett sees is too many planes, and these planes are burning cash lying idle on the ground.
Considering travel restrictions are lifted, and pent-up demand fills all seats, AC revenue might double or triple from last year. But most of this demand will be from leisure travelers who are sensitive to ticket prices. On top of that, oil prices will surge, and so will the interest burden, thereby hurting AC’s profits.
Both Buffett and Miller agree that airlines are risky. Even if you are eyeing the pent-up demand, invest a small portion of your portfolio in AC.
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Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool’s board of directors. Fool contributor Puja Tayal has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Microsoft.