9.3 C
New York
Thursday, March 28, 2024

Why Warren Buffett Invested In Southwest Airlines?

By Finbox. Originally published at ValueWalk.

The economics of the airline industry are dreadful. Here are some reasons why I believe so.

  • high fixed costs – employee, fuel, rents (terminal, etc),
  • no pricing power – commodity like pricing which is often dependent on your competitor,
  • violently cyclical – each time the economy sneezes, the industry catches a bad cold
  • capital intensive – simply think of the cost of a single airplane,
  • highly mobile capital assets – if one market is unprofitable, airplanes can be flown to the next location
  • labor intensive – each large airline has tens of thousands of employees,
  • asymmetric exposure to negative events – think 9/11,
  • fluctuating raw material costs – no one really knows what oil prices will do next
  • tight safety, security and other regulations leading to higher cost

Get The Timeless Reading eBook in PDF

Get the entire 10-part series on Timeless Reading in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues.

We respect your email privacy

Timeless Reading eBook

Also read:

Thus, it is easy to understand why Mr. Buffett has been so vocal in his opinions against the industry over the last three decades:

“Since our purchase of US Air, the economics of the airline industry have deteriorated at an alarming pace, accelerated by the kamikaze pricing tactics of certain carriers. The trouble this pricing has produced for all carriers illustrates an important truth: In a business selling a commodity-type product, it’s impossible to be a lot smarter than your dumbest competitor.” – 1990

“As the seat capacity of the low-cost operators expanded, their fares began to force the old-line, high-cost airlines to cut their own. … Eventually a fundamental rule of economics prevailed: In an unregulated commodity business, a company must lower its costs to competitive levels or face extinction.” – 1994 shareholder letter

“The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.” – 2007

“Investors have poured their money into airlines … for 100 years with terrible results. … It’s been a death trap for investors.” – 2013

This is why it was mystifying when he recently bought large stakes in the four large airlines: American Airlines (NasdaqGS: AAL), Delta Air Lines (NYSE: DAL), United (NYSE: UAL) and Southwest Airlines (NYSE: LUV). So I decided to dig deeper into the airline industry, and found something that mystified myself even further.

Southwest Airlines (“Southwest” or the “Company”) has not become bankrupt even once since it started flying in 1971. In an industry beset by bankruptcies, and where some airlines become bankrupt multiple times, this is quite an achievement.

Now get this – Southwest has never made a loss since 1973 – it has 44 consecutive years of profitability. This is a stunning achievement when you realize that this period includes the Arab oil embargo, the Gulf War, the 9/11 and the Great Recession. In fact, in the previous decade, the terrorist attack, a worldwide credit crisis, and the five-fold rise in energy prices have resulted in total financial losses for the US airline industry in excess of $50 billion.

You would be wrong to assume that it is because of their labor advantage. Southwest is one of the most unionized airlines in the US at 83%. And it has never fired or furloughed any employees, and almost never instituted pay-cuts. Its employees are in fact among the highest paid in the industry.

Southwest also does not have pricing power. In fact, they pride themselves on having among the lowest fares in the country.

And despite all this, the Company has not just survived, but thrived as indicated by the fact that it is a 145 bagger since 1980, a CAGR of approximately 15%. This made me very, very curious.


Business Model – Keep Fares Low, Keep Costs Lower, Have Fun

Southwest’s business model can be summed up in one sentence as articulated by co-founder, Chairman Emeritus and former CEO of Southwest Herb Kelleher:

“If we offer our customers a quick, safe and convenient mode of transportation at a very low fare (rivaling that of land travel) and ensure they have a little fun too, why would they choose anything else?”

Southwest’s strategy is to keep fares low and volumes high. Any new route Southwest enters has to have enough local traffic which would support this business model. The principal strategy has been the same since its inception: Focus on the local short-haul traveler, keep the fares low which would increase demand for air travel, provide services at high frequency and ensure the customers have fun. Here is a little example of the fun provided by Southwest.

After zeroing in on a city, Southwest would enter the market with low fares, often much lower than that of the incumbent carriers there. This would lead to the other airlines slashing their fares as well. The lower fares would drive up the traffic as more customers begin choosing air travel; in some cities the traffic has risen by 300%-500%. And within a short time, Southwest substantially increases the number of flights from that city to ensure the customers have frequent, conveniently timed options. This phenomenon has actually been named by the Department of Transportation as the ‘Southwest effect‘ in the early 1990s.

By keeping fares low and following up with multiple conveniently timed flights, the Company increases its market share in its cities of operation. It is in most cases the largest or the second largest airline in its markets by customers. Larger volumes of customers allow it to spread its fixed costs (ground employees, facilities’ rents) across a larger base, ensuring that the Company has a low unit cost of operation per customer. This low unit cost further reinforces its ability to charge low fares and still maintain a profit. The frequent flight availability also ensures customer loyalty.

Because the focus is primarily on the local short-haul customer, aircrafts are scheduled on a point-to-point, not hub-and-spoke basis. The hub-and-spoke system concentrates most of an airline’s operations at a limited number of central hub cities and serves most other destinations in the system by providing one-stop or connecting service through a hub. Any issue at a hub, such as bad weather or a security problem, can create delays throughout the system. Additionally, an extra stop results in unnecessary delays for the passengers. By not concentrating operations through one or more central transfer points, the Company’s point-to-point route structure allows for more direct non-stop routing than hub-and-spoke service and therefore allows better control over delays and total trip time. Also, direct passenger base is more resilient than connecting passenger base, as the passengers might be agnostic to which connecting hubs they fly through.

The fanatic focus on costs comes across in other avenues as well. The Company uses a single class of airplanes – the Boeing 737. This has multiple advantages. This allows for simplified scheduling, maintenance, operations, and training

The post Why Warren Buffett Invested In Southwest Airlines? appeared first on ValueWalk.

Sign up for ValueWalk’s free newsletter here.

Subscribe
Notify of
0 Comments
Inline Feedbacks
View all comments

Stay Connected

157,452FansLike
396,312FollowersFollow
2,280SubscribersSubscribe

Latest Articles

0
Would love your thoughts, please comment.x
()
x