Recently, I’ve been spending quite a bit of time pondering airlines. Perhaps out of concern that someone could violently drag me down United’s tiny aisles! Good thing I don’t fly United…but I kid, of course.
What has caught my attention is Buffett. He now owns approximately $10 billion of airline stocks. And for anyone that has followed Buffett over the years, this is unusual not least because he’s never minced words with respect to airline industry economics:
“The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, then earns little or no money. Think airlines. Here, a durable competitive advantage has proven elusive 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.” -Buffett
Following the disclosure of his airline investments at the end of 2016, here’s what Buffett had to say:
“It’s true that the airlines had a bad 20th century. They’re like the Chicago Cubs. And they got that bad century out of the way, I hope…The hope is they will keep orders in reasonable relationship to potential demand.” –Buffett on CNBC
Buffett’s thesis appears to be industry rationality (finally!) now that the industry has consolidated down to 4 major airlines.
Although that could very well be the thesis, it just didn’t feel like the full story to me. After all, memory chips is a consolidating industry, why not own memory chips? Oil and gas services is a consolidating industry, why not own oil and gas service providers? This last comparison is even more compelling when you consider that a company like Schlumberger has much more differentiated technology than peers, whereas every airline offers essentially the same product.
I believe the critical insight is in recognizing that the airline industry now generates a significant amount of “float” and evolution of the airline business model has made it much more similar to an insurance operation.
Modern Airline Business Model
To understand why, we need to understand how airlines make money today. By chance, I came across the excellent Bloomberg article, Airlines Now Make More Money Selling Miles Than Seats, which makes the following points:
- Airlines now make more money selling miles than seats.
- Many customers carry airline branded cards that earn miles. Banks are responsible for rewarding those miles and buy those miles from airlines at 1.5-2.5 cents each.
- Revenue from mile sales is estimated to be up to 3x the final cost to an airline (e.g. margins of 66%).
- Miles are earned and paid for far in advance before redemption.
“Float”-ing Miles in the Air – Similarities to Insurance
The last point in the list above is key – by virtue of earning the vast majority of income from selling miles that won’t be redeemed for months or even years, airlines have essentially created float.
In insurance, an insurance company receives payment upfront with the promise to pay in the future upon a contingency. In the airline industry, airlines now receive the vast majority of income upfront with the promise to dispense seats/services in the future. That is the essence of float.
In insurance, an insurance company can generate an underwriting profit if premiums received exceed payouts. Similarly, airlines can generate an “underwriting profit” if miles expire, if customers forget to redeem miles, or even if customers develop the habit of accruing miles far faster than they redeem (which is very likely the case).
Airline Float Better than Insurance Float?
Risking the potential that I’ve taken this idea to far, I do wonder if airline float could even better than insurance float:
- Insurance float is not costless on average since the industry tends to generate underwriting losses with the intention of making it up via investments. Airlines do not appear to suffer from this underwriting tragedy.
- Insurance contingent liabilities are fairly fixed (e.g. you know the value of the house insured or car insured or life insured), but the value of a mile can change over time (e.g. if necessary, an airline can significantly devalue miles).
- Monoline insurance leads to exposure to a very specific sector/area (e.g. housing, healthcare, autos), while airline miles are generated via card spending, which is diversified across a number of industries (but most likely concentrated on high frequency, day-to-day spend).
The points above are likely oversimplified, but I believe there are merits to the argument. Taking the miles business model into mind and similarities to insurance “float”, airlines as an investment would appear to be much more Buffett-like.