Not All Executives Are Good Capital Managers… And The Pandemic Just Exposed Them
In a reference to the real value of companies, Warren Buffett has a well known saying… when the tide goes out, it is only then you discover who’s been swimming naked. After a decade of a rising stock market, the Coronavirus (or more so the reaction to the Coronavirus), has definitely caused the tide to go out exposing many investors and the companies (and entire industries in some cases) to be less than they appear. Yes, when businesses are ordered to close, there is not much they can do to generate revenue. But, it’s actually management’s decisions made long ago that will dictate how well a company comes out of a crisis. Specifically, decisions regarding how to use capital or more to point… what they decided to do with all the cash they generated!?!
Exhibit A: The airline industry. From the jump, air travel is a capital intensive business. Airplanes cost a lot of money to produce and just as much to maintain them. Forever, even the investors who view the industry as a good place to invest, they were hard pressed to find any airline that produced a return on capital that exceeded their cost of capital. In our world, we call these companies capital destroyers. But, as they say, every dog has it’s day. For the past decade, the planets aligned and all things air travel all of a sudden had value. So much so, even Mr. Buffett himself (who once quipped he had a support line to call any time he even thought of investing in airlines), was investing across the majority of the airlines. (Note: He sold his positions during the first quarter.)
In his defense, it seemed the industry was finally well situated. Capacity was right sized, the economy was growing, prices were right (for the airlines), and oil prices were down. Like I said, the planets aligned and airlines were creating value… more to the point, free cash flow! Lots of it, at least for this industry. Unfortunately, that’s where the good vibes ended.
Every management’s objective is to create shareholder value. Makes sense, right? As the owners of a company (via stock), you are interested in seeing the value of your investment grow. Management can achieve this by 1) Returning money to shareholders via stock buybacks or paying dividends and 2) Reinvest profits (cash) back into the business for growth and ultimately the stock price will rise. Making these capital decisions is clearly management’s most important job.
So how did the airlines fair in the capital deployment department? As you can see in the graphic, over the past ten years the major airlines had $50 billion in free cash flow and pretty much distributed it all via stock buybacks. Of course, we are viewing this in hindsight, but was it a great idea to spend all your cash on stock in an industry, as noted, is capital intensive… and by the way, has seen business disruptions (beyond their control) in the past? Maybe they should have kept at least a bit of their cash (i.e., keep some powder dry)?
Well, what is done is done but the ramifications will be felt for a while. For example, over the past two years, American Airlines has bought back nearly $2 billion in stock for an average price of $27 a share. In April, as part of their bailout they have given the government warrants to but 14 million shares at a bargain basement price of $12.50 a share (current share price is $16.55). Put another way, American Airlines management had to sell shares at a price at less than half what they paid for them through their stock buybacks. Ouch! Not a great use of capital!
Airlines are never going to be obsolete. We will always need them. Probably more so in the future as this world becomes more and more connected and people want to travel to far reaching areas of the globe. But, from an investment standpoint, the current period for this industry is a real life lesson in what is a company’s managements most critical job… what to do with the cash its business creates (i.e., capital management). Period.
Note: Nothing contained herein this letter should be considered to be investment advice, research or an invitation to buy or sell any securities.