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  • Writer's pictureIshfaaq Peerally

Airline Stocks are the Worst

If a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.

According to Warren Buffett, airlines are the worst business to be in, and I agree with him, using an exceptional airline as an example.

If there's one airline in America that stands out for its exceptional performance, it's Alaska Air Group (NYSE: ALK). With a robust balance sheet and a strong market position, ALK stands as a premier example of a well-managed airline.

Alaska Airlines, the best airline in America shows why airlines are the worst

With $1.9 billion in marketable securities in addition to $516 million in cash and cash equivalents, Alaska Air Group is well protected against any rainy day and faced the 2020 storm relatively well compared to competitors.

Alaska Airlines, the best airline in America shows why airlines are the worst

Besides, the company's debt maturity is well spread out, with only a 3.5% fixed interest rate on most of the debt. This is a balance sheet that not many airlines can boast about.

Recession: The Cash Flow Devourer

However, despite its impressive financial profile, ALK, like all airlines, is not immune to the damaging effects of an economic downturn. During a recession, even the best airlines can see their cash flows go into the red, sometimes erasing the positive cash flows accumulated over previous years. This volatility is a stark reminder of the unpredictable nature of the airline industry.

Alaska Airlines, the best airline in America shows why airlines are the worst

Alaska Air Group generated free cash flow ranging from $500 million to $1 billion a year for the five years preceding the 2020 pandemic and recession, most of which came from the acquisition of Virgin America in 2016. Organically, there was not much growth in free cash flow, and any growth is easily eroded during an economic downturn.

The Intrinsic Value Challenge

To calculate a company's intrinsic value, we often turn to a method advocated by Warren Buffett: the Discounted Cash Flow (DCF) analysis or using Owner's Earnings instead of Free Cash Flow. Either way, it depends on our ability to predict future cash flows, and when it comes to airlines, this is hard to do.

With airlines, accurate prediction is a daunting task. The airline industry is subject to a myriad of external factors that are beyond its control. Fuel prices, geopolitical events, economic downturns, regulatory changes, and technological disruptions all play a role in an airline's financial performance.

In the case of Alaska Airlines, while the company can stabilize maintenance capital expenditures, much will be spent in the coming years on growth by buying new aircraft. Switching to an all-Boeing fleet will save cost over the long term, but anything can happen in the short term.

Alaska Airlines, the best airline in America shows why airlines are the worst

Alaska Airlines, the best airline in America shows why airlines are the worst

This pattern is common among airlines, as written by Warren Buffett in his 2007 letter to shareholders.

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.

The Importance of a Margin of Safety

That doesn't mean that we should not invest in airlines. Airlines are cyclical stocks and investing in an airline as we are coming out of a recession with fuel prices dropping might be a good idea.

However, given the inherent unpredictability of future cash flows, a large margin of safety is crucial when investing in airline stocks. This margin of safety provides a cushion against adverse events and helps to ensure that the investment still offers a positive return even if the actual results fall short of the predictions. Also, savvy investors should know when to take profits, sometimes even before the stock price hits the intrinsic value.

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