How to value Buffett’s purchase of American Airlines

Disclaimer: This is for entertainment and educational purposes only. This is not investment advice. I am not an investment advisor, nor have I considered your personal situation as your fiduciary. In other words, any investment you make ​​ (or don't make) is completely your responsibility.

American Airline - Ticker AAL

This is one of Buffett’s latest additions to his overall portfolio. Buffett now owns 49,278,854 shares of American Airlines, adding a total of 3,734,000 shares this last quarter. ​​ His shares of AAL are worth $2.494 Billion Dollars. ​​ This is a compelling enough reason to look into AAL and see if it’s obviously on sale at today's price.

I should also note that Buffett’s reported buy price for the company was $42.30. Compare that to today’s share price and you’ll see how close you can get to what Buffett paid to own American Airlines.

Here’s what we need to know

Part 1: Am I capable of understanding this business? (Meaning)

Part 2: Does this business have excellent Long-term Economics? (Moat)

Part 3: Is the Management team honest and disciplined capital allocators?

Part 4: Is the stock seriously undervalued? (Margin of Safety)

AAL Snapshot

(Google, 2017)

As you can see above, AAL has a Market Cap of $24.63 Billion, giving it a current P/E ratio of 12.37 and a fairly small dividend yield of 0.79%. ​​ It’s important to note that the Analysts believe that next year AAL will have a P/E (Something called a; Forward P/E) of 8.65. (Who, if you’re on my email list, you’ll know are almost always wrong…).

It’s also interesting to note that with a Market Cap of $24.63 Billion, Buffett owns roughly 10% of the entire Business.

This means that the analysts are expecting American Airlines to grow at a rate of 12.30% next year. ​​ If they can keep that up, this would likely be a good time to buy this company. ​​ Let’s see what we can learn…

Part 1: Meaning

Most of us (if we’ve done any form of traveling in the US) will have run into American Airlines from time to time. ​​ They are one of the Biggest airlines in the United states, with a mainline fleet of 930 Aircrafts. ​​ They serve 350 destinations in approximately 50 countries. ​​ The Airline industry has undergone a large amount of consolidation over the last few decades, and American Airlines has been strong enough to survive. ​​ It’s also interesting to know that it was founded in 1934 and its current headquarters are in Fort Worth, Texas.

Before Buffett’s recent purchase of airline stocks, most believed he absolutely hated them as a business. ​​ It appears he has since changed his tune;

“It’s true that the airlines had a bad 20th century,” Buffett said in a recent interview on CNBC. “They're like the Chicago Cubs. And they got that bad century out of the way, I hope.”

You can see the classic Buffett humor and honesty shine through in that quote. ​​ I think it’s safe to say that Buffett is putting his money where his mouth is, and really putting his weight behind the idea of a brighter future for airline businesses.

Why Buffett likes Airlines today and the possible Tailwinds that exist (pun intended)

1. A large consolidation in the airline industry provides a more stable fare rate and a quasi-monopoly for the remaining airlines;

-Seats sold (called ‘Load Factor’) increased from 73% to 83% over a 7 year period.

2. Four of the top Airlines (including AAL) now control over 80% of the nation's domestic flights

3. A sharp drop (52% from 2013 to 2016) in fuel costs have increased profit margins.

-This is also likely to continue into the future due to American Fracking now being the main driver in Oil prices. (we can talk more about this another time)

4. Airline began to ‘Unbundle fees’ such as baggage and entertainment, generating billions of dollars for the industry over the past decade.

5. The top 25 airlines now make more than $35 Billion in combined operating profits when compared to the $685 million of just 8 years ago.

I believe I’m able to wrap my head around this business, this means I can move onto the next step.

Part 2: Moat

Although I already alluded to one of the moats above, we must still ask ourselves; “Does American Airlines has a Durable competitive advantage?”.

As far as I can tell, they have two:

1. ​​ Brand Moat: in other words people recognize and trust them and therefore continue to fly.

2. Switching Moat: They are one of the four largest Airlines in the United States, this gives them a Quasi-Monopoly allowing them to garner large amounts of traffic simply due to the availability of specific flights at certain times to specific destinations. ​​ In other words, some people will be forced to use AAL due to availability. ​​ 

As long as American Airlines stays the course, they should be around for a long time. This is what we like to see. Now let’s look and see who’s Piloting this company (Pun’s are just too easy today).

Part 3: Management

This is one of the most difficult and subjective components with investing. And yet, we still want to identify certain qualities that can potentially make for a ‘Next Level CEO’.

What we’re really looking for is ‘Level 5 Leadership’ (from Jim Collins excellent book Good to Great).

American Airline Management

Now we travel to the AAL website to search under Investor relation, so that we can better get to know the CEO and the rest of the management team. ​​ We want to know if this guy or gal is just here for the paycheque, or if they are here for their employees and the owners of the business (the shareholders).

(American Airlines, 2017)

Well, he looks friendly enough… let’s see what the company has to say about him:

Doug Parker was named Chairman and Chief Executive Officer in 2013. He oversees American Airlines Group and American Airlines, its principal subsidiary company.

Previously, Parker was chairman and CEO of US Airways. Before the merger of US Airways and America West Airlines in 2005, he was chairman, president and chief executive officer of America West. Parker became the CEO at America West just 10 days before Sept. 11, 2001, and led the carrier through the crisis.

Under Parker’s leadership, US Airways achieved record revenue growth, operational performance and profit margins that outpaced most industry peers. Parker has been a vocal proponent of airline industry consolidation, which provides a more stable and competitive industry for employees, customers, communities and stockholders.

Parker’s experience prior to joining America West in 1995 includes four years with Northwest Airlines as vice president, assistant treasurer and vice president of Financial Planning and Analysis. From 1986 to 1991, he held a number of financial management positions with American.

Parker received a Bachelor of Arts degree in economics from Albion College in 1984 and a Master of Business Administration degree from Vanderbilt University in 1986.

Looks like a pretty decent track record to me, but let’s see what they employees have to say about our pal Doug.

Doug through the looking glass…

As you’ll know (if you’ve read my other valuation posts) I like to use a website called ‘glassdoor’ ​​ in order to get a feel for how well the CEO treats their staff. Let’s take a look.

(GlassDoor, 2017)

As you can see above, Doug managed to get a respectable 77% approval rating out of the 540 reviews received. This leads me to believe that Doug is likely a decent manager, without doing any more digging I’ll give this one a pass and move onto Margin of Safety before I really want to get my feet wet and really dig deep into this business.

If you want to dig deeper into Doug here, you should look at his pay and bonuses and see if they align with what that of the shareholders. Also, you should look into how much of his own money he has in the business. This is a great indicator of where his values truly lie. (I can't give you all the answers, right?)

Part Four: Margin of Safety

Those are the three most important words when it comes to being a Next Level Investor. ​​ We never want to overpay to own anything, no matter how great the business may seem. ​​ This is what gives us an advantage over the institutional guys. ​​ We have the luxury of simply sitting on our hands and waiting for the price that we decide we want to pay. Remember what our friend Charlie Munger said;

“The Big money is not made in the buying and selling… But in the Waiting”

-Charlie Munger

They, on the other hand, have shareholders to answer to roughly every three months.

It’s great to be us, isn’t it?

Anyway, let’s do a simple DCF using the free calculator found on Gurufocus.

(Gurufocus, 2017)

As you can see, we are 40% below our sticker price. ​​ In other words, we would need the stock to drop by $14 in order for us to pay what appears to be the fair value for this stock. ​​ Now let’s do a reverse engineered DCF to figure out what growth rate is currently built into today's stock price.

(Gurufocus, 2017)

Looking at the image above we see that in order to get our Minimum Next Level return of 15% (our discount rate) then AAL must grow at 10.62%.

Margin of Safety Price

Remember: we want to be as conservative as possible whenever we’re assessing a company. ​​ We can look at the past growth rates, and the current trend of those growth rates and come to a reasonable future growth rate. ​​ The more conservative we are, the less likely we’ll lose money if we are able to buy it at that price. ​​ Buffett’s #1 rule is Don’t Lose Money, and it is ours as well. That’s why we must demand a large Margin of safety.

As you already know from my last post, we always want to pay as little as possible when owning any company. ​​ This gives us both the greatest upside potential, and the least amount of downside risk. ​​ That’s exactly what we are striving to do as Next Level Investors. ​​ 

For AAL, based on our simple Free Cash Flow calculation, we would prefer to pay $18 to own this business. This gives us a 50% Margin of Safety, and with a company like American Airlines, where earnings are seemingly all over the place, we must demand a healthy MOS in order to justify owning this business.

Now let’s look and see what price we are likely to get the business at in the (maybe near) future.

Next Level Margin of Safety Price

Now that we know our fair value price of $36 and our MOS price of $18, we need to figure out what the price we are likely to buy this business for during it’s regular ebbs and flows.

(WolframAlpha, 2017)

This chart was fairly surprising to me. You can see that AAL is very often in the very low P/E territory with an average P/E ratio of 6.08 over the last two year period. It looks to me like we could easily see another P/E ratio of around 4. So let’s use that as our number. This gives us a Next Level Price of:

$16.68

Sound unrealistic? Well, if we look back we find that AAL was selling for that price and lower in 2013. This means we will likely see this price in the future is well (during times of economic turmoil).

Fair value if cheap Fuel continues

If you think these cheap Fuel prices will continue into the future then this valuation would likely change. As I mentioned earlier, cheap fuel means higher margins which leads to greater earnings potential. In other words, if you think cheap prices will continue into the near to mid term, the valuation on AAL would likely have to change.

Fair price for AAL if fuel prices stay depressed:

$30

Conclusion

Well, there you have it. If you're patient and wait for the next market crash, you will likely get to pick this company up at the Next Level Investor price of $18.

However, if you believe in continued depressed fuel prices, than a good place to pick up this stock is at $30.

If you think this might be a Next Level business then you will have to do some more digging into the company. This is just a quick and dirty overview of the business and is just the first step towards making an investment. You need to read the 10K’s and quarterly reports if you really want to get to know how this business operates.

Let me know what you think in the comments section below.