In a note to investors this morning, Morgan Stanley analyst Rajeev Lalwani assessed Berkshire Hathaway’s (BRK-A, BRK-B) escalating stakes in the U.S. airlines. While investors may not be expecting this to be a step toward a full-scale acquisition, the analyst says the possibility is “not worth dismissing,” with Southwest (LUV) as a “plausible candidate.”
ACQUISITION SHOULD NOT BE WRITTEN OFF: With Warren Buffett’s Berkshire recently disclosing an increase to its overall airline exposure, making the firm a number one or two holder for each of the U.S. airlines “Big 4” – American Airlines (AAL), Delta Air Lines (DAL), Southwest and United Continental (UAL) – Morgan Stanley’s Lalwani told investors that he polled investors and found that about 60% do not expect this to be a step toward a full-scale acquisition of one of them given strong multi-year stock returns, the magnitude of purchase prices, the diversified ownership approach taken thus far, and a risky business model. While he noted that he has no knowledge of any potential transactions, Lalwani pointed out that U.S. airlines have structurally changed for the better following consolidation that has resulted in more pricing power, supply discipline, and a focus on margins over market share. The prospect of Berkshire buying an airline is a possibility that is “not worth dismissing,” he argued, citing the historical precedent of Buffett’s involvement in the rail industry and eventual deal to buy Burlington Northern Santa Fe in 2009. Not only had the rails also seen an improved industry structure resulting in a supply-demand balance and pricing power following a period of capacity cuts and consolidation, but also the BNSF acquisition was preceded by positions in peers Norfolk Southern (NSC) and Union Pacific (UNP), the analyst added.
SOUTHWEST A PLAUSIBLE CANDIDATE: Pointing out that 40% of the investors polled viewed Southwest as the most logical candidate for a takeover by Berkshire, Morgan Stanley’s Lalwani said he also believes the company is a “plausible candidate,” highlighting its domestic focus, robust and sustainable free cash flow, range of growth opportunities, defensible cost structure, and more tenured management team. Additionally, Lalwani noted that while missing from the group, Alaska Air (ALK) is a similarly high quality airline, though the ongoing integration with recently-acquired Virgin America as well as its lower overall size are likely making it a less obvious play.
