We started the quarter with a 15.0% position across five airlines: Ryanair, Delta, Southwest, Hawaiian and United. With share prices falling between 34.0% (Southwest) and 64.4% (Hawaiian), they together cost the portfolio 8.4% and by the end of the quarter they represented 11.5% of the Fund (although we had sold Hawaiian).
Our rationale for investing in these businesses was that all were achieving (and had been many years), acceptably high returns on their invested capital (ROIC), and were trading at prices in-line with our valuations. Based on the Fund’s weighted average positions and their share prices at the start of the quarter, these airlines offered a free cash flow yield of 7.6% and a net profit yield of 9.8%. As for the quality of the businesses – their ROIC over the last 8 years has been close to 20%, and their annual sales had increased by 5.1% on average over the last three years. And as for risks, we were comfortable with their short term financing arrangements and we felt their average fixed charge ratios ranged from tolerable (for Hawaiian and United) to acceptable (for Delta and Southwest) to comfortable (for Ryanair).
These businesses all reported solid operating results for the periods to the end of last year. Aside from some concerns in relation to Hawaiian (increasing competition from Southwest, regulatory problems with proposed code share arrangements, and clampdown on accommodation providers in Hawaii), we were comfortable with our holdings. And, in what hindsight clearly suggests was poor timing, we actually bought a little more United in early February.
Then along came Covid-19. We were not smart enough to quickly predict the extreme ramifications, and as they became increasingly apparent, we felt the sudden mark-down of prices was extreme. Our thinking was (and still is) that air transportation is not an industry that will simply fall by the wayside. We are in no doubt there are difficult times ahead. We do not dismiss the possibility of changes in the way we travel, and we foresee a period of general hesitation. But unlike, for example, large scale cruise line tourism, we believe air travel will re-emerge largely unscathed within a reasonable timeframe.
The obvious question then is: how has the value of these businesses been impacted? Firstly, let’s acknowledge that in order for a business to have any value in the current environment it needs to actually exist in the future environment (when we assume things will have recovered). So our imperative was to try assess the risk of business failure, first by estimating out how long each airline could survive with no revenue, and then also trying to assess their ability to raise additional capital if necessary. The analysis led to us having concerns with Hawaiian, and we sold that position.
Then came the news of the $2 trillion stimulus and the subsequent passing of the Coronavirus Aid, Relief, and Economic Security Act (CARES Act), which stipulates a $50 billion airline component. At the time of writing, the airline’s submissions to US Treasury have provided greater clarity on the actual ‘cash burn rates’, and the grants (and their broad terms) have been announced. This increased our confidence of their survival. But now we need to consider the likely costs of this, the additional capital likely to be required (and the likely terms of those issues), and the values of these businesses over the longer term.
The last of these is the easiest for us to predict and the one we have the most confidence. In our view, the business values are unlikely to be materially different in say, ten years time, to what they would have been had there not been Covid-19 pandemic, way back in 2020. In fact, past incidents like this have proven to be catalysts for industry consolidation resulting in fewer but stronger participants and more rational pricing. We have already seen in Europe the collapses of Flybe, the UK carrier (in early March), and Germanwings (the Lufthansa subsidiary) in early April. Both will be to the benefit of Ryanair.
However, although the business values may be unchanged, the share of value between stakeholders (debt and equity) is expected to materially change. We have applied the new information in relation to CARES Act grants and loans, and refined our assumptions on cash burn rates and the likely additional capital required. Based on that analysis, we foresee the underlying equity values to be impaired to varying degrees, and to the extent that we feel justified (but very disappointed) with selling Hawaiian, and we have since started to divest our United position.