American Airlines has announced a new financing initiative that will significantly dilute shareholder value. Warren Buffett was right to quit.
After Warren Buffett dumped the big four U.S. airlines in April, he gave the reason:
We will not fund a company … where we think that it is going to chew up money in the future.
Less than two months later, American Airlines (NASDAQ:AAL) is proving the Berkshire Hathaway (NYSE:BRK.A) chairman and CEO right.
The heavily-indebted airline is now seeking to add to its debt. On Sunday, American revealed that it would be raising $3.5 billion in new financing. American’s debt at the end of the first quarter stood at $34 billion.
After entirely exiting his stakes in the four major U.S. airlines, Warren Buffett came under instant fire.
Among those who criticized him included President Donald Trump and Raytheon Technologies CEO Gregory Hayes. Trump called Buffett’s move a “mistake” while Hayes said Buffett was wrong about the future of airlines.
To add insult to injury, the airline stocks went on to rally after a brutal selloff–leading many to question Buffett’s judgment.
The big four U.S. airlines are still a favorite among millennial investors. The four–American, Delta Air Lines (NYSE:DAL), Southwest Airlines (NYSE:LUV), and United Airlines Holdings (NASDAQ:UAL)–are among the top 35 stocks on Robinhood that saw the largest increase in new investors over the past 30 days.
American Airlines is in the fourth position, having amassed over 100,000 new holders in the past month.
At the time Buffett sold Berkshire’s entire stakes in the big four airlines, there was talk that the injection of government funds would dilute shareholder value. In the case of American Airlines, that fear has now materialized even with government loans absent from the picture.
American’s financing plans will see the airline sell stock worth $750 million. The carrier will also grant shares to underwriters worth $112.5 million.
This will introduce nearly 54 million new shares to the market, further diluting the current shareholders. That’s about 12% of the carrier’s total number of outstanding shares.
Another observation Warren Buffett made while announcing his exit was that the “world had changed for the airlines” following the pandemic.
Even as lockdown measures ease and economies begin to reopen slowly, passenger numbers are still on a painfully slow path to recovery.
On June 18, the Transportation Security Administration reported the highest number of air travelers since March 20 (576,514).
But this was just a fifth of the number recorded on the same day in 2019, offering more proof that normalcy in the airline industry is still a long way off.
Although Warren Buffett tried to sound optimistic about the future of airlines post-pandemic, he likely feared for the long-term sustainability of some carriers. If so, American would not have been far from his mind.
If the price of its credit default swaps is anything to go by, the chances of American Airlines going bankrupt are increasing by the day.
Between February 20 and May 15, the price of American’s five-year credit default swaps rose by 4,000%.
As a financial derivative that allows investors to offset their credit risk with a counterparty, the higher the CDS price, the higher the chances that the market thinks there will be a default.
Warren Buffett may have been criticized for exiting airlines. But Sunday’s move by American proves he was right to exit and salvage what little is left of the industry before more damage ensues.
The Oracle of Omaha’s last laugh is well deserved.
Disclaimer: The opinions expressed in this article do not necessarily reflect the views of CCN.com and should not be considered investment or trading advice from CCN.com. The author holds no investment position in the above-mentioned companies.
Last modified: September 23, 2020 2:01 PM