Why You Should Follow Warren Buffett and Sell American Airlines Stock

Stocks to sell

On Saturday, Berkshire Hathaway (NYSE:BRK.A, NYSE:BRK.B) had its annual meeting. From it, we learned that Warren Buffett’s company had sold all its positions in the airline industry. In doing so, it liquidated billions of dollars of stock. Those sales included Berkshire’s formerly large position in American Airlines (NYSE:AAL) stock.

Why You Should Follow Warren Buffett and Sell AAL Stock

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In case you weren’t following the annual meeting, Buffett had a clear message. He said that the airline industry has changed “in a very major way.” Buffett said that the major four airlines, including American, would — on average — have to borrow around $10 to $12 billion each going forward.

Buffett warned that this huge debtload would cause a massive decrease in the post-crisis value of the airlines. The companies will deal with more interest costs in the interim, and will need to pay down their debt levels back to more comfortable levels before resuming any dividends or share buybacks. For a company like American, it may not even make it that far, as the company may well end up in bankruptcy.

In addition to the burden of additional debt, Buffett also worries that airline traffic may not come back to previous levels. He said that passenger miles may come back to normal within two or three years, but he suggested that this possibility was far from certain. Even a two to three year recovery period would be a disaster for American, given its tremendous debtload.

Is Buffett Correct?

Of course, it’s fair to question if Buffett is being too pessimistic. His Berkshire Hathaway stock has underperformed the market in recent years. And investors have become increasingly critical of some of Buffett’s decisions lately.

However, don’t dismiss Buffett’s airline warning so quickly. Keep in mind that Berkshire Hathaway owns railroads, it owns Precision Castparts, which makes all sorts of parts for airplanes, and it owns a business in the private jet space, among other things. If you wanted one person who is uniquely informed on the state of aviation, Buffett would be a good choice. His downbeat assessment of the airline industry, thus, is one we have to take seriously.

That’s because American Airlines simply doesn’t have the cash necessary to survive a prolonged downturn. If airline traffic comes back strong within a quarter or two, American has a shot. But that doesn’t seem likely. China, for example, has been reopening business for several months now, but domestic air traffic is still down roughly 50%, and international traffic hasn’t really resumed at all. This sort of modest recovery pace will leave weaker airlines like American in deep trouble.

American Airlines Doesn’t Have The Luxury Of Time

If you’re a low-debt, low-cost airline like Southwest (NYSE:LUV), you can probably survive long enough to make it until the next upturn. If you’re among the most indebted, most challenged airlines out there, like American, by contrast, you’re in deep trouble.

American only has a market capitalization of around $4.5 billion now. How exactly will it raise the $10 to $12 billion that Buffett is talking about to ensure its survival? You can’t realistically issue your market cap in new stock three times over without obliterating the share price. That’d be a jumbo-sized order of dilution.

And it will be awfully hard to sell more debt, given that American has existing debt trading at a massive discount to par. If it does manage to issue more debt, it will be at such a high interest rate that it will eat up a huge chunk of its cash flows. If your business only makes single-digit profit margins in good times and you need an ultra high-interest loan to keep the lights on, there’s simply no easy path to recovery. That’s just math.

The Verdict for AAL Stock

The fact that Buffett just dumped his stock and said that the airlines are in deep trouble may accelerate American’s fall toward bankruptcy. People were counting on Buffett to be the white knight for these airlines. Who is going to step in and help them now with Buffett explicitly saying the businesses may be busted? Buffett rescued the banks — the worst-hit sector of the economy — in 2008. But the airlines today? In his view, they’re seemingly too far gone to be worth investing in.

The most likely path forward is a sharp and swift decline in the price of AAL stock, as it’s the most leveraged major U.S. airline. Raising more funds will be brutal. American could easily lose half its remaining market value in a month or two. The odds of it going bankrupt are high, and, as such, you should be particularly careful holding it for anything other than a short-term trade.

If you hold the view that 50% of airline traffic comes back reasonably quickly — as Chinese data seems to suggest may happen — and then we gradually get back to 80-90% of previous traffic by 2022-23, stronger airlines probably do alright. They’ll be able to raise more funds as investors back the apparent survivors and best-positioned firms.

American, unfortunately, won’t find itself in that group. It needs a major fundraising effort or massive government aid to have a solid chance at having its stock recover. Otherwise, expect the company to reorganize to ease its debtload and get a fresh start.

Ian Bezek has written more than 1,000 articles for InvestorPlace.com and Seeking Alpha. He also worked as a Junior Analyst for Kerrisdale Capital, a $300 million New York City-based hedge fund. You can reach him on Twitter at @irbezek.  At the time of this writing, he owned BRK.B stock, and he was short AAL stock.

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