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In 1989 Warren Buffett’s Berkshire Hathaway bought $358m of preferred stock in USAir. It took only months for the airline’s managers indicate that losses were going to be made in both 1989 and 1990. That news sent the common stock to around $30, far below the $60 required to make it worthwhile for Berkshire to convert the preferred stock to common.
Writing his 1990 letter, wrapping his embarrassment in irony, Buffett told his shareholders that in making the USAir purchase he had “displayed exquisite timing: I plunged into the business at almost the exact moment that it ran into severe problems”. He added that no one had pushed him; in tennis parlance “I committed an ‘unforced error’”.
Almost everything that could go wrong went wrong:
- Low morale.
The resentments of ex-Piedmont employees kept coming to the boil, “an affliction I should have expected since almost all airline mergers have been followed by operational turmoil” mused Buffett in his 1990 letters to BH shareholders.
The resulting operational and service hiccups caused USAir to fall so far from grace that is was ranked as the worst in the industry for on-time performance. Ed Colodny, acknowledging the problems, told the Washington Post in September 1990, “When the economy is growing, growth covers up a lot of sins” (Martha M. Hamilton (1990) USAir Group Flies into Turbulence, September 3).
- Increasingly commoditised industry structure
Buffett blamed the “kamikaze pricing tactics of certain carriers” for accelerating the deterioration in airline industry economics. It was impossible for any airline to escape the downward pressure on fares because the flying-public can easily observe numerous rivals each desperate for their dollar; airlines tend to offer much the same service and therefore passengers shop around for low prices.
When some in the industry are stupid enough to offer prices below operational costs it’s difficult for more rational players to stand apart and try to sell tickets at higher prices, “The trouble this pricing has produced for all carriers illustrates an important truth: In a business selling a commodity-type product, it’s impossible to be a lot smarter than your dumbest competitor.” (1990 letter)
Bankruptcy law made matters worse because airlines were kept operating under bankruptcy court protection, including reducing or eliminating their previous debt burden. Thus, surplus capacity was not eliminated, and, relieved of the cost of debt, the zombie companies tended to price fares aggressively.
- Fatal crash
In September 20, 1989 an inexperienced pilot overran the runway on take-off at LaGuardia resulting in 21 injuries, 2 deaths, bad publicity and damaged employee morale.
- Recession
To squeeze inflation in 1989 the Federal Reserve pushed up interest rates resulting in the real estate boom going into reverse and widespread loss of business and consumer confidence, followed by recession.
The poor outlook was worsened by a more than doubling of oil prices following Iraq’s invasion of Kuwait August 2, 1990. The combination of higher fuel costs and slackened consumer demand was a dreadful mix. Recently added airline capacity was met with little or no growth in demand resulting in carriers facing the dilemma of flying empty or battling to fill seats with discounted fares.
USAir cut its workforce by 7% (3,585 people) and implemented other cost savings but still it racked up loses both in 1989 ($63m) and in 1990 ($454m). Of course, common stock nosedived, all the way to $14.
Despite the troubled first year Buffett, writing in February 1991, was convinced that “our investment should work out all right” but he acknowledged it was less secure than at the time he made it.
Things can only get worse
1990 was a bad year, but 1991 was terrible. In fact, it w………………To read more subscribe to my premium newsletter Deep Value Shares – click here http://newsletters.advfn.com/deepvalueshares/subscribe-1
