Last week, United Airlines (UAL -1.21%) reported strong Q3 results that easily surpassed analysts' expectations. It also offered up a bullish forecast, telling investors that profits are set to exceed pre-pandemic levels in the fourth quarter, with more growth ahead.
Sounds pretty good, doesn't it? And despite this rosy forecast, United Airlines stock trades for just seven times forward earnings. Yet Warren Buffett wouldn't dream of buying this airline stock today -- even though Berkshire Hathaway owned it just a few years ago. Here's why.
Image source: United Airlines.
The historical problem with airlines
Warren Buffett has had a love-hate relationship with airlines over the years. Berkshire invested in USAir in 1989: a move that Buffett later regretted, even though he escaped in 1998 with a big gain. (The airline filed for bankruptcy twice between 2002 and 2004.) After this experience, Buffett wrote in Berkshire's 2007 shareholder letter:
The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers.
Buffett maintained this stance for many years. However, in late 2016, he started to invest in the airline industry again, including a big stake in United. A key reason for Buffett's change of heart was that a wave of consolidation and more rational management had made the largest U.S. airlines much more careful about growth and capital spending. This paved the way for higher profitability and returns on invested capital across the industry. (Buffett subsequently exited all of Berkshire's airline investments in the early months of the COVID-19 pandemic.)
Unfortunately, United Airlines may be abandoning caution in pursuit of faster growth and higher future profits. That would make Buffett extremely wary of United Airlines stock today.
Huge capital spending ahead
Last year, United Airlines unveiled an aggressive five-year growth strategy. The airline set a plan of expanding capacity at a 4% to 6% compound annual growth rate between 2019 and 2026 to drive earnings growth by increasing connectivity and reducing unit costs. At the midpoint, this plan implied 41% capacity growth over 2019 levels by 2026.
To enable this growth, United is ramping up capital expenditures. The airline has committed capex of $3 billion for the last quarter of 2022, $8.4 billion for 2023, and $6.9 billion for 2024. Including non-aircraft spending, which often isn't contracted far in advance, capex could easily total $20 billion over the next nine quarters.
In 2019, its best year ever for cash flow, United Airlines generated just under $7 billion in cash from operations. Even if United matches that figure for the next two years, free cash flow will be negative over this period, requiring the airline to significantly increase its adjusted net debt, which already exceeds $20 billion.
United Airlines cash from operations (annual), data by YCharts.
Capex is currently scheduled to moderate somewhat beginning in 2025. But United is looking to place a large order for wide-body jets later this year. That could increase its future capital commitments by $10 billion or more and keep capex high for the foreseeable future, making it hard for the airline to strengthen its balance sheet.
All in search of uncertain profits
Thus, United Airlines stock has two strikes against it in Warren Buffett's book. First, United aims to grow quickly: Whereas capacity has been well below pre-pandemic levels this year, management is targeting capacity roughly 30% to 50% higher than 2019 by 2026. Second, the company is spending lavishly on new jets to support this growth.
This aggressive plan could still pay off handsomely for shareholders if air travel demand continues its recent surge. In that scenario, rapid capacity growth would translate to higher revenue and dramatically higher earnings and cash flow. Management is optimistic about the future, believing that the growth of hybrid and remote work will permanently increase demand going forward.
It's certainly plausible that more flexible work arrangements will lead to permanently higher leisure travel volumes. But it's also possible that pent-up demand will subside over the next year or two, particularly as inflation continues to crimp discretionary budgets. If United and its competitors ramp up capacity beyond pre-pandemic levels just as demand starts to waver, airfares would likely plunge, crushing airlines' profits.
That would lead to Buffett's nightmare scenario, with United's big investments failing to generate adequate returns. As alluring as United Airlines stock might seem right now, prudent investors should follow Warren Buffett's advice and look for better investment opportunities elsewhere.
