Warren Buffett says this is one behaviour that causes airlines to go broke

Berkshire Hathaway chairman Warren Buffett doesn’t invest in airlines very often.

And it’s for good reason.

According to the legendary investor, the capital intensive nature of the business and frequent bankruptcies have made airlines a tough buy.

In an interview with CNBC on Monday, Buffett called the industry a “disaster for capital” and noted that the glamour of airlines makes them attractive for investors.

Even though Buffett has made money on his past airline investment, he cautions that it is easy for airlines to sink into behaviour that’s detrimental to their own well being.

“It’s a tough business because … you have these huge fixed costs and yet if you take one more person on there’s virtually no cost. So you’re very tempted to sell that last seat too cheap,” Buffett said. “What kills you is when they have too many aeroplanes around and [prices] get down to marginal cost and marginal cost causes you to go broke over time.”

Since, the marginal cost of increasing seat capacity is relatively low, US airlines have been guilty — in the past — of flooding the market with excessive seat capacity to boost revenue. However, the increase in capacity outpaced the growth in demand which led to diminished margins. According to Buffett, airlines should be running their planes with at least 80% of its seats filled.

Southwest airlines aeroplaneWikimedia CommonsSouthwest Airlines Boeing 737.

In the years since the financial crisis, airlines have been far more conscious to practice capacity discipline. However, with their coffers filled with cash from lower fuel costs, airlines are once again tempted to up-gauge their aircraft to larger models in an attempt to drive down unit costs. For instance, 50-seat regional jets are being phased out in favour of larger 76-seat models. At the same time, larger variants of the Airbus A320- and Boeing 737-families have vastly outsold their smaller siblings.

However, it remains to be seen if airlines are up to their old tricks.

In 1989, Warren Buffett invested $US358 million in US Air — now a part of American Airlines. Even though Buffett made a quite a bit of money on US Air when he sold in 1998, the hyper-competitive nature of the industry made for an unpleasant investment experience.

Over the past six months, Berkshire Hathaway has invested roughly $US10 billion in American, Delta, United, and Southwest Airlines. As Buffett noted in the interview, all but Southwest have spent a considerable amount time in bankruptcy. Southwest has reported more than four decades of continued profitability.

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