Berkshire Annual Letter (Part 8)
Richard Branson, the owner of Virgin Atlantic Airways, was once asked how to become a millionaire. He had a quick answer to it: “Start as a billionaire and then buy an airline.”
Warren Buffett decided in 1989 to put that statement to the test by investing $358 million in a 9.25% preferred stock of USair. It turned out that Warren’s analysis of USair’s business was both superficial and wrong.
The long history of profitable operations and protection offered by the ownership of a senior security appealed to Warren, but a crucial point was overlooked.
The effects of an unregulated and fiercely competitive market would be severely felt compared to the days when the industry was pretty much protected by regulation. If the cost structure was left unchanged, disaster was bound to happen.
To streamline the costs, major improvements would be needed in all the labor contracts. This is something that most airlines have found it extraordinarily difficult to achieve.
USair was no exception and in 1990-1994, $2.4 billion was lost, wiping out the book equity of its common stock. During this period, preferred dividends was still paid to Berkshire (except for 1994).
One thing that Warren got right was to write into the contract a provision stipulating that “penalty dividends” five percentage over the prime rate would have to be paid whenever dividends were missed.