Is United Continental a Buffett Stock?

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As the world's third-richest person and most celebrated investor, Warren Buffett attracts a lot of attention. Thousands try to glean what they can from his thinking processes and track his investments.

We can't know for sure whether Buffett is about to buy United Continental (NYS: UAL) -- he hasn't specifically mentioned anything about it to me -- but we can discover whether it's the sort of stock that might interest him. Answering that question could also reveal whether it's a stock that should interest us.

In his most recent 10-K, Buffett lays out the qualities he looks for in an investment. In addition to adequate size, proven management, and a reasonable valuation, he demands:

  1. Consistent earnings power.
  2. Good returns on equity with limited or no debt.
  3. Management in place.
  4. Simple, non-techno-mumbo-jumbo businesses.

Does United meet Buffett's standards?

1. Earnings power
Buffett is famous for betting on a sure thing. For that reason, he likes to see companies with demonstrated earnings stability.

Let's examine United's earnings and free cash flow history:

anImage

Source: S&P Capital IQ.

Like many airlines, United's earnings have fluctuated a fair bit over the past several years with the state of the economy. The huge earnings shortfall in 2008, while still bad, looks a bit worse than it really was, since it partly resulted from a $2.3 billion asset writedown.

2. Return on equity and debt
Return on equity is a great metric for measuring both management's effectiveness and the strength of a company's competitive advantage or disadvantage -- a classic Buffett consideration. When considering return on equity, it's important to make sure a company doesn't have an enormous debt-to-equity ratio, because that will skew your calculations and make the company look much more efficient than it is.

Since competitive strength is a comparison between peers, and various industries have different levels of profitability and require different levels of debt, it helps to use an industry context.

Company

Debt-to-Equity Ratio

Return on Equity

5-Year Average Return on Equity

United Continental569%42%N/A*
Southwest (NYS: LUV) 55%3%5%
JetBlue179%5%2%

Source: S&P Capital IQ.
* Negative equity.

United Continental generated an enormous return on equity over the past year, though it's important to keep in mind that the figure is inflated by the company's huge debt-to-equity ratio. In fact, Southwest, often considered the low-cost air carrier, looks more impressive from this table. Even though a 5% historical return on equity is pretty low on an absolute basis, it's probably superior to those of JetBlue and United Continental once you take debt into account.

3. Management
CEO Jeffery Smisek has been at the job since only 2010, but he's had years of executive experience elsewhere in the airline business.

4. Business
The airline industry isn't particularly susceptible to technological disruption, though Buffett has commented in the past that its brutally competitive nature generally makes the industry a terrible investment.

The Foolish conclusion
So, is United a Buffett stock? Probably not. Even though it operates in a technologically straightforward industry, it doesn't particularly exhibit the quintessential characteristics of a Buffett investment: consistent earnings, high returns on equity with limited debt, and tenured management. However, if you're interested in a stock that our top analysts and chief investment officer picked to beat the market, you can check out The Motley Fool's Top Stock for 2012. I invite you to download this special report for a limited time -- it's free.

At the time this article was published Ilan Moscovitzdoesn't own shares of any company mentioned.Motley Fool newsletter serviceshave recommended buying shares of Southwest Airlines. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

Copyright © 1995 - 2012 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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