Southwest Airlines, Strategically Positioned For Long-Term Success (NYSE:LUV) (2024)

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Southwest Airlines Co. (NYSE:LUV) is a great company with a superior business model and operational strategy, a strong balance sheet, and now an attractive valuation due to investors being overly focused on potential short-term stock price and earnings volatility. This presents an attractive opportunity for long-term oriented investors. It is my conclusion that this company's stock is undervalued, with a significant margin of safety. Reasons that the market has placed this stock at value include:

Reintroduction of volatility into the stock market
Concerns about other airlines increasing capacity and pushing fares down
Concerns about the price of oil and labor headed into 2018/2019
Historically, poor performance and conditions within the industry

Company Overview

Southwest Airlines is currently the second largest U.S. airline in terms of market share captured. Southwest achieved its 45th year of consecutive profitability in 2017 and ended the year with operations in 100 destinations across 40 states and ten near-international countries, with over 4000 departures per day. Unlike some of the other major airlines, Southwest just recently commenced international service in 2014, leaving it plenty of room to grow. Southwest will also commence service to Hawaii this year.

Business Model and Operational Strategy

Southwest Airlines provides Point-to-Point service rather than the Hub-and-Spoke service the other major airlines provide (United Continental (UAL), American Airlines (AAL), Delta Air Lines (DAL)). Each model has its advantages and disadvantages, but the way Southwest executes the Point-to-Point model gives it considerable cost and competitive advantages. The hub-and-spoke model concentrates most of an airlines operations and services on a few major "Hub" cities and serves its other destinations by providing one-stop flights or connecting flights through one of its hub cities. The point-to-point business model that Southwest operates allows it to fly more direct and nonstop flights. In 2017, about 76% of Southwest's customers flew nonstop. This business model allows Southwest to provide quicker, more convenient flights than most of its large competitors. Also, in the last two years, Southwest has introduced the Boeing 737-800 and Boeing 737 MAX 8 into its fleet, and these larger aircraft allow the company to increase capacity as well as more economically provide nonstop long market-connecting flights (L.A. to Nashville, Las Vegas and Orlando, etc.).

Southwest has another unique strategy that complements its Point-to-Point business model; it exclusively operates Boeing 737s. This strategy affords Southwest lower maintenance and repair costs, as well as lower training costs (don't have to teach pilots to fly new planes or mechanics to fix new planes). Southwest also keeps a relatively modern fleet with an average age of 11.8 years as of the end of 2016, which is most likely even lower now with the 2017 retirement of the Boeing 737-300 classic fleet and the started incremental adoption of the Boeing 737 MAX 8 aircraft. This is compared to an average age of 17 for Delta Air Lines, 14.3 for United Continental, and 10.8 for American Airlines. The relatively younger fleet also contributes to Southwest's lower maintenance costs and Capex. These strategies result in Southwest having lower unit costs (CASM - cost per available seat mile) as shown in my comparable statistics sheet (that I compiled from the various companies' 2017 and 2016 8-K earnings reports). This sheet also lays out other important metrics used to measure performance in the airline industry such as Load factors (utilization), and ASMs (Available seat miles - Capacity). Some other strategies that help Southwest keep its unit costs low and achieve the levels of continuous profitability that it has are:

Operating out of smaller, cheaper, and more conveniently located airports
Utilizing a random boarding process (which was shown on Mythbuster's to be the fastest way to board a plane) allowing for quick turnaround times
Investing in continuous fuel efficiency improvements

Industry Dynamics

The airline industry has historically been volatile, labor intensive, technologically intensive, energy intensive, capital intensive, cyclical, seasonal (higher sales during Q2 and Q3), highly regulated, highly taxed, and very competitive. Recently though, there have been significant improvements recently due to factors varying from industry consolidation to fleet modernization to technology improvements. Since 2002, load factors have increased from an industry average of around 70% to over 84%. The industry is also now realizing tax benefits as its high tax burden has been reduced with the passage of tax reform. In this industry, it is vital for airlines to keep their cost structures low and thus restructuring and continuous modernization have become staples of the industry. The industry is likely to remain competitive in the future, and its future performance will be dependent on U.S. GDP and business cycles, oil prices and jet fuel prices (crack spread), labor laws, and future tax laws.

Outlook on Southwest's Key Costs

Labor:

Historically, Southwest's highest cost has been labor, which last year amounted to 34.6% of the company's revenue and accounted for 41% of total operating expenses. This is significantly higher than the 5-year average of 31.5% of revenue, but Southwest may continue to face high labor costs like those in 2016 (33.3% of revenue) and 2017 (34.6% of revenue). As mentioned in the most recent 10-K, Southwest's labor is approximately 83% unionized and it has seen increasing costs in the past few years. I think it is reasonable to assume that these costs will remain a high and at a high percentage of revenue over the next few years. These numbers are also dependent on unit costs and revenues, so if we see improvement in those areas, this number will come down as a percentage of revenue even if the expenses remain high.

Fuel:

The next largest cost for Southwest is fuel and oil expense. For 2018, management provided guidance in the 2017 Q4 conference call estimating that the cost the company would pay per gallon of fuel will be around $2.10-2.15 (which will correspond to around 20% revenue based on historical unit productivity and efficiency). This is slightly higher than Southwest's historical average of $2.10/barrel for the years 2003-2017. It is important to note though that the price of fuel is extremely volatile and depends both on the price of oil and the crack spread (spread between cost of oil and cost of jet fuel, refining cost). Since 2003, fuel and oil expense has fluctuated from being as low as 16.5% of operating expenses and as high as 37.7% of operating expenses (last year fuel costs were 19.4% of revenue and 22.8% of operating expenses, and despite this volatility, I think that the $2.10-2.15 range represents a normalized level of fuel expense for Southwest Airlines and thus, does not skew the company's current valuation one way or the other). Southwest is one of the few large airlines with current hedges in place, which has increased its costs relative to its competitors in the last few years when the price of oil has been historically low but has been starting the pay off now with the price of oil rising at the end of 2017 and beginning of 2018. Another thing to note is that Southwest has been investing heavily in both fleet upgrades, technology, and route improvements to maximize its use of fuel and in the years 2012-2017 alone has increased its ASMs per gallon of fuel from 71.7 to 75.2.

Source: 10-K

Competitor Overview

United Continental Holdings:

United Continental airlines is one of the major legacy airlines that operates a hub-and-spoke business model. United offers flights to over 337 airports across five continents. United's largest hub is the George Bush Intercontinental Airport in Houston. In 2017, United captured 15.8% of the U.S. passenger air transportation market. United has a debt-to-equity ratio of 1.55, TTM ROIC of 13.38%, a load factor of 82.4% (2017), RASM (revenue per available seat mile) of 14.38 (2017), and CASM excluding fuel costs of 10.24 (2017). United paid an average of $1.74/gallon of fuel in 2017 and ended the year with a total fleet size of 1262 aircraft with an average age of 14.3 years. Its newest aircraft are 32 Boeing 787 Dreamliners with an average age of 2.5 years.

Financial Analysis

Southwest Airlines has the strongest balance sheet and highest returns on capital in the industry. This is reflected especially when looking at the Debt/Equity, and ROIC metrics. The fact that Southwest has the lowest amount of leverage and still boasts the highest returns on capital is impressive. When looking at CASM, Southwest has the lowest unit costs out of all the major carriers and is only rivaled in that metric by the smaller ultra-low-cost carriers like Spirit Airlines. This allows Southwest flexibility that the other major airlines don't have. If price-wars were to intensify and it's looking like they might with UAL's recently announced capacity expansion plans (2017 Q4 conference call), this most likely would be negative for Southwest, but it wouldn't be nearly as negative as it would be for the other major airlines. This is an industry with volatile input expenses and intense competition and yet Southwest has still managed 45 years of consecutive profitability, a statistic that is unrivaled in the industry. Another important metric in the airline industry is load factor. Southwest's load factors of 83.9% and 84% for the years 2017 and 2016 respectively, are slightly above the industry average of 83.6%, falling behind only Delta, and Alaska. Looking at fuel costs, Southwest has paid more than its competitors in the last few years due to its various hedge positions and the relatively low price of oil. I think this trend may change in the future, and if it does, Southwest is in a much better position to face it. When thinking about potential adverse future scenarios that could negatively affect the industry such as rising oil/fuel prices, price competition, and low GDP growth/recession, Southwest is much better positioned strategically in terms of capital structure, cost structure, hedging contracts, and overall business model than any of its peers.

Altman Z-Score Analysis

The Altman Z-Score is a mathematical formula that uses data from a company's income statement and balance sheet. The Z-score weights five different financial ratios to evaluate the financial health of a company and has boasted a 72% accuracy at predicting bankruptcy two years in advance.

Interpretation:

Z-Score > 2.99 = Safe Zone

1.81 > Z-Score > 2.99 = Grey zone

Z-Score < 1.81 = Distress zone

One quick caveat to note is that the Altman Z-Score varies in effectiveness for different industries. The predictive power of the final score has also been questioned in recent years. Despite this, it is still a useful tool to use to compare companies within the same industry, and it is especially insightful when the different ratios used are analyzed.

Altman X1 - Working Capital/Total Assets:

This ratio can tell us a lot about the short-term financial position of a company. Negative working capital isn't always a bad thing though and is very common in the airline industry, so the X1 statistic may skew all the final Z-Scores slightly down. One reason working capital is negative in the airline industry is because of the large number of tickets that are purchased in advance, which are reflected as a current liability on the airline's balance sheets. Most of the scores are pretty in line, with DAL being the lowest due to its higher level of current liabilities which from a quick glance looks like it's from a recent spike in accounts payable.

Altman X2 - Retained Earnings/Total Assets:

The purpose of this ratio is to measure how much a company relies on debt, (if a company has low retained earnings it must use debt to fund its asset purchases) with a high score indicating less reliance. As you can probably guess from earlier descriptions of peers, Southwest scores considerably higher here, and American (much more leveraged) scores very low.

Altman X3 - EBIT/Total Assets:

This ratio is a variation of return on assets which measures a company's ability to generate profits from its assets. Southwest again scores the highest on this metric, and American again scores the lowest.

Altman X4 - Market Cap/Total Liabilities:

This ratio is intended to show how much a company's price could decline before liabilities exceed assets. This ratio though has received a lot of criticism because if a company has a higher stock price, it will score better. Most of the companies in the industry though do have similar and reasonable valuations (a company like Tesla (TSLA) would still score very high despite possible financial weakness), so I don't think the score is too skewed by this statistic. The main reason Southwest scores a lot higher on this metric is because it has significantly less total liabilities than its peers.

Altman X5 - Sales/Total Assets:

This is the same as the asset turnover ratio used in Dupont analysis. It just measures how many dollars in sales a company generates for each dollar of assets. Most of the airlines scored in line with each other on this metric with Southwest and United scoring the highest, and Alaska and Spirit scoring the lowest.

Calculation:

The final Z-Score is calculated with the formula Z = 1.2 X1 + 1.4 X2 + 3.3 X3 + 0.6 X4 +1 X5.

Interpretation of final results:

The results place Southwest as the only company in the safe zone, Alaska, Spirit, and Allegiant in the neutral grey zone, and Delta, United, and American in the distress zone. Regardless of the actual predictive power of the Altman Z-Score, I think the score along with its individual ratios provide significant insight into the financial health of these companies, and it is easy to see that Southwest is the clear winner here.

(Source: My own chart, financial data from most recent 10-Ks and 10-Qs)

Valuation

Earnings Yield:

Southwest Airlines currently trades on a TTM P/E of 10.05 and a forward P/E of 11.51, offering an earnings yield of 10% or 8.7%, respectively.

Dividend and Share Buyback Yield:

Though Southwest's dividend yield is quite small at 0.78% (TTM) or 0.87% (Forward), management has been consistently buying back stock with a three-year average share buyback yield of 4.20%.

Historical P/E:

In the last 7 years, Southwest Airlines has traded at average and median P/Es of 19.33 and 15.18, respectively. This is significantly higher than where Southwest trades today and is most likely reasonably indicative of where Southwest will trade at in the long-run. Applying these multiples to 2018 forward earnings estimates would result in share price of between $75 to $95. On a TTM earnings basis, after adjusting for the Q4 tax benefit and applying a likely 2018 tax rate, the share price would be between $66 and $82.

FCF yield:

Southwest currently trades at a TTM price-to-free cash flow ratio of 21.07, offering a free cash flow yield of around 4.8%. This is another area that Southwest should see improvement in due to both the tax reform and lower Capex for 2018 and 2019 (as mentioned in the 2017 Q4 conference call).

Conclusion

Based on Southwest Airline Co.'s current market price, it looks like investors are throwing the stock out with the rest of the airline industry and ignoring the fact that it is much better strategically positioned than its competitors. Gauging current market sentiment, I see worries about increases in the price of oil, worries about legacy airlines (especially United) overextending themselves with capacity increases and driving down fares, and the beginnings of worries of a larger market correction. While it is true that these factors could negatively affect Southwest's earnings over the next couple of years, they won't be affected nearly as much as their competitors, and none of them will materially affect the company's normalized earnings power nor impact its position at the forefront of its industry. The reality of the situation is that this is a great company, in a historically poor but improving industry, that is now priced at an attractive level due to investors being overly focused on potential short-term stock price and earnings volatility. If you have a long-term time horizon, Southwest Airlines deserves a place in your portfolio.

ValueResearcher

Long-term value-oriented investor. Manage my personal account. Natural contrarian who is passionate about learning and independent thinking.

Analyst’s Disclosure: I am/we are long LUV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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