Southwest Airlines: Don't Be Tempted To Join The Bandwagon

Dec.13.13 | About: Southwest Airlines (LUV)

Investors in Southwest Airlines (NYSE:LUV) are adding to 2013's momentum following a bullish research report from analysts at Bank of America.

After shares nearly doubled in 2013, and given the terrible track record of the airline industry, I would stay away, even at this bright spot within the industry.

Bank Of America Turns Bullish

Analysts at Bank of America/Merrill Lynch (NYSE:BAC) are bullish on the prospects for Southwest, upgrading the shares from "Neutral" to "Buy." The accompanied price target of $23 per share suggests some 28% upside from Wednesday's closing levels.

Analyst Glenn Engel believes the tide is turning in the company's favor. The carrier will benefit from growth at Love Field, with the Wright Amendment's restriction expiring, as well as expanded international flying.

Furthermore Engel sees the travel bookings showing better momentum compared to corporate travel. Southwest is focused on travel and leisure flying, having less exposure to the corporate market. As a result of a modest 1-2% growth in domestic supply, demand for Southwest's seats is outpacing supply growth boosting pricing.

Engel furthermore notes that while the cost advantage versus competitors has narrowed over the past decade, the situation has stabilized and could increase again. On top of these tailwinds, investors might benefit from a dividend hike and accelerating share buybacks.

Valuation

Warren Buffett, among others, famously quoted that investors have no business being involved in the airline industry. The industry is very competitive and many investors have lost a lot of money investing in airline carriers.

At the end of October Southwest released its third quarter results. The company ended the quarter with $3.3 billion in cash, equivalents and short-term investments. Total debt stands at $2.9 billion, resulting in a healthy net cash position of $0.4 billion.

Revenues for the first nine months of the year came in at $12.5 billion, up 3.0% on the year before. Lower oil prices which resulted in a lower fuel bill boosted earnings which rose by 58% to $542 million. Full year revenues are seen around $17.5 billion at this pace, while earnings could come in around $750 million.

Trading around $18.50 per share, the market values Southwest at $13.5 billion, or operating assets just north of $13 billion. This values equity in the firm at roughly 0.75 times annual revenues and 17 times annual earnings.

The quarterly dividend of $0.04 per share provides investors with an annual dividend yield of 0.9%.

Some Historical Perspective

While it is hardly impossible to make money in airline stocks, Southwest might be the only exception. First hour investors who held the stock for decades have seen solid returns while most competitors have been involved in (numerous) bankruptcies over time.

Over the past decade however shares have seen stagnation. Shares traded around $15 per share between 2004 and 2008, falling to lows of just $5 in 2009. Shares have recovered and have seen strong year to date returns of 80% to current levels at $18 per share.

Between 2009 and 2013, Southwest is set to increase its annual revenues by a cumulative 70% to $17.5 billion. The bottom line has been volatile, but Southwest has been posting earnings in recent years.

Investment Thesis

Even as shares of Southwest have hardly moved over the past decade, its shares have fared relatively well compared to other airline stocks. The company turned modest profits many years in a row now, making it an exception within the industry. Strong holiday bookings should result in a strong end to the year.

Other large drivers of this year's performance have been the integration process of AirTran into the company, realizing $400 million in net pre-tax synergies by 2013. On top of that Southwest will open its first international terminal next year, starting services to the Caribbean, Mexico, Central America and South America.

Besides these operational achievements, Southwest has boosted payouts to investors as well. Over the past two years, Southwest has retired little over a billion worth of its own shares, or 6-7% of the share base at current prices.

While all of this looks nice, be aware of the terrible track record of the industry, even as Southwest is an exception. Analyst Engel sees earnings of $1.25 per share in 2014, still implying a price-earnings ratio of 15 times which seems too expensive in light of 2013 peak earnings, the volatile nature of earnings and the strong momentum in 2013.

I have to agree with Buffett and will never put a dime in a flight carrier's stock in my investment career. I'll pass and won't follow Bank of America's optimism.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.