Why Southwest Airlines Has More Room To Soar

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 |  About: Southwest Airlines Co. (LUV)
by: Jon Hill

Summary

The airline industry has turned itself around and has strong fundamentals going forward.

There's great potential for future growth through the impact of acquisitions, expansion into additional markets, and growth in passenger fees.

Southwest is up 21% year to date, and with an ongoing share repurchase program has the potential to do even better in the coming months.

Going by the advice of Warren Buffett, one would never even consider buying an airline these days. During an interview in 2002 with the London newspaper The Telegraph, he famously said that "if a capitalist had been present at Kitty Hawk back in the early 1900s, he should have shot Orville Wright. He would have saved his progeny money."

Those comments aside (Warren actually ended up making money on the US Air deal that caused this statement, though not without some headaches), Southwest Airlines (NYSE:LUV) is looking very attractive these days based on the current market valuation. Although trading near its 52-week high, it still has a strong potential for more growth. Considering how well the airlines are doing right now across the board, Southwest has the potential to throw off market-beating returns over the next year.

The table below provides a bird's eye view of Southwest.

Southwest Brief Summary (Source: Bloomberg)

Approximate Price

$22.51

Shares Outstanding

700.47M

Market Capitalization

15.70B

Total Debt

2.82B

Enterprise Value

15.37B

Dividend Yield

0.6%

Free Cash Flow T12M

1.05B

Shareholder Yield

5.24

Enterprise Value/EBITDA

6.89

Price/Book

2.15

Price/Earnings

20.1

Price/Sales

0.90

Price/Cash Flow

6.46

Price Change Last 6 Months

+47.03%

Click to enlarge

The fact that Southwest's shareholder yield is so high is particularly interesting considering their dividend yield is a measly .7%, which translated into $71 million in dividends paid in 2013. This is mostly due to the share repurchase program and two separate accelerated share repurchase programs that returned $540 million to shareholders in 2013. LUV appears to be fairly valued when looking at most of these valuation metrics, but as I'll show below they have a much greater potential for growth compared to other airlines when looking at the impact from recent acquisitions, expansion into other markets, and the relatively untapped potential for charging additional fees.

Check out this chart showing the price activity of LUV compared to the S&P 500 over the past year.

Click to enlarge image.Click to enlarge

Those investors who picked up Southwest back in October of last year have been very happy with their results. As the chart demonstrates, LUV has clearly outperformed the market over the past seven months, and overall this year it's up 21%.

Many of the problems the airlines were facing after start of the Great Recession have started to clear up and the stock price is reflecting that. Additionally, Southwest received a vote of confidence from Argus Research, raising it from "hold" to "buy" and projecting a price target of $28. This follows a string of other analyst community upgrades, including one from Deutsche Bank. While one should never rely too much on analyst opinions, they do at least provide a trend on how a company's prospects are lining up.

Southwest has also extended it market coverage to LaGuardia, Washington National, and several international markets. It's not yet known exactly how much they will benefit from the domestic expansion, but the international expansion to markets such as Jamaica, the Bahamas, and Aruba beginning in July 2014 should increase margins as international flights are generally more profitable. Also, according to the company's 2013 annual report, AirTran should be fully integrated into its operations by the end of 2014. Each of these factors should contribute substantial bottom line growth well into the future.

The company also implemented other initiatives beginning in 2013 that are projected to increase revenues going forward. They began selling open premium boarding positions (for those like me who can't stand getting caught up in the cattle-like boarding process), increased the early-bird check in fees, and increased the fees for certain checked excess baggage.

Each of these improvements aside, Southwest also has the option of implementing checked bagged fees similar to what other airlines such as Delta implemented several years ago and which led to huge amounts of additional revenue. I'm sure everyone has seen the commercials Southwest put out about your bags flying for free, but this is fertile ground for increased fee generation whenever the company is willing to take it. Although these fees were and still are extremely unpopular, at this point everyone is at least used to seeing them.

Risks

All these things bode well for Southwest in the near future, but there have been some rumblings of late about them losing their edge in the marketplace. Long known for having outstanding customer service and low prices the impacts of the acquisition of AirTran and expansion into larger markets has created growing pains and caused them to fall in terms of service quality. In the annual Airline Quality Rating Report, Southwest has placed eighth in each of the last two years. In their heyday they would normally be within the top three. Declines in on-time performance, overbooking of passengers, and mishandled bags all led to this decline.

Another major risk would be some type of macro event that leads to surging fuel prices, which would cut directly into the bottom line of Southwest. The company does have hedges in place to cover some of this, but there is only a limited amount of protection this can provide. These are certainly things to look out for over the next two to three years and could eventually lead to Southwest becoming just another large airline. However, over the short term these shouldn't deter them from generating market beating returns and benefiting from the overall industry turnaround.

Conclusion

Southwest Airlines has had a good run in stock price since the fourth quarter of 2013. However, this is still a stock that's on the upswing and has fantastic growth opportunities going forward, especially when compared to some of its peers who have already mined those same opportunities. Keep in mind that Southwest has differentiated itself by having a quality management team in place and generating 41 consecutive years of profitability. Those unfamiliar with this company would not believe such quality exists within the airline industry. They strive to efficiently deploy capital by targeting a 15% pre-tax return on invested capital and implement common sense improvements for saving fuel and reducing emissions. Southwest has also had great relations with its employees and so far has only had one labor strike in an industry rife with them.

Don't let this recent upswing in the stock price and fears of the airline industry deter you from catching a great opportunity that is still yielding inordinate returns. Airlines have been in the past and will in the future be prone to extreme cyclicality. However, blue skies are currently ahead and Southwest can be expected to continue their market beating performance.

Disclosure: I am 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.