- Southwest plans to extend in to international routes give the company considerable operational leverage.
- The new post Wright Amendment playing field give the company a significant domestic operation booster.
- Capacity expansion into the growing economy provides high leverage in terms of profitability.
We like industry leaders. And, we especially like industry leaders that consistently make money. Southwest Airlines (NYSE:LUV) has been one of the rare airline companies that ever fit this criteria. Over the years, Southwest's low cost, no frills model, coupled with consistent profitability made it a standout in the middle of money losing behemoths. But that image of Southwest has been changing quite a bit over the years and customers are starting to see that Southwest, while still friendly to the needs of a budget/leisure traveler, no longer offers the cheapest fares. Nowadays, the other big boys of the airline industry - American (NASDAQ:AAL), United (NYSE:UAL) and Delta (NYSE:DAL) - routinely offer fares lower than Southwest on some of their routes.
Consumers don't like the new Southwest as much as before and investors may be somewhat unsettled by what appears to be Southwest's lack of differentiation. But is this all bad?
The reality is that Southwest has outlived its original point-to-point, short-hop model of air transportation. Southwest has grown to be a big player now and its route system is starting to look like a hub-and-spoke system that other airlines use. The much vaunted cost advantage that Southwest had in the earlier years has reduced. Southwest costs have gone up over the years and other airlines have been able to lower their costs by reducing their debt loads, employee obligations, and other cost factors through negotiations, bankruptcies and mergers. Airlines have also learnt to manage business more cost effectively. So, with the passage of time, the cost advantage has narrowed and the competition has gotten stronger.
In other words, Southwest is not the same differentiated company that it used to be. So, why would we want to be long LUV? We have four main reasons that make us believe in the continued bull case.
1. International routes: With the acquisition of AirTran, Southwest has acquired an international operations and has now set its sights on this highly profitable segment. Southwest now has plans to extend well beyond the original AirTran routes and this should give Southwest considerable operational leverage. Given its strong leisure customer base, Southwest can very rapidly become a dominant international vacation travel carrier.
2. Capacity expansion: Southwest has been a beneficiary of US Air/American merger and other industry consolidations. Over time, it had the opportunity to buy its way in to airports and gates at some very attractive prices. The new routes made possible by these acquisitions offer considerable growth potential to Southwest.
3. Wright Amendment changes: Since 1979, Southwest operated out of Dallas Love Field, its home base, with some very tight restrictions due to the Wright Amendment. Some of these restrictions have eased over time but the biggest changes at Love Field will be occurring starting October this year. Southwest will not only be able to fly non-stop to any other city in the Nation but will also have the opportunity to increase the number of the gates it operates from. This is a big news for Southwest and the new nonstop services will also dramatically improve the connection options for Southwest's long-haul customers. We expect this to have meaningful impact on Southwest's revenues and an even bigger impact on profits.
4. Economy: The final factor that plays into our thesis is the economy. As the economy continues to expand, we expect leisure/budget travel to pick up strongly. And coupled with the three factors mentioned above, we expect Southwest to be a major player in the international leisure travel market.
LUV is not cheap. At trailing PE of about 23 and an estimated forward PE of about 14, this stock is pricey by airline industry standards indicating that the market is expecting Southwest to grow meaningfully from the current levels. We believe this expectation is justified in the context of expected domestic and international revenue growth and more so because Southwest will have considerable operational leverage and the profitability will grow more rapidly than revenues.
A factor that we do not consider into our thesis is the potential upside Southwest can have by implementing some of the fees that its competitors have already implemented. Baggage and cancellation fees are two examples of fee that could bring in substantial new revenues to Southwest. We do not believe Southwest policy on these fees will change in the near term but when it does, it could have a big impact on Southwest's bottom line.
We see LUV as a buy at the current levels and expect to remain bullish on LUV until some of these factors play out over the next year or two.