As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In Southwest's (LUV) case, we think the firm is fairly valued at $10 per share, slightly higher than where it is currently trading. Our report on Southwest and hundreds of other companies can be found here.
For some background, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index (click here for more info on our methodology), which ranks stocks on a scale from 1 to 10, with 10 being the best.
If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Southwest posts a VBI score of 3 on our scale, reflecting our 'fairly valued' DCF assessment of the company, its unattractive relative valuation versus peers, and bearish techinicals.
Our Primer on the Airline Business
The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.
-- Warren Buffett, annual letter to Berkshire Hathaway shareholders, 2008.
The airline industry has undergone meaningful changes since the beginning of the last decade. The painful restructuring of labor agreements and balance sheets by most of the legacy carriers via Chapter 11, the significant mega-mergers of Delta (DAL)/Northwest, UAL (UAL)/Continental, US Airways (LCC)/America West, and Southwest /AirTran, the introduction of ancillary revenue streams to combat rising fuel costs, and the continued efforts to rightsize domestic capacity to slow the long downward trend in real yields are but a few. While unarguably these are steps in the right direction, airlines remain shackled to the poor structural characteristics of their industry. Absent implicit price collusion across every participant within the domestic landscape (a very unlikely event), airline stocks should solely be viewed as speculative bets or hedges on the trajectory of the economy (passenger travel) and the direction of crude oil prices, and not as long-term investments.
Perhaps the most enlightening of analysis of an airline's business model is to test the sensitivity of its profitability and cash flow to changes in the forecasts of a few industry-accepted metrics: revenue per available seat mile (RASM) and cost per available seat mile (CASM). RASM, or unit revenue, is a function of yield (pricing) and capacity utilization (load factor), while CASM, or unit cost, is predominantly driven by jet fuel prices and labor. The difference of the two represents unit profit, or the profit generated by an airline to fly one seat one mile. Due to the tremendous operating leverage inherent to airline business models non-pursuant to capacity purchase agreements (regional airlines operate on cost-plus arrangements), it becomes readily apparent that even minor changes in these key metrics can have large implications on profitability, cash flow and ultimately the fair value of an airline's equity. And while operating leverage may spell opportunity should these metrics move in favorable directions, the wide range of potential outcomes in forecasting these metrics suggests that most airline stocks should be viewed as no more than boom-or-bust, speculative vehicles.
As many airline executives may attest, both unit revenue and unit cost are largely out of their control. For one, air travel service is largely commodified and suffers from substantial and intense fare competition driven by severe price transparency and the unavoidable concept of perishable inventory -- when a flight takes off, empty seats cannot be filled. Such a combination is the weight that keeps real pricing (yield) growth from being sufficient to meaningfully alter the long-term economics of the industry. To do this day, network airlines are still forced to match fares offered by low-cost carriers or suffer even greater revenue declines. Fare increases can only be sustained if they are matched permanently by low-cost peers (like Southwest or JetBlue (JBLU), for example).
Further, with barriers to entry primarily limited to capital costs (any US carrier deemed fit by the Department of Transportation can operate passenger service in the US), it's safe to assume that we haven't seen the last domestic start-up, even after the most recent failure of upstart Skybus. The mere existence of interested, economically-tied parties (like Boeing, for example) seem to suggest that new entrants will always pose a threat to dump unwanted capacity on otherwise healthy routes. Perhaps unsurprisingly, one can even tap Boeing's expertise in launching an airline: Starting an Airline. The poor performance of systemwide--domestic and international--real yields (pricing) across US airlines is very unlikely to change anytime.
As an airline's unit revenue is pressured by intense pricing competition, its unit cost is significantly impacted by the price and volatility of jet fuel. According to the Air Transport Association, jet fuel now represents more than a quarter of industry operating costs, surpassing labor expenses as the largest cost item. Although airlines may hedge fuel to some extent, such a strategic move is financial and should not be viewed as an operational boost or any sort of sustainable competitive advantage. And due to the presence of low-cost providers, network carriers have traditionally found it difficult to hike fares or charge additional fees sufficient enough to pass along these rising energy costs.
With more than 160 airlines failing since deregulation in 1978, the structural characteristics of the airline industry do not lend itself to long-term investing, and even meaningful shifts in the industry landscape over the last decade have done little to change this. Equity or option speculators with firm conviction in the trajectory of the economy (passenger travel) and the direction of crude oil prices may make some money in the near term, but long-term investors will inevitably be left holding the bag, especially if they find themselves holding shares of legacy, network carriers (such as AMR or US Airways, for example). As Warren Buffett would probably agree, savvy investors can find better places to put their money than the airline industry.
Our Report on Southwest
click to enlarge images
Southwest 's average return on invested capital has trailed its cost of capital during the past few years, indicating weakness in business fundamentals and an inability to earn economic profits through the course of the economic cycle. We think there are better quality firms out there.
The company looks fairly valued at this time. We expect the firm to trade within our fair value estimate range for the time being. If the firm's share price fell below $5, we'd take a closer look. However, we feel more comfortable betting on the declines in airline shares when they become overvalued in the portfolio of our market-beating Best Ideas Newsletter. In the spirit of transparency, we showcase the performance of our portfolio below:
Southwest has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 2.7% in coming years. Total debt-to-EBITDA was 2.4 last year, while debt-to-book capitalization stood at 35.3%.
The firm's share price performance has trailed that of the market during the past quarter. However, it is trading within our fair value estimate range, so we don't view such activity as alarming.
The firm experienced a net income CAGR of about 0% during the past 3 years. We expect its net income growth to be better than its peer median during the next five years.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. Southwest 's 3-year historical return on invested capital (without goodwill) is 5.4%, which is below the estimate of its cost of capital of 9.8%. As such, we assign the firm a ValueCreation™ rating of POOR. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Southwest 's free cash flow margin has averaged about 5.1% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information about our fully-populated discounted cash flow valuation models, please visit our website here. At Southwest , cash flow from operations increased about 41% from levels registered two years ago, while capital expenditures expanded about 65% over the same time period.
Our discounted cash flow model indicates that Southwest 's shares are worth between $5 and $15 each. The margin of safety around our fair value estimate is driven by the firm's VERY HIGH ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $10 per share represents a price-to-earnings (P/E) ratio of about 43.5 times last year's earnings and an implied EV/EBITDA multiple of about 5.6 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 1.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 12.4%. Our model reflects a 5-year projected average operating margin of 8.6%, which is above Southwest's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 1.1% for the next 15 years and 3% in perpetuity. For Southwest, we use a 9.8% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $10 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Southwest. We think the firm is attractive below $5 per share (the green line), but quite expensive above $15 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Southwest 's fair value at this point in time to be about $10 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Southwest 's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $14 per share in Year 3 represents our existing fair value per share of $10 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements