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Buy Southwest Airlines (LUV) And Hedge With A Covered Call

|Includes:Southwest Airlines Co. (LUV)

01/21/14 Covered Call Pick: Southwest Airlines (NYSE:LUV)

Southwest Airlines (LUV) is a major U.S. airline that predominantly provides point-to-point, high-frequency, short haul domestic flight services to over 97 cities throughout 41 states. Headquartered in Dallas, Texas with over 46,000 employees serving more than 100 million customers every year, "Southwest" is the world's largest low-cost airline carrier.

Southwest Airlines has a market capitalization of $14.78 billion with 696.7 million outstanding shares.

Southwest currently pays a $0.04 quarterly dividend for a current yield of 0.8%.

With a beta of 1.10, LUV trades with approximately 10% more volatility than the current market.

The last few years have seen big changes in the Airline Industry and, recently, great gains for the sector. One of the biggest winners out of the industry has been Southwest, with 3 yr average Revenue and Net Income Growth far outstripping the industry averages. They have been able to do this through their business model: targeting leisure fliers and obtaining a low-cost advantage. By flying one aircraft type (Boeing 737s) on direct point-to-point routes minimizing delays and inventory and flying into "second-tier" airports to reduce landing fees. This has led to 40 consecutive years of operating profits in an industry that has seen over 180 bankruptcies since 1978. One of the most important metrics we like in a company is the ability to survive during times and conditions where their peers are struggling. Most companies can make money during a good economic period when everything is in their favor. Very few companies are able to still turn a profit when they are facing every headwind the world can throw at them, and it is these companies we look to invest in.

In 2010, Southwest acquired AirTran, which marked a new era for the company as it entered into its mature growth cycle. AirTran opened up 37 new markets including the Hartsfield-Jackson Atlanta International Airport, the world's busiest airport by passenger volume. Currently, Southwest in continuing to work through completing the AirTran integration, of which it is believed that 15% has yet to optimized, mostly out of Atlanta. This revenue growth is estimated to be 2% over the next 5 years for the company, alongside 2% increase from capacity and pricing increases, and 1% increase through utilization and efficiency factors. Average passenger fares are up 30% since 2009, and these price increases along with the additions and increases of other fees have helped the firm grow. We believe with now 82% of the domestic market dominated by the top 4 airlines, a price war is unlikely, leaving pricing power will remain and the industry (and Southwest) will remain profitable.

For a Covered Call Pick on Southwest we are recommending the June 2014 $23 Call. The stock has recently taken quite a pop and has yet to form any strong technical base of support yet. Because Southwest is purely a domestic play, any slowdown or sluggishness in the U.S. economy will affect them more so than their competitors who have international business and are not so targeted towards the lower-end leisure flier who might hold off on a plane ticket if money is tight. We think that 2014 will be a better year for the U.S. economy, but with no strong technical support levels yet after this recent pop, we want to still get some upside on the stock while getting a decent level of protection from the premium. We also recommend buying more than one lot of the stock if your portfolio allows for it, as the stock price is relatively low and you will save on commission costs that way. That is why we are recommending buying LUV and selling the June 2014 $23 Call.

Scenario:
 

  • Buy 300 shares of LUV @ $21.76 = $6,528 + Commission ($12.95) = $6,540.95
  • Write 3 LUV June 2014 $23 Call @ $240 - Commission ($8.70) = $231.30

Note: Prices may vary from the time of post. Actual commissions paid will vary returns.


Static Return (Not Called):
(Call + Dividend)/Stock Price X (Days/Year)/Days to Expiration

(0.77 + (2*0.04))/21.80 X (365)/150

= 9.49% Static Return


If-Called Return:
(Call + Dividend + Strike Price - Stock Price)/Stock Price X (Days/Year)/Days to Expiration

(0.77 + (2*0.04) + 23 - 21.80)/21.80 X (365)/150

= 22.88% If-Called Return


Disclosure: Clients and/or principles of OakTree Investment Advisors may or will have an investment in the above positions, but only on the same sides of the trades. The above numbers are analytic estimations based on information known at the time of this post. OakTree Investment Advisors does not guarantee the above, or any, result. All investment decisions should be made based upon individual's personal investment goals and risk tolerance.

Posted by OaktreeAdvisors at 1/21/2014 11:17 AM
Categories: Weekly Picks

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Disclosure: I am long LUV, .

Additional disclosure: At OakTree Investments Advisors we are active managers and may sell or add to positions in our clients portfolios.

Stocks: LUV