Southwest Airlines: THE Low-Cost Airline

| About: Southwest Airlines (LUV)

Summary

By following a simple strategy to be the low-cost airline, Southwest has been able to reliably produce profits when other airlines have hemorrhaged money.

Southwest Airlines has by far the cleanest balance sheet in the industry.

Free cash flow and net income are both rapidly improving over 2013.

Herb Kelleher, co-founder and longest serving CEO at Southwest Airlines (NYSE:LUV) once told someone,

"I can teach you the secret to running this airline in thirty seconds. This is it: We are THE low-cost airline. Once you understand that fact, you can make any decision about this company`s future as well as I can."

(Source: Made to Stick by Chip Heath and Dan Heath)

By sticking to this simple principle, Southwest has been the only US airline to consistently produce a profit. The company is a case study on how a company should be managed. While Delta (NYSE:DAL), American Airlines (NASDAQ:AAL) and United Continental (NYSE:UAL) have all faced a laundry list of issues over the past 10-15 years, Southwest has kept its simple strategy of being the low-cost airline and as a result has a pristine balance sheet and avoided bankruptcy, cost over-run, and labor issues that its peers seemed to be constantly plagued by.

Balance Sheet

($ Billions)

Market Cap

Enterprise Value

Total Debt

Cash

Debt/Equity

Southwest

$ 21.8

$ 20.8

$ 2.8

$ 4.0

0.37

American Airlines

$ 23.8

$ 31.0

$ 16.7

$ 9.5

4.10

Delta

$ 29.4

$ 36.2

$ 10.9

$ 4.1

0.89

United Continental

$ 16.7

$ 22.9

$ 12.3

$ 5.8

3.68

Southwest stands head and shoulders above its competitors when viewing their balance sheet and it goes back to company's vision of being the low-cost airline. If a strategy doesn't directly relate to the company improving their goal of being the low-cost airline, they will not pursue that strategy. It sounds like an oversimplification of how Southwest operates, but that's the brilliance of their strategy and why they have been able to run a profitable company for so many years. Their pristine balance sheet also reflects why their fundamentals are given a higher weighting than industry peers.

Fundamentals

($ Billions)

P/E (NYSE:TTM)

EV/EBITDA

EV/Revenue

Profit Margin

P/B

Southwest

20.3

7.53

1.15

5.9%

2.9

American Airlines

N/A

6.50

0.87

-1.0%

5.8

Delta

2.7

5.88

0.93

27.7%

2.4

United Continental

26.7

6.50

0.59

1.8%

4.9

Looking at the fundamentals of the companies in the airline industry, Delta jumps out as the most undervalued. Delta turned in an incredibly strong 2Q14 and the company expects 3Q14 to be even better. Delta believes they can improve their operating margin to 15-17% in the third quarter and can expand upon their $1.5 billion in free cash flow. Over the next 6-12 months, Delta may very well be the best pick in the industry, but I still believe Southwest's track record of steady profit margins is ideal for long-term investors. Looking at the 2 companies side-by-side over the past 10 years, you can see Southwest has been a model of consistency compared to Delta.

LUV Net Income Chart

LUV Net Income (TTM) data by YCharts

Southwest Improving

Southwest has seen its top and bottom line improving over the past several quarters. Through the first 6 months of 2014, revenue is up 5.2%, operating expenses are down 0.4%, net income is up 118% and free cash flow is up 50%. The company has a trailing 12 month free cash flow yield of over 7%, but this figure should continue to rise through the remainder of 2014. The company is projecting to spend $1.8 billion in capital expenses in 2014 and through the first 6 months has spent $907 million. With free cash flow at $1,553 million through the first half of 2014, up from $1,033 for the same time period in 2013, the company could achieve a 2014 free cash flow yield of 13%-14%. This amounts to the potential for Southwest to generate approximately $3 billion in free cash flow during 2014, or $2 billion more than 2013. Through the first 6 months, Southwest has generate nearly as much net cash from operating activities as the company did all last year.

The company has returned this money to shareholders through a 50% increase in its dividend and the repurchase of $555 million in common stock as of June 30, 2014. The company completed its $1.5 billion stock buyback authorization in May, which was quickly followed up by an additional $1 billion authorization. At the end of 2Q14, the company still had $780 million under its authorization.

Southwest projected 3Q fuel costs per gallon to be $2.95-$3.00 per gallon, down from $3.06 in 3Q13. This is a 2%-4% drop that will result in $30 to $50 million dollars in savings. With the price of oil continuing its rapid decline, it's safe to assume 3Q14 fuel costs will be closer to $2.95 per gallon and 4Q14 will again see a noticeable reduction in fuel costs. This drop will likely result in Southwest saving over $100 million in the back half of 2014, which should add roughly $0.14 to 2014 EPS.

Tailwinds exceeding headwinds

With the rapid drop in the price of oil, you would expect investors would be flocking to the airline industry as companies benefit from having their largest expense significantly decreased, but the fear of a reduction in passengers due to ebola fears has tempered some enthusiasm. I believe investors can take advantage of this short-term irrational fear, by buying these airlines on drops. The threat of ebola may have a significant impact of travelers flying to and from western Africa, but I think it's a little far-fetched to believe a significant number of travelers would cancel their plans to fly domestically because 1 person has died in the US from ebola. This is a media driven event that has resulted in headwinds for airline stocks. However, if you look at the tailwinds of the cost of fuel dropping 4-6% for airlines through the rest of 2014, it's clear this is a meaningful impact that will have a direct benefit on the bottom line.

Airlines as a hedge

Investors in E&P companies are feeling the pain from a rapid decline in the price of oil and many analysts predict the fall isn't yet over. A slowing global economy and an added supply of oil have lead to a 20% drop since June. Some price targets have the price per barrel reaching $75 over the coming months. If this drop continues and OPEC decides not to cut production in their November meeting, E&P stocks will continue the sell-off. A way to hedge a heavily oil-weighted portfolio against this continued decline would be to invest in airlines, such as Southwest. Fuel costs represent one-third of all expenses for Southwest, so any meaningful drop in fuel costs will add to their value. Assuming a modest 4% reduction in fuel costs for Southwest yields an added $0.14 to EPS in the back half of 2014 alone. If oil were to fall another 15-20%, fuel costs would again be drastically cut and airlines would be one of the largest beneficiaries.

Conclusion

Southwest has a profitability track record that blows away all of its industry peers. The company's simple strategy of being the low cost airline has worked for decades. With continued cost containment, steady international expansion and declining fuel costs all on the horizon, Southwest is set-up for a strong finish to 2014. Both net income and free cash flow should more than double over 2013. The company has by far the cleanest balance sheet in the industry and the best track record of profitability. Traders looking for a quick turnaround pick, may benefit more from Delta in the short-term, but investors looking for a solid long-term investment should consider Southwest. The stock is up more than 100% over the past 12 months, but its future is still bright. At its current price around $31/share, I think the stock has 15-20% upside over the next 12 months. Any continued fall in the price of oil, would further add to the stock's value. Either way, Southwest is a best in-class pick and a solid long-term investment.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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