Southwest Airlines' (NYSE:LUV) stock price has been on an upward trajectory since October 2016. After falling significantly post its third quarter 2016 results, the company's stock price began ascending. This is primarily attributable to Warren Buffett's investment in the airline sector at the time and diminishing yield pressure on the U.S. carriers. Furthermore, the fourth quarter 2016 results bode well for Southwest as its stock price surged 9%. This is mainly due to the carrier beating its consensus estimate for both earnings and revenues, and the general operational out-performance it showcased. Consequently, since October 2016 to date, Southwest's price has risen over 33%.
In line with the company's most recent earnings and the path it has laid down for future earnings growth, we have revised our price estimate for Southwest to $54 per share. Below we present some of the key reasons supporting the upward revision of the company's valuation:
Southwest has historically grown its capacity the most as compared to its peers. The first quarter of 2016 saw the carrier's capacity up as much as 9.2% y-o-y. However, as the headwinds related to unit revenues became sticky, the company followed the path of legacy carriers and trimmed its capacity growth. Consequently, the second and third quarter of 2016 saw a growth of 4%-5% in terms of average seat miles. This capacity restriction helped the company arrest the free fall being seen in unit revenues. Complying with the strategy of capacity restriction, Southwest continued to grow its capacity at 4% y-o-y rate in Q4'16, helping the unit revenues to fall lower than seen the entire year. Going forward, the company has decided to follow the trend of moderate capacity growth, which is likely to help the company turn around its unit revenues.
Through 2016, the industry underwent a high pressure period, wherein the airlines saw their unit revenues constantly declining in the international markets (except Latin America). Keeping this in mind, United wants to align its interests such that a majority of the incremental growth comes from domestic routes. The following table lays down the company guidance for capacity, a majority of which is expected to come from domestic routes.
After increasing conservatively for a number of quarters, Southwest's unit costs excluding fuel, were hit hard in the third quarter of 2016. While a part of this was attributable to the technology outage episode the company underwent in July-August, most of it is due to the increasing wage costs after the ratification of the new labor contract. Although these costs came in lower in Q4'16, they are expected to move upwards in Q1'17, normalizing only through the end of 2017. To combat this and the increasing fuel costs, which are likely to affect the company's bottom line negatively, Southwest is working on reducing fuel consumption while upgrading its fleet to promote efficiency and reduce maintenance and service expenditure. To this end, the company announced its intent to accelerate the retirement of its 737-300 aircraft in the third quarter 2017, when it is scheduled to take delivery of its first, more fuel-efficient, Boeing 737-8 aircraft.
Currently, Southwest serves 101 destinations, of which the majority are in the U.S. This translates to less than 2% international capacity of the carrier's total capacity. The need to expand internationally arises out of Southwest's flattening growth. For the last decade, the carrier has strengthened its presence in the U.S. by offering lower fares, using a point to point business model, and a single Boeing fleet which is cheaper to service and maintain. Further, it has almost exhausted the list of cities it would like to serve domestically. In such a scenario, it becomes important for Southwest to spread its wings to foreign destinations.
After launching flights to Mexico and Cuba in 2016, the Dallas-based carrier is considering expanding to Canada, Caribbean, Central America, and South America. It is also looking at routes across the Atlantic. The management gave a timeline of 15 to 25 years, to establish its services across 48 states in South and Central America. According to our estimates, international operations would translate to approximately 15% of total capacity and 5% of total revenues for the company, over the next five years.
Moderating Capital Expenditure
As mentioned above, Southwest plans to upgrade its fleet by adding Boeing 737-8 and 737-800 to it, in 2017. It expects to order 60 737-800s and 170 737-8s, allowing the company to fly longer-haul distances. Although this would mean significant expenditure on capital goods, in the long run, it would save the company from incurring precious dollars on fuel, as the new aircraft are more efficient as compared to the fuel guzzling 737-300s in the company's fleet now. Furthermore, the addition of new aircraft shows that Southwest anticipates its international demand to grow exponentially in the next decade or so.
In addition, Southwest doesn't pursue a multiple fleet strategy like other airlines, instead concentrating on one kind of aircraft. This is in complete contrast to legacy carriers who source their aircraft from a multitude of manufacturers. The single fleet strategy allows Southwest to curtail its post sale costs by reducing the amount spent on servicing and maintenance.