Southwest Airlines Continues Hot Start To 2018

Summary

• Southwest Airlines reported year-over-year February 2018 increases of 3.5% and 1.0%, respectively, in revenue passenger miles and available seat miles year over year.
• With the continued rebounding of the U.S. economy and lower oil prices, airline activity is expected to see consistent growth which was evident by a busy 2017 holiday travel season.
• Earnings growth will allow Southwest to improve its load factory and strategically invest in expanding capacity, which will reap the benefits of improving airline industry trends.
• I believe Southwest is an attractive long-term growth investment given its low valuation, its ability to return value to shareholders, and the key investments it's making to execute its differentiation strategy.

Southwest Airlines (LUV) stock is an attractive investment opportunity given the airline's history of profitability. The company is focused on its differentiation strategy, which is evident in investments in its profit sharing contribution and fleet additions in 2017 as well as 2018 guidance. These investments should continue to build the Southwest brand and result in future earnings growth as the airline takes advantage of the favorable U.S. economy.

The third largest airline in the United States, Southwest Airlines, reported February’s traffic this past week. The airline, which trails American Airlines (AAL) and Delta Air Lines (DAL) in terms of enplaned passengers, fleet size and number of destinations, reported another solid month building on its promising start to 2018 with the release. Southwest surpassed February 2017 metrics by 3.5% and 1.0% in terms of revenue passenger miles (RPMs) and available seat miles (ASMs) year-over-year. After busy holiday travel months in November and December, it’s encouraging to see Southwest start the year off on the right foot and put together a better month than the competition. Refer to Southwest’s monthly RPMs and ASMs dating back to February 2017.

It’s encouraging to see Southwest has sustained growth following the difficult 2017 hurricane season that really hit September hard. Southwest has been able to return to most RPM growth rate of 2% to 4% each month since. Additionally, it’s also positive to see RPM growth staying above ASM growth, which signals an increase in the very important metric: passenger load factor. Passenger load factor is an important measurement for the airline because it represents the capacity utilization of the airline. It essentially represents the efficiency of the airline to fill seats and generate revenue. If an airline is increasing ASMs but decreasing RPMs, it shows that a lot of flights aren’t at capacity and a missed revenue opportunity. In the case of Southwest, it is increasing revenue miles at a higher rate of seats which could represent tightening capacity, but as long as the load factor isn’t at 100%, it represents an efficient airline. See the following table that represents the company’s load factor since February 2017.

This downtrend in December and January is evident, but Southwest did manage a slight uptick in February with a load factor of 81%. It’s clear that Southwest isn’t near 100% load factor, which certainly adds optimism that RPMs are growing faster than ASMs. Additionally, it’s important to note that the first couple months of the year are lower load factor months. Both January and February of 2018 were improvements from 2017’s metrics. February 2018 increased from 79% in 2017. Despite this underlying positive, the load factor still trailed major competitor - Delta Air Lines at 82% (domestic only) in February 2018.

There are two main factors making up the load factor metric. The first, RPMs, measures the traffic for an airline and is calculated by multiplying the number of revenue-paying passengers for the month by the total distance of flights for the month. Southwest’s RPMs increased 3.5% year over year to nearly 9.0 billion. This was slightly higher than main competitor Delta Air Lines who reported a 3.3% domestic metric year-over-year. Delta is much larger at over 19.2 billion.

The other factor, ASMs, measures the airlines' flight carrying capacity and is calculated by multiplying the number of seats available for passengers during the month by the total distance of flights for the month. Southwest’s ASMs increased 1.0% year over year to over 12.2 billion. This was slightly lower than main competitor, Delta Air Lines, who reported a 5.1% domestic year-over-year increase. Again, Delta is much larger at just under 23.9 billion.

Based on these results for the month of February 2018, Southwest is gaining on Delta Air Lines from a RPM perspective which means they are attracting additional routes, but they’re investing more slowly in increasing ASMs. Given the lower load factor, it makes sense that Southwest would be concentrating on optimizing current routes and attracting customers before increasing the ability to carry more passengers. Given the smaller size of Southwest, there is a lot of room to grow. Southwest has been able to consistently produce results by differentiating itself from other airlines. While new entrants, Spirit and Frontier, are focusing on ultra-low fares and add-on fees, Southwest operates on a balanced approach of low fares plus a great customer service. Unlike the other airlines, they aren’t willing to lower the price of fares to the point where the travel experience is impacted. At the center of this strategy is Southwest’s employees as management believes happy employees make happy customers. This has created an impressive brand and has differentiated the airline from other major airlines with a difficult to imitate strategy.

The execution of this customer-focused strategy was evident in the Wall Street Journal’s 2017 Airline Scorecard. The ranking was based off a scorecard of 7 items including on-time arrivals, canceled flights, delays, tarmac delays, mishandled baggage, involuntary bumping, and complaints. In this ranking, Southwest was ranked #1 in complaints, which is important. Despite this strong ranking, Southwest didn’t rank as well in mishandled baggage, involuntary bumping, and on-time arrival. Overall, the airline fell to #3 overall behind Delta and Alaska (ALK), which are both likely to have higher fees than Southwest. Despite that, in order for Southwest’s differentiation strategy to continue succeeding, the airline must work to improve this scorecard in 2018. If the company falls, it will definitely have an impact on the Southwest brand.

When the company reported fourth-quarter 2017 results prior to releasing January 2018 traffic results, the company exceeded analysts’ expectations in terms of revenue growth with a 3.7% year-over-year increase. Additionally, earnings per share of $0.77 was in-line with expectations. The company was able to overcome load factor challenges to grow revenue. This was the 45th consecutive year of profitability for the company which allowed management to return $543 million back to employees through profit sharing. In addition to employees, the company returned approximately $1.9 billion to its shareholders through the payment of dividends and an aggressive share repurchase plan. Despite the aggressive buybacks, the company still has the authorization to buyback $1.35 billion in stock from the May 2017 authorization. Despite this cash outflow, the company is still investing strategically in aircraft as ASMs are expected to increase near 5% in 2018 compared to only 3.6% in 2017. Attracting top talent, retaining happy employees, and increasing routes is key to the differentiation strategy. Despite these investments in capacity and employees, the determinant of whether or not the profitability will continue is whether or not the company can continue to attract passengers to fill those seats.

From a valuation standpoint, Southwest’s stock looks cheap at a PE ratio of only 9.9 compared to an industry average of 13.1 meaning the stock has nearly 25% to grow until it reaches the industry average. This 25% is a decrease from the 30% last month which indicates that the stock saw some appreciation over the last month compared to the industry. The stock is also trending well below the 5-year average of 19.1. While the airline industry continues to trade at a discount compared to the S&P 500, there is no reason that Southwest Airlines shouldn’t be trading at the industry average. In addition to the discount, the stock’s dividend yield is almost 1%.

In conclusion, Southwest’s stock is trading at a 25% PE ratio discount to the industry average despite its long history of producing results and returning value to shareholders. The airline is off to a good start to 2018 after strong January and February traffic results and has made strategic investments in its employees and fleet to allow the company to execute its differentiation strategy going forward. Southwest’s stock is a great long-term investment.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in LUV over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.