- Substantial insider selling recently at Southwest Airlines calls into question current valuation.
- Using insider trading to make buy/sell decisions can only be effective if the insider is also a good investor, knowing when to buy or sell their own shares.
- A discounted cash flow analysis helps cut through the noise.
Investors too often speak in overly clear-cut terms when analyzing insider trades: insider buys are always good, and insider selling isn't necessarily bad. Both these situations should be viewed with more nuance, namely that insider trades are only a reliable source of actionable data if the insider is actually a good investor. If the insider is a poor appraiser of business prospects or valuation, then their insider moves should actually be taken as a counter-indicator: buy when they sell and sell when they buy. I spoke of this back in an April 2020 article where I wrote:
Peter Lynch is... often quoted as saying that, "There are many reasons insiders sell, but only one reason insiders buy: they think the price will rise." This quote has been repeated so much it is a platitude in my opinion. Most investors interpret it to mean that insider buys are always a good thing, a likely sign that the stock is headed up. There is good logic, or shall we say conventional wisdom, backing up that interpretation. After all, insiders should be the ones best acquainted with the business proper. We should trust them, right? The main thing that is over-looked with all this is the THINK part of the Lynch quote, they think the price will rise. How much trust should be placed on what insiders think?
We should only place trust in insider trades if we also trust their capacity as an investor. Some CEOs might be great at running their business, but really bad at knowing when their stock has a good value. Buy or sells by them should be put under more of a microscope.
My intent with today's article is to do just that. Substantial insider selling has occurred recently at Southwest Airlines (NYSE:LUV). That selling happened on many occasions from many different insiders on considerable volume. Is this bearish? Is the stock overvalued in light of the current business climate? One of the only ways to answer this question is by conducting a discounted cash flow analysis, with inputs colored by challenging conditions for airlines. Bottom line up front: if Southwest is trading at a level that is completely unsupported by conservative estimates of future cash generation potential, then insiders should be followed out the door.
The following table shows the trades that were made (the % reduction column shows how much they reduced their total position by):
|Insider||# shares||Price||% reduction|
|Michael Van de Ven, COO||32,522||$56.06||11.8%|
|Thomas Nealon, President||53,300||~$56||25.8%|
|Andrew Watterson, EVP & CCO||16,300||~59.25||26.8%|
|Tammy Romo, EVP & CFO||30,000||~$58.05||15.5%|
|Mark Shaw, EVP & Legal||15,503||~$57.79||19%|
|Alan Kasher, EVP daily ops||2,000||$57.80||10.6%|
|Gregory Wells, EVP daily ops||15,909||$57.46||20.8%|
*Data compiled by author from Form 4s
All of these trades happened within three days of each other. For seven different insiders to cash out at around the same price is, to me, indicative of their opinion regarding valuation. If they thought there was upside from here, why would they have sold? Do they think that the stock price has marched ahead of fundamentals? It would seem so. But should we put much weight on what they think?
Discounted Cash Flows
I have argued time and time again the merits of DCF analysis. It stands superior to other forms of quantifying value because it has no component that attempts to factor in human emotion or market sentiment, like P/E and other like ratios inherently do. It's just numbers.
To arrive at my inputs for a DCF analysis with LUV I drew from two primary sources: one is managerial guidance and the other is historic trends.
For 2021, management has a goal of breaking even on a cash basis, as stated in the conference call, due to the still rough conditions related to travel. So for 2021, we assume zero free cash flow. Easy enough.
Almost two years from now at year-end 2022, I assume struggles will still remain in the airline industry and LUV generates $20 billion in revenue, levels last seen in 2016 and 11% below 2019 sales. Margins likewise remain compressed, coming in at 16%, in the context of a five-year trend where margins averaged 19.2%.
After that, revenue grows by 4% every year, significantly below their average of 4.59% annually in the last decade. This means that revenue doesn't completely recover to 2019 levels until 2025. Margins steadily improve annually and peak at 20% also in 2025, never to recover to the record margin year in 2018 of 22.2%. Beyond 2025 is a terminal growth rate of 2%, in line with my expectations of general long-term economic expansion.
CAPEX level stays at 8% of revenue, their long-term average. The discount rate is 10%, the long-term return of the stock margin. I assume most folks would at least want to match the market.
Here is the worksheet:
Under this scenario, where revenue recovery is sluggish and margins stay compressed, Southwest Airlines is worth at least $52 today. Interestingly, this isn't much below the prices all the insiders were selling at. I believe that LUV has the potential to do substantially better than these inputs assume. By changing just one number in this exercise, bumping the cash margin in 2025 up to 22.2%, Southwest is worth $59 today. What is more likely is that several aspects come together to bolster performance, but the point is that doing even mildly better will have the intrinsic value at Southwest go up considerably.
Challenges to the Thesis
So what evidence is there that LUV is overvalued and the insiders were right to get out? The biggest hurdle that Southwest faces right now is of course cash burn, and whether or not, they can ameliorate that issue by year-end. Unfortunately, that is largely out of the company's control. There is only so much that can be done on the expense side: people need to start flying again. Without sales, free cash will never materialize.
While the coronavirus is clearly subsiding, that doesn't mean that there will be an immediate or robust resumption of airline travel. The recession has financially hamstrung plenty of families. Stimulus or no, people simply may not have the money to get a plane ticket. Furthermore, fears may remain regarding a resurgence of the virus and/or governments may continue the implementation of restrictions that will deter travel even if people want to go.
Finally, there is the omnipresent argument of business travel being permanently impaired as work from home will forevermore be a reality, though that will affect Southwest less than other airlines as their focus has long been on leisure travel.
The other part of the picture is potentially higher fuel prices. Oil has strongly rebounded off the coronavirus trough:
*Image from Macrotrends
While not yet stepping outside the five-year range, it is headed in that direction. If a further breakout occurs, airlines will be squeezed at one of the worst times where the economic climate is such that raising ticket prices to offset rising fuel costs is impractical. Certainly, an issue to keep an eye on.
Only time will vindicate or condemn LUV insiders for selling now.
I can't speak for other investors, but I am in the habit of BUYING at (or below) intrinsic value, not selling. Yet, it seems to me that even under conservative assumptions, all the insider selling that happened at Southwest recently was just that. With all the disruption that has happened with airlines recently and the potential for Southwest to capture meaningful market share, as they have the best balance sheet in the industry and an enviable reputation, I would not be a bit surprised to see Southwest return far better than 10% looking forward.
My cost basis is $47.50 and I am very happy with that. That is a good margin of safety on top of the conservative assumptions I used in the DCF analysis. If Southwest goes back below $50, I will be adding to my position.
Southwest is not overvalued. Not by a long shot, in my opinion. Risks exist to monitor, but nothing that upsets the thesis for me.
I only sell the stock for two main reasons: A) something has changed at the company or in the economy that breaks the investment thesis (or I discover something sour that I missed in earlier analysis) or B) the stock has advanced to levels such that all future value to be gained has been pulled forward to the present and is reflected in the current stock price.
All other sell decisions are derivations of these reasons. Because Southwest is still a great company and because the economy isn't permanently impaired due to coronavirus, and because they're not overvalued, I will most certainly NOT be following insiders out the door. In fact, I hope that shares dip below $50 so I can buy some more.
This article was written by
Analyst’s Disclosure: I am/we are long LUV. 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.
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