Description

Summary:

“We have the best combination of revenues and costs and returns, period.”  CEO Gary Kelly, Q4:18 conference call.

Southwest Airlines is a long-term compounder trading at a bargain price (about 11X 2019 earnings).  LUV has been profitable for 46 consecutive years—truly incredible performance in its industry. It has the best balance sheet among the airlines and one that is very strong against corporate America overall.  The company generates ample free cash and has repurchased over 250MM shares, 1/3 of its outstanding stock, since 2011. Returns on capital and equity are enviable. Looking forward, a combination of mid-single digit unit growth, very modest pricing, strong cost control enhanced by the introduction of the 737 MAX, and continued share repurchases should produce 10% or so earnings growth—faster than any realistic long-term forecast for S&P earnings growth.  That combination should lead to at least modest multiple expansion. So with the modest (1.2% yield) but growing dividend, I think a total annual return of 12-15% over the next several years is reasonable.

Current Investor Presentation:

http://investors.southwest.com/~/media/Files/S/Southwest-IR/20190425_Booklet.pdf

The Southwest Business Model:

I am certain that most readers are familiar with Southwest, but it is worth going through the deck above.  In addition, there is a terrific VIC analysis by Lord Beaverbrook (wish I had paid more attention!) from June, 2013 which is well worth reading. From inception in the early 1970’s, management has employed a very simple and consistent strategy:  Simple pricing; one class; one airplane (Boeing 737); high utilization; point-to-point versus a hub strategy. Fast forward, Southwest is now the leading domestic airline and also enjoys the best margins and returns on capital. While it’s true that ULCCs (ultra low cost carriers:  Spirit, Frontier and Allegiant) have a cost advantage over Southwest, I believe it is more important that Southwest has a meaningful advantage (see page 8 of the presentation) versus American, Delta and United, as the Big Four represent about 90% of the industry.

While impossible to quantify, it undoubtedly is an advantage that most customers like Southwest.  It is the highest rated airline by Consumer Reports and in the DOT customer satisfaction survey. On the Q1 call, CEO Gary Kelly noted that NPS (net performer score) ratings are strong and the best in the industry.  Southwest also consistently ranks at the top of Best Employer ratings: Number 2 on the Forbes Magazine list. Especially in an industry where labor relations are critical, this is a big deal.

Industry Dynamics:

Lord Beaverbrook outlined emerging changes in the industry in his 2013 recommendation and he has largely been accurate.  It is a better industry today. More recently (2/18) on VIC, nilnevik devoted a portion of his analysis of Delta to describing why this is the case.  Two guys who have noticed are named Buffett and Munger. To quote Charlie, “[Railroads were] a terrible business for about 80 years. But finally they got down to four big railroads and it was a better business.  And something similar is happening in the airline business.” Berkshire Hathaway is now a major shareholder in all four major airlines.

737 MAX:

As noted above, Southwest only flies 737s.  When the planes were grounded in mid-March, Southwest had 34 737 MAXs in its fleet.  The company has adjusted its schedule through August 5. Of course, Boeing has suspended deliveries of additional planes—LUV had expected to receive 41 more in 2019 and the plane is key to its growth plans for the next decade or more.  

In the short term, of course, this is a negative development for Southwest, although the reduction of industry capacity growth is a slight offset.  I have no special insights into when the FAA will allow both the plane to fly again and Boeing to resume deliveries. My gut feel is that by the beginning of 2020 this will cease to be an overhang.  If that is true, LUV is more leveraged than its competitors to the cost benefit, especially in fuel efficiency, of new airplane technology.

One Valuation Note:

Since early 2014, when it became clear that LUV (and the industry) profitability was moving up to a new level, Southwest has not traded below 1X current year revenues.  That would suggest a floor of about $44 this year (the stock was $45 in early January) and $49 in 2020. Conversely, it has traded at over 1.5X revenues every year, which would suggest over $70 in the next 18 months or so. I would take all this with a grain of salt but do believe that, apart from the long-term merits of the idea, the near-term risk/reward is good.

Conclusion:

I could go into much more detail on any of the points here and others if there is interest:  Just fire questions away. Frankly, I don’t think it is that critical to the long-term investment thesis.  It could well be that other airline stocks will do better than LUV. I wrote up Spirit a year ago and believe that, in the short term, it will.  But especially for those of you with a multi-year investment horizon who manage large sums of money, I would look closely at Southwest.

Catalyst

1.  737 MAX returns to the sky

2.  Further evidence of more disciplined industry structure.