Long Idea: Southwest Airlines (LUV) by Kyle Guske II
Many times, when an entire industry faces selling pressure, buying opportunities arise for those willing to wade through the details. The airline industry has seen share prices significantly fall throughout 2016, and one firm stands out as undervalued. With a long history of industry-leading profits, improving ROIC, and an attractive valuation, Southwest Airlines (LUV: $39/share) is on July’s Most Attractive Stocks list and is this week’s Long Idea.
Impressive Revenue & Profit Growth
Since 2009, Southwest’s after-tax profit (NOPAT) has grown by an astounding 52% compounded annually to $2.8 billion in 2015 and $2.9 billion over the trailing twelve months. Similarly, Southwest’s NOPAT margin has improved from 2% in 2009 to 14% TTM. See Figure 1. Since 1998, the company has grown NOPAT by 11% compounded annually.
Figure 1: Southwest’s Improving Margin & Profits
Sources: New Constructs, LLC and company filings
Further showcasing the strength of Southwest’s operations, the company generated $2.8 billion in cumulative free cash flow (FCF) over the last decade.
Improving ROIC Highly Correlated With Increasing Shareholder Value
The growth in profits has come without significant expansion of the balance sheet. As a result, Southwest’s return on invested capital (ROIC) has improved from 6% in 2005 to a top-quintile 18% over the last twelve months. This improvement is impressive since ROIC is directly correlated with creating shareholder value. In fact, Figure 2 shows that ROIC explains 84% of the changes in stock valuation for LUV and its competition. Considering Southwest links executive compensation to improvements in ROIC (more on this below), it is clear executive interests are aligned with shareholders. As such, shareholders should expect LUV’s ROIC to improve moving forward, which directly equates to growing shareholder value.
Figure 2: ROIC’s Correlation With Valuation
Sources: New Constructs, LLC and company filings
Southwest’s Consistent Profitability In A Volatile Industry
Southwest operates largely in the regional airline industry and offers select international flights. As such, the company faces competition from many providers, including JetBlue Airways (JBLU), United Continental (UAL), and Delta Air Lines (DAL), among others. As can be seen in Figure 3, Southwest’s ROIC is surpassed only by low-cost regional provider Allegiant Travel Company (ALGT), a featured Long Idea in November 2015. While Southwest’s NOPAT margin might not top the industry, its long-term track record of profitability (positive NOPAT in every year of our model, which dates to 1998), provides stability that has eluded many competitors. Additionally, Southwest is the largest domestic flight operator in the U.S., and in 1Q16, operated nearly 40% more flights than its nearest competitor, American Airlines (AAL).
Figure 3: Southwest’s Strong Profitability
Sources: New Constructs, LLC and company filings.
Bear Concerns Are Largely Overdone
We see four major bear concerns:
- The firm’s impressive increase in profitability is only a result of low oil prices.
- The supply of flights is at a cyclical low and is inviting new competition into the mix as we speak. As a result, flight prices will have to come down as more low-cost providers enter the business.
- Concerns over global economic conditions cast a shadow over demand expectations across the entire airline industry.
- Protracted negotiations with its pilots union over the introduction of a new, more efficient airplane could cause service disruptions or undermine cost structure.
The first concern is dispelled when comparing the timing of the recent oil price drop to the increase in the firm’s profits. The decline in oil prices, which occurred in mid 2014, hits two years past the time that Southwest’s profits and margins began improving. While the company certainly benefited from lower oil prices, it is not the sole reason for improved operations. Rather, the company’s investment in technology and superior operations separates Southwest from the other providers. In addition, the decision to accelerate the retirement of its classic fleet will only help to lower maintenance costs and increase fuel savings going forward.
The second concern ultimately plays out in the form of margins. Low prices have long been a staple of Southwest, however, new competition, such as ALGT, offer even lower pricing (albeit with some add-on costs). The success at ALGT will only invite new competition as low-cost providers see a path to success in the airline industry, which could bring prices down across the board. Not only is Southwest aware of this threat, it is actively investing in new technology for its reservation system that should bring additional cost savings from increasingly superior operational efficiencies. The new reservation system will allow the firm greater flexibility in scheduling routes, balancing capacity, and dynamic pricing. Once completely rolled out in 2017, the firm believes the new system could boost annual profit by $500 million by 2020. We think that the capabilities that have made Southwest more efficient will continue to make the company more efficient. Accordingly, the company will continue to operate with higher profits while offering lower prices.
The third concern is certainly piqued by ‘brexit’, which sent shockwaves through the market. For Southwest, operating a largely domestic flight base, with limited international flights to Mexico, parts of South America, and the Caribbean, the company faces little exposure to weakness in the European economy. Additionally, as noted in our Long Idea on Thor Industries, the domestic economy, despite its struggles, is still steadily showing signs of improvement in wage growth and unemployment rate.
Lastly, the biggest concern, and possibly largest risk to our thesis, is the potential strike organized by the union representing Southwest’s pilots. The sticking point relates to Southwest’s plans to introduce a more efficient airplane, the 737-800 MAX, which has a more efficient engine over its predecessor. The union contends that the new plane requires terms to be re-negotiated, and in May sued Southwest. Southwest noted that the negotiations have plenty of time to be resolved, and a lawsuit at this time is unnecessary. While the risk of labor strike is certainly present, Southwest has a longstanding history of negotiating deals with its employees, with only 1 work stoppage throughout its 45-year history. Furthermore introducing more efficient planes is key to long-term success of the company, which means both the firm and the employees are motivated to avoid any type of work stoppage.
As we’ll show below, each of these concerns appears already priced into LUV, which leaves significant, upside potential should one, or all, of these issues dissipate or be proven otherwise.
Valuation Ignores Southwest’s Profits
Despite the strength of Southwest’s business, and potential for significant cost reduction, which could lead to greater profitability, the stock is down 9% year-to-date. LUV’s current valuation represents an overly pessimistic view of the company’s profit potential. At its current price of $39/share, Southwest has a price to economic book value (PEBV) ratio of 0.7. This ratio means that the market expects Southwest’s NOPAT to permanently decline 30% from current levels. This expectation runs contrary to the reality of Southwest’s profit growth throughout its history.
Even if Southwest were to never again grow profits