Airlines: Give Me Some LUV
Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
I recently watched a video from Motley Fool, where the theme was “run away from the airline industry.” While I agree times have been tough, I think there is still at least one attractive name in this space. There are multiple reasons that Southwest Airlines (NYSE: LUV) has managed to do well, while many of its competitors struggle. Let me walk you though what I've found and what seems likely in the future.
First, a little about Southwest the company. Most investors know they acquired Airtran Airways last year. What I believe is less evident is what a watershed event this could be for Southwest. The company trades at about $8.80 per share, which gives it a forward P/E of about 10.86. Analysts expect low growth going forward of about 1.43% (Yahoo Finance - Next 5 years per annum). Southwest is the only major airline that pays a dividend. While those numbers don't look great at first, when you dig into the financials a little more you can see this company has a lot going for it.
Southwest has made its name as the low cost operator. The company, at least on a gross margin basis, actually comes in second to United Continental (NYSE: UAL). In their most recent quarters, Southwest shows a gross margin of 49.37%, versus UAL's 62.74%. I believe the difference has to do with the size of assets each company is operating with. Southwest, even now, has about $18 billion in total assets. This is less than half, of the nearly $40 billion in total assets at United. The short version is, in the airline industry it is easier to make money with a larger fleet. The reasons aren't hard to imagine. The more routes you offer, the more travelers you can appeal to. This is why the Airtran merger is such a big deal. Airtran gives Southwest more routes, which allows the company to appeal to more travelers.
Another example of this theory that bigger airlines live cheaper, is Delta (NYSE: DAL). Delta creates about $0.036 in free cash flow per $1 of assets. By contrast Southwest generates about $0.023 of free cash flow per $1 of assets. Since Delta has over $43 billion in total assets, versus $18 billion at Southwest, you can see that they can spread their fixed costs across a greater base.
While United and Delta have much larger bases of assets, they also have much more debt. Just for comparison, United's debt-to-equity ratio is 5.11, Delta's ratio is negative, and Southwest comes in at just 0.45. In plain english, United makes more money per $1 of assets (about $0.044), but the company struggles with 10 times the debt payments. In theory, if United can generate nearly twice the cash flow because of their larger size, then Southwest should be able to increase their cash flow once they fully integrate the Airtran merger. This should generate higher earnings, and higher free cash flow for the company.
I also question analyst estimates for Southwest expecting 1.43% growth. With Delta expected to grow at over 15%, United at 3%, and JetBlue (NASDAQ: JBLU) coming in at 7%, we get an average of 8.33%. I don't see how the class of the airline industry would grow at much less than the average of their competition. I believe based on this, that 8% - 10% earnings growth is very possible. When you add the additional earnings power of Airtran, shareholders could see growth come in higher.
Last, but not least, never underestimate the consumer's affinity for a simple to understand pricing strategy. With the Airtran merger, Southwest gets into Atlanta in a big way. The existing carriers haven't had to deal with Southwest, and their much talked about "No Bag Fees." This is clearly a differentiating factor for the company in their existing markets, and customers in and around Atlanta are about to experience this perk as well.
If you believe that the economy is improving, as I do, Southwest as a cyclical airline play seems to be a good fit. The Airtran merger brings some challenges, but major opportunities as well. Southwest has less competition on solid footing after the rough economy of the last few years. It seems the company is poised to capture even more business than before. If you are considering a play on the airline industry, I would suggest giving Southwest some LUV.
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