The Cheapest Industry and the One Stock to Buy

By Chad Henage - August 9, 2012 | Tickers: DAL, JBLU, LUV, UAL | 0 Comments

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For many people, the idea of investing in the airline industry is something that they just simply won't consider. There are many examples over the years of airlines that once were respectable businesses and now have completely disappeared from investors' memory. One of the few companies in this industry that seems to consistently produce good results is Southwest Airlines (NYSE: LUV). With the company recently releasing their earnings results, we get a chance to see what a successful airline looks like. 

The airline industry is actually tremendously simple to understand. Each airplane has the potential to carry a maximum number of customers from point A to point B, and the airline wants every single seat filled on every flight. In addition, the airline needs fuel efficient jets that require little maintenance. The longer the company can leave its fleet in service without incurring high maintenance costs, the better the company's long-term profits should be. It's amazing that something so simple can be so unendingly complicated because of competitive pressures and the changing economic landscape. The obvious problems are: no airline completely fills every single flight, and as fleets get older they have to be replaced. Looking at a cross-section of the industry, there are huge differences in growth expectations, cash flow production, and the companies' balance sheets. For instance, take a look at some of the key numbers for Southwest Airlines, Delta (NYSE: DAL), JetBlue (NASDAQ: JBLU), and United Airlines (NYSE: UAL).

You can see that if analysts are even half correct about each company's future growth rate, this might be the cheapest industry in the market. The challenge of course is, figuring out which company will be able to produce the results that analysts are expecting. We get some sense of the separation between the companies by looking at their free cash flow and their long-term debt versus total assets. United Airlines appears to be the most efficient operator with the most free cash flow generated from each $1 of sales. However, investors looking for safety would probably gravitate toward Southwest Airlines. The company's long-term debt represents the smallest portion of their total assets relative to their competition. This is particularly impressive when you consider that Southwest acquired AirTran and has begun to integrate the two airlines.

With Southwest Airlines reporting revenue up 11.61%, the company said about 45% of this increase was due to AirTran. This merger added more than 140 additional aircraft to the Southwest fleet. The company's network has also expanded to cover Atlanta, Washington Reagan, the Caribbean, and Mexico, making this acquisition one of the most transformative in Southwest's history. Given the company's excellent management, I would expect that Southwest will slowly adjust their fleet to meet the demand of passengers from their new and existing hubs. As the economy slowly improves, all airlines should benefit from additional passengers, and it appears this is already beginning to happen. Southwest reported that their revenue from passengers carried increased by 6.4%, while the average passenger fare was up 4.7%. These positive factors, and the addition of AirTran, helped EPS increase by greater than 42%. There were also several positive factors in the company's financials that investors should be aware of.

Southwest Airlines' net income and depreciation came in at about $14 million. With the company paying about $8 million in dividends, the result is a 57.14% payout ratio. While the airline industry is notoriously difficult to predict, this less than 60% payout ratio should give investors some comfort that Southwest's dividend should be safe. The company also repurchased 26 million shares at an average price of $8.65. On a year-over-year basis, the company's diluted share count decreased by 2.92%. While there might be other airlines that look more attractive based on their potential growth, there are several reasons I believe Southwest represents the best opportunity.

One of the biggest worries for investors in this industry is each company's long-term debt. Since Southwest Airlines maintains the lowest relative amount of long-term debt to total assets, the company should be in position to more affordably upgrade its fleet over time. With recent innovations in airline fuel economy, an upgraded fleet can help with fuel costs. While the remainder of their competition would be considered turnaround opportunities, Southwest has been a consistent performer even in difficult economic environments. While the company's stock is relatively more expensive based on P/E ratios, Southwest is clearly the class of the industry. The company's expanded fleet and presence should serve customers well and could give some lift to investors portfolios.

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