This Airliner Could Continue to Outperform

Piyush is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Thanks to rising disposable income and recovering global economies, investing in airlines has again become a profitable affair. Yes, there are growth stocks in the industry, but Southwest Airlines (NYSE: LUV) seems like a value play. Over the last year, its shares have appreciated by nearly 35%, yet the company still seems to be gaining ground. Analysts estimate that its annual EPS will grow by over 21% for the next five years. Here are a few reasons why I love the company.

Business Restructuring

Although its load factor in January slid by 1.7%, the company was able to increase its passenger capacity by 0.5%. Moreover, its passenger revenues per average seat miles (PRASM) in January rose by 2%, and the management expects higher PRASMs in March due to high bookings. According to its senior VP of finance, Southwest will be increasing its passenger capacity by 2% in FY13. According to my calculations, respective increases in ASMs and PRASMs should boost its revenues by around 5%, assuming a constant load factor and constant fares.

Management also said that it repaid $39 million of its recent acquisition AirTran's debt this year, and would be paying $220 million in FY13. Interest rates for these loans are not known, and going by the industry average of 5%, these repayments should save Southwest around $11 million in annual interest expenses. Southwest Airlines is not hard pressed for cash, as its debt/equity stands at a modest 45%. Moreover, it was also announced that its ROIC could increase to 15% in FY13, up from the current 7%. Altogether, these moves contribute to a solid restructuring plan, and I think the best is yet to come.

A Hike in Fares?

I think that the merger of US Airways (NYSE: LCC) with the bankrupt American Airlines (NASDAQOTH: AAMRQ) could be beneficial for all airlines, including Southwest.

Once the merger is through, the joint entity will be operating with 6,700 daily flights in 336 locations. I think that with less competition, airlines would feel free to hike their fares. Delta Airlines (NYSE: DAL) tried to raise prices earlier this year, but failed because other airlines did not follow suit.

Even if less competition doesn't bring higher fares, rising oil prices should give airlines like Southwest another reason to increase their fares.

Investors’ Delight

Southwest also has a $1 billion share repurchase program under way. As announced on March 6, the company has already repurchased nearly $725 million worth of its shares, and $275 million still remains. This amounts to a pending repurchase of nearly 22 million shares, and should reduce its dividend burden by nearly 3%. Besides highlighting the faith of the board, share repurchases artificially add to the EPS, and reduce the burden on  management to report growth even when there is no room for it.

<table> <tbody> <tr> <td> <p><strong>Company</strong></p> </td> <td> <p>Forward P/E</p> </td> <td> <p>P/FCF</p> </td> <td> <p>Gross Profit Margin</p> </td> <td> <p>Debt/Equity</p> </td> </tr> <tr> <td> <p>Southwest Airlines</p> </td> <td> <p>10.09x</p> </td> <td> <p>12.71x</p> </td> <td> <p>17.56%</p> </td> <td> <p>45%</p> </td> </tr> <tr> <td> <p>Delta Airlines</p> </td> <td> <p>5.3x</p> </td> <td> <p>26.42x</p> </td> <td> <p>6.96%</p> </td> <td> <p>1186%</p> </td> </tr> <tr> <td> <p>US Airways</p> </td> <td> <p>4.64%</p> </td> <td> <p>NA</p> </td> <td> <p>34.68%</p> </td> <td> <p>607%</p> </td> </tr> </tbody> </table>

Although Southwest Airlines trades at higher valuations compared to the industry average, it boasts a solid balance sheet. Its debt/equity and P/FCF are relatively impressive, and naturally its interest expenses are lower than its peers. American Airlines however seems like a value play. The company is battling bankruptcy, and post-merger it would have access to the credit line of US Airways. In return, its lenders would get a 70% stake in the joint entity.

In conclusion...

I believe that Southwest Airlines needs to work on its load factor, which is more dependent on marketing strategies and tactical routing of airlines. That said, the fleets of AirTran and Southwest just merged in January, which indicates that the financial benefits of the acquisition haven't shown up yet. Given its promising future prospects, I think Southwest Airlines is worth a closer look.

PiyushArora has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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