Southwest Airlines (LUV) – Stock Analysis

As blogged previously, SWA’s personality identifies with our frugal consumer lifestyle. In the last fifteen years we have flown domestically 3-4 times annually and more than 90% of the time Southwest has been our airline of choice. Patience and flexibility help the “Wanna get away” fares go further. Southwest’s policy of generally staying away from the main airports in major cities works in our favor as that essentially reduces airport hassles. It also helps that we are a hop, skip, and a jump away from the Oakland airport, one of the top-10 secondary airports served by Southwest. Flight delays or missed baggage has not been our lot so far. However, the minimal catering fare is not commendable especially on coast-to-coast trips, usually in the same flight with one or more stopovers.

Airline industry is an extremely tough business with razor thin margins constantly squeezed and sandwiched between huge fixed costs and heavy regulation. Also with ticket pricing not regulated the formula is carved for an industry with companies competing their way into bankruptcy! Southwest Airlines sports a unique appeal as they were profitable for more than 35 continuous years. This achievement is especially significant considering they are a low-cost airline and as yet not a big player in the more lucrative business travel market.

Business Issues:

Southwest strives for a completely optimized smooth operation. A key factor behind that philosophy is employee productivity and is the distinguishing dynamic even when comparing SWA with other up-and-coming airlines emulating their business model. Specifically, Southwest’s unwritten rule of minimizing layoffs along with significant employee ownership has enabled them to nurture the industry’s most productive employees. It is remarkable that the philosophy stood the test of airline crisis following September 11, 2001. Southwest's strength compared to legacy airlines boil down to:
  • Liquidity: Southwest have been able to maintain a high level of liquidity while legacy carriers have long struggled to maintain profitability and have found it hard to raise capital in a low-cost fashion. Indirectly, this results in a combative relationship between the management and the labor unions as management’s effort to decrease costs by reducing salaries/benefits conflicts entirely with the interests of the labor unions, and
  • Solid Employee Relationship: Again, SWA has an admirable turnaround of aircraft at the terminal resulting from its highly cohesive relationship among employees in different silos. This is a tall order for legacy airlines as historically, the very rigid line among employees in different capacities make it hard to achieve shared goals.
Even so, there is a downside to Southwest’s strategy. Employee per aircraft, a key metric for performance measurement has varied between the high 60’s and the high 80’s – that number is better low. In a downturn, should the company decide to reduce fleet size, it is inevitable for this number to go high and in extreme cases can spin out of control.

Some well-known business optimization skills pioneered by Southwest that have successfully been adopted by other airlines include:
  1. Point-to-point short-haul network of flights instead of the hub-and-spoke method. Historically, hub-and-spoke was considered the most profitable method of running an airline as it allowed for concentrating maintenance staff in one location as well as consolidation of flights thus permitting for market share gains at the hubs which paves way for increased pricing power. Southwest blew away this concept by optimizing for quick turnarounds of aircraft at the gate. Even though, Southwest’s costs per aircraft per minute at the terminal is high, by minimizing the time at the terminal, Southwest proved that costs can be contained to be below hub-and-spoke operators. Further, hub-and-spoke is limited by airport capacity. Southwest’s passenger load factor (a measure of how much of an airlines passenger carrying capacity is used) is stuck in the low 70s and this is one area they can focus to improve.
  2. Use of a single aircraft type: Southwest exclusively employs Boeing 737 series aircraft for all its flights. This allows them to streamline operations and reduce cost.
Southwest maintains a fleet of 537 Boeing 737’s with an average age of slightly over 10 years. Of these, 210 (almost 40%) planes are aged over 17 years and the remaining 327 (more than 60%) are around 5 years. Effort is underway to replace some of the older fleet with new ones. In fact, their committed aircraft orders stand at 104 and the total including options and purchase rights add up to 220 over the next 5 years, remarkably close to the number of Southwest airplanes aged over 15 years. It can be deduced that Southwest does not anticipate fleet growth in the foreseeable future.

In keeping with the spirit of a low-cost no-frills airline, Southwest ran a highly successful no-hidden fees marketing campaign. This was especially successful because the timing of the campaign was precisely when competition increasingly started charging fees for almost everything not nailed on - additional baggage, ticket change, booking etc. Southwest has managed to keep add-on fees to a minimum although nominal fees for certain things were introduced recently for –
  • From the 3rd checked-in baggage onwards, and
  • Unaccompanied minors and for pets.
Other minor business decisions that directly affect the Southwest customer experience include:
  • Single ticket class. There is no first-class or business class or elite class on Southwest flights. Recently, they introduced Business select, a glorified regular ticket with preferential seating privilege.
  • Tickets are almost exclusively purchased directly from the airline (phone or website) thus eliminating middle-men (travel agents and other travel sites).
  • No seat assignments: The boarding pass does not have a seat number assigned and one can choose a seat as long as it is unoccupied. Boarding first is critical and Southwest introduced a new boarding process last year in an attempt to minimize the time customers spent in line. Basically, passengers are assigned to one of three boarding groups depending on check-in time. Online check-in 24-hours in advance is available and if boarding first is a priority, early online check-in is recommended.
These initiatives help create a unique experience for Southwest’s customers and most tend to become loyal. There is a level of resistance among customers that have flown on other airlines to switch to Southwest – the oft cited excuses include lack of service in their “home” airports, and frequent flyer benefits customers wanting to take advantage of, etc. This is a challenge for Southwest as they have not focused enough on the business customer. Southwest’s focus on servicing from secondary airports has slowed its ability to service business customers who prefer main airports despite the consequences. SWA effort to play this market is proving to be a painfully slow process – many of the primary airports are operating at capacity and making the entry tough as costs can quickly become prohibitive. Philadelphia and Denver are success stories and New York should soon follow suit with Southwest’s successful bidding for the 14 take-off and landing slots in La Guardia from ATA airlines, a code-share partner that went bankrupt last year. Minneapolis is another location expected to be served starting March 2009. For Southwest to grow at a healthy rate they need to carve a niche in this area and it is imperative for them to revamp the business model to serve this customer base in a satisfactory manner. The top-three Southwest airports are Las Vegas, Chicago (Midway), and Phoenix. It is expected to remain this way as Southwest cannot afford to lose market share in these routes while attempting to expand in other areas. Southwest’s commitment to existing locations is evident in its support for the extensive plan to revamp the Love Field airport in Dallas, Southwest’s home base.

Another critical route that Southwest has not chartered yet but will need to for growth is International operations. So far, focus has been on local flights but given the size of the airline and the expected stagnation in the domestic market, Southwest will have to tackle the international market sooner than later. Their forays into this space have been modest with a couple of code-share agreements with airlines serving Canada and Mexico - West Jet of Canada and Volaris of Mexico. This could be especially challenging as many of the business strategies that worked well to optimize the domestic area will not apply when the horizon broadens and in certain cases can be counter-productive. For example, Southwest will not have the luxury to work with a single type of airline as it will not be suitable for transcontinental flights.

Financials:

The year over year (yoy) revenue growth for Southwest stood at a respectable 11.8% at the end of 2008. Net income was down 72.4%. Below is a consolidated look at their financials over the last four years:



Year2008200720062005
Operating Revenue$11.02B$9.86B$9.09B$7.58B
Operating Expenses$10.57B$9.07B$8.15B$6.86B
Net Income$178M$645M$499M$484M
Net Margin1.6%6.5%5.5%6.4%
Fleet Size537520481445




Revenue went up almost 50% over the last four years. Fleet size increased around 20% over the same period. Net income was all over the place as it stayed steady in the 2nd year, showed a growth of almost 30% in the 3rd year followed by a decline of over 70% last year, clearly demonstrating the cyclic nature of the business.

The company finished 2008 with 1.8B in cash. In a tough credit environment, this is an achievement in itself. $891M was generated in fourth quarter of 2008 by tapping the revolving credit facility and the loan market – these are comparatively expensive loans at an interest rate of over 10%. Additionally, 346M was generated through sale and lease back transactions of ten of its Boeing 737-700 aircrafts. The company still owns about 83% of its aircraft fleet and the non-mortgaged aircraft market value stood at $8-$9B giving a Debt to Capital ratio of 45 % at EOY 2008. As Southwest demonstrated, using sale-and-lease back is a good option that the company can tap in tight credit environments.

Southwest’s hedging strategy accounts for its outstanding performance relative to other airlines in the last few years. When fuel price fluctuated between $35 and $150 last year, Southwest’s hedges at $51 came in real handy and helped it remain profitable. Southwest guessed right that fuel prices were artificially low in the 2003 timeframe by purchasing forward contracts at low fixed prices. As fuel prices rose over the last few years, these contracts rose in value thereby offsetting a substantial portion of its expenses to purchase fuel at higher prices. This is going to be hard to replicate moving forward. As of the end of last year, Southwest participated in 85% of the fall in energy price as they significantly reduced fuel hedges through 2013. As of March 2009, Southwest has started to become more active as they have hedged 29% and 27% of its estimated fuel needs for 2009 and 2010 respectively, primarily using call options at $66. Below is a look at fuel price as percentage of total operating expenses for the last four years:



YearCostAverage Cost Per GallonPercent of Operating Expenses
2008$3.71B$2.4435.1%
2007$2.69B$1.8029.7%
2006$2.28B$1.6428.0%
2005$1.47B$1.1321.4%



The estimated consumption is roughly 1.5B gallons per year. Thus, a 1c change in price results in 15M change to bottom-line.

Summary:

Southwest is the golden kid of the domestic airline industry as it has managed to stay profitable consistently over the last 35 years, a feat that has never been accomplished by any other domestic airline. Outstanding management and their ability to innovate and optimize Southwest’s operations are directly responsible for this performance. As such, investors should be willing to pay a premium for Southwest shares. Growth prospects in the domestic market are limited but Management has shown a willingness to cautiously enter other potential growth areas such as expansion in the business market and international operations. Given the company’s outstanding performance in the last three decades, timing is right to bet on Southwest growing in new areas in the near future.

Southwest is valued very close to book value. Forward PE is in the 20s as the combination of higher fuel prices and lower demand due to the recession should result in earnings in the low double digits for 2009. As the economy recovers, Southwest’s earnings prospects should improve but it is anybody’s guess as to when exactly it will happen. As such, an investment in Southwest is a gamble on the eventual recovery of the US economy.

Related Posts:

1. Southwest Airlines - An Experience.

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