Everyone Hates Airlines, But Southwest Is Extremely Cheap

LUV’s management had tripled capacity per share since the peak of the last cycle while at the same time the share price had fallen by fifty percent. So the market is offering the opportunity to own six times as many airplanes (capacity) per dollar of investment.

Furthermore, domestic airline capacity has fallen 16% since 2007 as the sector has consolidated down to four players who control 80% market share. Finally, LUV has the opportunity to add incremental revenue and still remain a low cost carrier. As a further catalyst, falling oil prices can greatly enhance investment returns in LUV. In 2000, fuel costs represented 14% of operating expenses; now they are 36%. If oil prices were to fall, that would be clearly a favorable and (to many investors) an unexpected tailwind to an investment in LUV. Should such a tailwind fail to appear, few expected it anyway so there is little risk to this thesis and is essentially a free option. We would be left “only’” owning an under-valued, well-managed industry leader.

Investment Thesis:
• Historically hated industry with major tailwinds
• Airline industry structural shift – industry consolidation over past few years, Delta/Northwest (2008), United/Continental (2010), Southwest/ AirTran (2011), and American/US Airways (2013), leading to improved pricing, higher load factors, and better route optimization – industry left with only four main players –LUV, UAL, DAL, and AAMRQ
• Brent Crude hedge –airlines benefit strongly from lower oil prices – see calculation below
• Best in class management and business model profitable for decades
• Attractive upside/downside
• Upside price target - $32, up 128%
• Downside Price Target - $10, down 28%

Positives:
• Disciplined capital allocator – using free cash flow to buy back shares, pay down debt, and expand capacity, no overpaying for big acquisitions at peak of cycle
• Valuation – stock down 50% from ATH, trading at 4x operating cash flow, 10-year low EV/Sales at .55 vs. 10-year average 1.46x, trading at 80% replacement cost vs. 300% in 2000 when LUV had highest profitability and margins
• Capacity growth – more than doubled (+125%) Available Seat Miles (ASMs) per share since 2000
• Better capacity management - increased average load factor 14% since 2000 from 70% to 80%
• Low leverage – debt-to-total capital (including off balance sheet aircraft leases) continues to decline to 41% at year-end 2012, compared to 47% in 2011, and down from just over 50% after acquiring AirTran in May 2011

Negatives:
• Domestic market nearing saturation – must expand internationally to Mexico, Caribbean, and Puerto Rico to keep healthy pipeline of target markets
• Cut-throat margins – capital-intensive upkeep for fleet and high employee costs, net margins at 2% for last few years, profitability increase likely in next few years for reasons outlined

Crude impact on Estimates:
• Analyst Consensus Estimates – FY2013 - $1.01
• Fundamental Global Estimate – FY 2013 - $1.08 (base case before any crude benefit)
• Crude Oil Decline – a 15% decrease in Brent crude provides incremental EPS $.65 a share – this assumes the current hedge of 15% of 2013 oil consumption

Other Risk Factors:
• Discussions with all major labor unions in 2013 could lead to higher employment costs as % of revenue
• Spike in crude oil prices (possibly from Middle East tension) could impact margins
• Shock to industry demand factors resulting from abnormal events like terrorist attack could decrease revenues, increasing competition from ULCC competitors like Spirit caps ability to raise prices