3 Reasons To Luv Southwest

By Will Ashworth | January 15, 2012 AAA
It wasn't a good year for airline stocks in 2011. In particular, AMR (OTCBB:AAMRQ), parent company for American Airlines, filed for bankruptcy and Southwest Airlines (NYSE:LUV), usually one of the industry's better performers, had a net loss of $140 million in the third quarter ended Sept. 30, 2011. In addition to rising fuel costs taking a toll on the company, excessive flight delays and baggage handling problems hurt Southwest's business. If you exclude the 2008/2009 market swoon, its stock is trading below $9 for the first time since around September 1998. No matter what its earnings look like in the fourth quarter, now is an opportune time to buy its stock. (For additional reading, see Can Earnings Guidance Accurately Predict The Future?)

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Customer Service

According to SKYTRAX, which dubs itself "the world's largest airline review site," the only U.S. airline with a four-star rating (there are no five stars in the U.S.) is JetBlue Airways (Nasdaq:JBLU). Southwest, American Airlines, Alaska Air Group (NYSE:ALK), Hawaiian Airlines, US Airways (NYSE:LCC), United Airlines subsidiary of United Continental Holdings (NYSE:UAL) and Delta Air Lines (NYSE:DAL) are one rung below with a three-star rating.

Despite a mediocre result for the airline known for excellent customer service, it still managed to have the fewest customer complaints filed with the Department of Transportation in 2011. In an effort to improve its baggage handling woes, it's working on implementing handheld scanners to reduce mishandled baggage. If this is what stands between a three-star and a four-star rating, I'm pretty sure it will implement them nationwide, as soon as possible.

It can't be happy with the notion that Delta is ranked number two in customer service satisfaction, one spot higher than Southwest. Considering its traffic growth, capacity and load factors all increased year-over-year in 2011, a slight tweaking of its system should generate positive results in 2012 and beyond.

Stock Performance

Southwest's stock lost around 35% in 2011, its worst performance in over a decade. If you invested $10,000 in Southwest at the end of 2001, today that $10,000 is worth about $4,700. That same $10,000 investment in the S&P 500 is worth approximately $11,200. However, according to Southwest's investor relations site, if you invested $10,000 in Southwest on March 17, 1980, (the last available date from its investment calculator), it would be worth about $536,000 today with dividends reinvested. That's a cumulative return of roughly 5,263% with all of the performance delivered between 1980 and 2001. In fact, it hasn't had a stock split since Feb. 16, 2001. So what must it do in order to rise above single digits? (For related reading, see Understanding Stock Splits.)

Financial Performance

The most important thing is stable fuel prices. In the third quarter of 2000, its fuel bill was roughly $195 million or 13.2% of revenue. In 2011, its fuel bill was around $1.59 billion or 36.8% of revenue. The fuel bill's compound annual growth rate is approximately 20.99% over the past 11 years, while its revenues have only grown about 10.21% annually. The stock can't possibly hope to revisit the 20s without bringing the two numbers closer together. I'm doubtful it can do much about rising fuel costs, but if it can maintain salary costs at approximately 30% of revenue, while keeping the fuel increases between 10 and 20% annually, it can generate an operating profit near or above $1 billion. That would translate into its highest operating profit ever, albeit on a much lower margin.

Delta introduced a $20 fare hike on its long routes Jan. 11, 2012, and Southwest followed suit. Last year, airlines attempted price increases 22 times with nine successfully implemented and maintained. It must continue to push the envelope once again in 2012 and this early increase provides hope that airlines will continue to pass along costs that are very real and very punitive to the bottom line. Consumers must share the burden.

The Bottom Line

Going back to 2001, Southwest's enterprise value (EV) was 11.2 times EBITDA. In the trailing twelve months ended Sept. 30, 2011, its enterprise value is 4.8 times EBITDA or roughly 233% cheaper. Business might be less than perfect these days, but at these prices, you have to like your odds. (To learn more, check out A Clear Look At EBITDA.)

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At the time of writing, Will Ashworth did not own shares in any of the companies mentioned in this article.

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