SOUTHWEST AIRLINES LUV
June 21, 2013 - 6:11pm EST by
lordbeaverbrook
2013 2014
Price: 13.50 EPS $1.00 $1.50
Shares Out. (in M): 727 P/E 13.5x 9.0x
Market Cap (in $M): 9,736 P/FCF NM NM
Net Debt (in $M): -147 EBIT 0 0
TEV ($): 9,589 TEV/EBIT NM NM

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  • Airline
  • Industry Consolidation
  • Stable Management

Description

If you want to take a flyer, I have a common stock idea you are going to LUV. Airlines! As a long! But because the canon on the airline industry is so rich, let’s warm-up with a few quotes:

Investors have poured their money into airlines and airline manufacturers for 100 years with terrible results, it’s been a death trap for investors. - Warren

The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down. - Warren

The net amount of money that's been made by the shareholders of airlines since Kitty Hawk is now a negative figure. - Munger

Me: I think a domestic airline is a safe, smart and cheap investment. 
You: Surely you can't be serious?
Me: I am serious, and don't call me Shirley.

The last time we were presented with the opportunity of the railroad we did the same thing Bill Miller would suggest [i.e. industry with structural improvement]. And what did we do? We missed it. We stumbled in late to the party [by buying BNI]. We proved to be slow learners. It’s conceivable that Miller is right in what he suggests. It goes into my too hard pile. - Munger 2013

Importantly, we recognize the benefit capacity discipline brings, and we are not going to depart from the strategy...Over our planning horizon of the next 5 years, we intend to keep our fleet count roughly flat. - John Rainey CFO UAL 2012


I believe there is a good probability that the domestic air carrier industry is going to go through a sustained period of a hard market and that industry earnings will be buoyant for a while. But I could be wrong or unlucky in developments. Either way, Southwest Airlines is a cheap stock that promises return of principal and an adequate to extraordinary return.

The airline industry is structurally unattractive. You already know this, but here is list to jog your memory: 1) high fixed-costs, 2) long-lived assets with capital spending required for growth, 3) low marginal costs, 4) perishable commodity-like product which price-sensitive consumers can easily compare, 5) powerful labor unions, 6) unfriendly government regulation, 7) high fuel costs, 8) price elastic and uncertain demand (particularly when considering the need to pass-through the price of fuel). And my favorite, just like the insurance industry, all surprises are negative and cost you money (weather, war, crashes, strikes, crazy flight attendants, etc.).

But the air carrier industry is not unique in being structurally unattractive. There are many other commodity industries (oil rigs, farming, mining, E&P drilling, etc.) that go through supply-demand cycles, with the feast always smaller than the famine with the fullness of time. Why has the domestic airline industry been somewhat unique in seemingly never going through a hard market?

I believe the reason for this is the history of government regulation in the industry. Before 1978, the domestic air carrier industry was regulated, with routes and prices determined by the government. Such a market allowed the formation of higher-cost hub-and-spoke route structures, militant labor unions, and competition based on service rather than price. Piano bars in the sky only made sense when competition was on brand, frills/thrills and service: http://boardingarea.com/blogs/unroadwarrior/2010/07/21/the-747-piano-bar/

The 1978 Airline Deregulation Act allowed Southwest Airlines and other low-cost carriers (LCCs) to enter the industry without hub-and-spoke route structures and with aggressive prices. The results of this were a thirty-year trainwreck, or should I say airplane crash, in slow-motion: 1) Southwest rationally added capacity, earning double-digit operating margins and attractive ROICs through the 1990s, 2) the industry collectively had too much capacity, and 3) prices were too low so the legacy carriers got in financial distress. Every “legacy” carrier that existed in 1989 went through bankruptcy, most in 2006. Since its founding, Southwest has had an operating profit in every fiscal year (two years it needed the help of hedges).

There has been a lot of merger activity in the industry (United-Continental, Delta-Northwest), but one is more interesting than the others. In 2011, Southwest chose to buy Airtran, its first acquisition of size (they had previously tried to buy Frontier). It is interesting that the #1 LCC chose to buy the #2 LCC (airline mergers are very difficult and take a long time) rather than incremental planes from Boeing. Southwest subsequently told its investor base that it would no longer grow capacity without generating a modest pre-tax return on capital of 15%. If LCC’s capacity additions are the reason the industry had been poor for so long, a curtailment of Southwest-Airtran capacity growth may indicate a favorable development.

The supply-demand and utilization numbers for the industry appear on their face to be very favorable. Demand (air seat miles or ASMs) has grown for decades at something above real GDP and the FAA expects it to grow 3.2% in the next 20 years. By my calculations, demand has grown ~1.7% pa from 2003 to today despite 3.5x fuel cost increases which needed to be priced through and the consumer recession. Supply is below the levels before the 9/11 attacks. Increasing demand and flat supply has led utilization (load factors) to go from the high 60s in the late 1990s to the low to mid 80s currently, all-time highs (IATA has the numbers on this, North America rather than domestic for the historicals). The highest monthly load factor I could find was 90% by JetBlue in August 2002 (when we all needed to watch American Idol on our flights), to frame what a maximum might be.

So supply-demand is tight, what is to stop history from repeating and too much capacity to come into the market? First, note that the primary bad actor from an industry perspective for the last several decades, Southwest, has emphatically said they will not add capacity until they get to a 15% pre-tax ROIC goal. Other managements say even more drastic things, such as the UAL quote above. Second, I think it is entirely logical for air carriers to be very cautious adding capacity. Air travel is price elastic, so demand is sensitive to price. But 40% of costs today are fuel (it used to be 20% in the last decade) and need to be priced through. So knowing the supply that the market demand can absorb requires knowing fuel prices. Delta’s CEO gave a presentation at JPM last summer where he showed a chart demonstrating that the futures market for crude oil had been wildly too low at year-end every year for the last decade. Airline managements know their industry has been terrible and they know that fuel prices can go up and they have been burned by fuel repeatedly. It is reasonable to expect them to be exceedingly cautious adding capacity for a long time. Third, Boeing and Airbus are sold-out of single-aisles for many years.

If the thesis works out, I imagine that most of the other airline stocks will appreciate more than Southwest. But the warnings regarding the industry structure I mentioned above are very real in my mind. For my purposes, there is only one common stock that is an “investment” rather than a “speculation.”

Understanding Southwest’s business is very simple. You already know how the business works. They are ~18% of industry capacity. They dominate some markets like intra-California, Texas, Las Vegas, Baltimore, etc. Southwest claims to be 20-30% cost advantaged in non-fuel costs versus the legacy competitors due to their lack of hub-and-spoke route structure and better distribution (they sell 85% of tickets through their website and pay no bounties to Kayak, etc.). Factoring in mix (Southwest has less premium), load factors (Southwest tends to be lower), stage length, etc. makes apples-to-apples comparisons difficult. But industry participants all seem to agree that despite having higher wage rates, Southwest is lowest cost among competitors of size. And the historical financial performance is consistent with that belief.

Their financial position is very strong, with $17B in PP&E (adjusting for leases) funded with $3B in negative working capital (one pays before one flys), $4B in net debt ( all inferred from leases), $3B in a tax liability due to accelerated depreciation (quasi-equity), and $6B in hard book equity. Most of their fleet is unencumbered, they have no material pension liability, and their order book has some flexibility (there are benefits to being Boeing’s best customer). They recently have pushed out some capital spending for upgrading their fleet and are repurchasing their common stock. My guess is that current trading prices of the common stock are somewhere near replacement value (book value per share is $9.65).

I believe the company is well managed. Gary Kelly is the second CEO after founder Herb Kelleher. To me, he sounds earnest and rationale. He is a CPA by training and he has placed an emphasis on limiting cost growth. Customer satisfaction scores remain high and labor unrest appears unlikely (Southwest is unionized). I don’t blame him for the rise in fuel prices or adding too much capacity in the past - many maturing great companies overshoot their market. There is a kerfuffle among industry observers because Southwest has refused to follow competitors and adopt incremental fees for many “services,” such as checked bags. I guess that management may be right and I admire their resistance to the “institutional imperative” to ape their competitors even if they are wrong. I don’t think whether they charge for bags or not will determine whether I get rich owning the stock.

Southwest earned 56 cents a share with 757 million shares outstanding last year. At the 2012 analyst day, management gave fairly detailed plans for how they will increase operating profit $630 million by 2015 ($700 million program less $70 million already in 2012 numbers) from fleet changes (adding a row of seats to most of their aircraft, adding 737-800s for older, smaller Classics, and ditching the 717s inherited from Airtran). They also believe they can add $258 million ($400 million program less $142 million achieved in 2012) from the Airtran merger synergies. The CFO said that they hope to be achieving a 15% run-rate pre-tax ROIC by year-end 2013, or around $1.50 per share, which can be mostly explained by the numbers above. They do not require changes in fuel prices or a more favorable consumer market. Farther out, the Wright Amendment (too much inside baseball for this write-up) will expire at the end of 2014, which will further boost earnings

But if the industry thesis is correct, I believe Southwest will also be able to raise prices; each 1% increase in prices corresponds with a 16 cent increase in EPS. If Southwest were able to increase prices 2% above inflation for three years, due to tight supply-demand dynamics, earnings would be $2.50+. And even then, after-tax returns on capital would be only in the low-teens. There is a lot of operating leverage with favorable pricing with $17B in revenue, low current margins, and $9-10B in enterprise value. 

In summary, I believe Southwest’s common stock at current prices affords security due to the business’s low cost and strong financial position, will provide an adequate return due to internal self-help initiatives, and promises extraordinary returns in the event of an industry hard market.

Note: Numbers. This write-up is intentionally qualitative, because the thesis is inherently a qualitative judgment and the numbers to judge the thesis are so simple. But the domestic airline industry is awash in numbers (and monthly reporting, because quarterly is not enough!). John Godyn at Morgan Stanley has data dump research available. The BTS website has a lot of data, and this website has a lot of slightly out-of-date financials: http://www.airlinefinancials.com/airline_data_comparisons.html

Another note: American Airlines-USAirways. Very smart observers of the industry believe that the potential merger will be salubrious to the supply-demand dynamics. The top 4 are ~65% of ASMs today, ~72% if the merger goes through. I think the merger is not required, however, for the overall thesis to work-out.

Another note: Spirit, Allegiant et al. A common response to the thesis is Spirit is analogous to the Southwest of the 1980s and will add too much capacity and destroy favorable supply-demand dynamics. Spirit has ~45 A320s and derivatives and is ~1.4% of industry capacity, growing capacity 20-30% per year. I believe Spirit will be too small to upset the favorable dynamics I describe above for many years. Also, note that in the 1990s, Southwest was selling a better product at a cheaper price - a pike in the pond. Spirit is selling a worse product at a cheaper price - market segmentation.

Another note: Barriers to entry versus barriers to capacity addition. There have been numerous start-ups and failures in this industry, so it is hard to argue that entry is difficult. But I note that barriers to scale seem quite large, and government regulation, IT systems, miles programs, etc. increase the advantage conferred with scale. I believe the top 4 players largely control their own financial destiny for the next decade. Foreign competitors providing domestic air travel is illegal.

Another note: Accounting earnings (and the 15% pre-tax ROIC target) are not high quality, due to maintenance capital spending being greater than book depreciation.

I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

None. But USAirways-American merger, declining fuel prices, or improving consumer market would be positives. 
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