Southwest Airlines: Taking Its Lumps, But The Future Looks Bright

Summary:

• Until this month, Southwest Airlines Co. navigated COVID admirably, coming out with its investment-grade ratings intact, profitability restored, and dividend reinstated, with significant fleet upgrades coming in the next few years.
• Southwest’s avalanche of cancellations in recent days will undoubtedly hit Q4 earnings. Management must focus on stopping the bleeding, compensating and retaining affected customers, and preserving its favorable brand.
• Southwest Airlines has made great strides in capturing business travel share from its legacy rivals, which represents a significant source of potential growth in the future.
• A strong record of profitability, net cash position, and high balance of unencumbered assets could perhaps make Southwest a rather large buyout target.
• However, the investment thesis for Southwest Airlines is in no way dependent on a buyout, which only represents an outcome to the upside.

I recommend a Buy rating on the shares of Southwest Airlines (NYSE:LUV), with a price target of $45 per share, roughly 15 times my forecast 2023 earnings per share before considering its cash position. The company’s recent investor day gave a lot of reasons for optimism and management recently reinstated its dividend, with share repurchases to potentially follow in the near future. While the company is likely to have more than a bit of a black eye from the large number of delays and cancellations it’s experienced over the past few days, this temporary setback should not diminish the airline’s long-term prospects.

Company and industry overview

Southwest Airlines Co. (LUV) is the fourth-largest U.S. airline as measured by Available Seat Miles and largest domestic carrier, where it generates the overwhelming share of its revenues. The top four U.S. airlines account for approximately three-fourths of air traffic, though Southwest pursues somewhat of a differentiated strategy from its slightly larger peers.

Southwest pursued some of the same measures as its peers to survive through COVID. It issued billions of dollars in equity and convertible debt and entered into a number of sale-and-leasebacks of unencumbered aircraft. Southwest was unique among the largest airlines in that it did not encumber its loyalty program, a valuable source of liquidity that has effectively been tapped out, at least for now, by several competitors.

Southwest shares are still 40% below their post-COVID highs reached in early 2021 in spite of the fact that it has a fortress balance sheet and a clear strategy to continue to grow profits. The market may be cautious on Southwest and the sector given the continued talk of a potential recession in the U.S. The shares currently trade at around 11 times my forecast of 2023 earnings. The multiple is closer to five times when netting off the entire cash balance, or nine times on a debt-free basis (reflecting the company’s net negative debt position). The gross multiple represents a significant premium to other majors, but one that is arguably deserved in light of the company’s massive cash position and long-term outlook.

Financials and projections

Southwest generated record third-quarter revenues of over $6 billion, with unit revenues up over 10% over 2022 levels with capacity that has returned roughly to pre-COVID levels. The airline shared its outlook for 2023 at its recent investor day, which can be found below:

The increased capacity, lower average fuel cost, and reduced CASM-X are all noteworthy. The following table shows my more conservative estimate of 2023 earnings, as well as my estimate in the event that Southwest achieves the above targets.

	Grey Ghost estimates	Implied airline guidance
2023 EPS	$2.75 – $3.25	$3.50 – $4.00

Click to enlarge

Source: Author’s own calculations.

The major swing factor is the anticipated fuel cost, and as discussed below, Southwest hedges a significant amount of its fuel consumption, particularly looking 6-12 months out.

Entrenched cost competitiveness

Southwest has closed the gap between itself and its ultra-low cost carrier (“ULCC”) peers, while widening its advantage relative to the other majors and legacy carriers. This cost competitiveness allows it to continue to offer attractive fares to customers and spurs its growth.

Cash position and net debt

Southwest carries a massive $21 per share in cash, which leaves it with a net negative debt position of over $5 per share. Management has managed to keep the balance sheet in great shape notwithstanding the tremendous impact that COVID had on Southwest and the industry at large. In addition, while the airline has a profit-sharing agreement in place with employees, it otherwise has relatively limited pension obligations compared to the billions owed by various U.S. majors. The business has stabilized, and Southwest is the first major airline to reinstate its dividend as well, at $0.18 per share, for a yield of approximately 2% based on recent prices.

Although the airline will incur significant CapEx in the coming years, there should be an ability to reward shareholders through share repurchases and/or further increases to the dividend.

Unencumbered assets

Part of having such a pristine balance sheet is the fact that it affords Southwest unique optionality. Southwest estimates that it possesses $11 billion in unencumbered assets excluding its loyalty program, which if it follows other major airlines, would add several billions more in asset value to this pool. These assets provide it with ample resources to be used to support its growth and/or to potentially be utilized to raise funds to return capital to shareholders.

Revenue growth opportunities

Southwest is making significant inroads into capturing business demand, an area of significant potential growth as Southwest increases its presence in the market and the gap in business travel from pre-COVID levels continues to narrow.

In addition, it is fair to say that revenue opportunities abound for the airline. While part of its draw to customers is the lack of extra fees and flexible terms of booking, there is an ability for Southwest to embrace new revenue initiatives without damaging its brand and standing with consumers.

Southwest has begun this process with a new fare class known as “Wanna Get Away Plus.” The early returns appear to be encouraging, as illustrated below.

In addition, the airline has been restoring its frequency on various routes and increasing its service to certain places, such as Hawaii interisland and inbound from the west coast. The 737 MAX deliveries will increase capacity in Southwest’s higher traffic markets and the increased range will allow Southwest to fly farther than it has in the past. A longer-term pursuit could involve an expansion of Southwest’s international presence with these new, fuel-efficient, longer-range aircraft.

Operational issues

In addition, Southwest has recently received plenty of negative press for the huge number of delays and cancellations throughout its network. This is sure to stick with them at least for a while and has attracted the attention of both consumers nationwide and the Department of Transportation. It will surely put a dent into fourth quarter results, and potentially those into 2023 as well. It reinforces the fact that the company clearly needs to reinvest in its operations given what appears to be an outsized impact from large-scale extreme weather events due to its point-to-point network. However, Southwest is in an extremely strong financial position to be able to make these investments and management should be highly motivated to prevent a repeat of this debacle. Ultimately, while costly in the near-term and an embarrassment for the airline, it should not ultimately derail the positive momentum that the business has.

Massive buyout and/or activist target?

While not critical to my thesis, you have to wonder whether a large private equity firm (or firms) might be willing to take a run at Southwest given a number of factors mentioned above. In addition, although Berkshire Hathaway sold out of its position in the four largest airlines in 2020, a costly decision, Southwest might well be a fit if Berkshire were to ever reconsider taking a more permanent position in the sector again. An activist investor might be interested in it given the massive cash position and negative net debt as well, and might look to drive accelerated returns of some of that capital to shareholders notwithstanding the company’s recent struggles.

A private equity play would likely involve the monetization of at least some substantial portion of Southwest’s unencumbered assets. This buyout financing would conceptually mirror the approach that Onex took when it acquired Canadian airline Westjet in 2019. Onex, as part of the C$5 billion purchase (including assumption of debt), tapped the leveraged loan market to issue a Term Loan B collateralized by many of Westjet’s unencumbered aircraft and other assets to fund a substantial portion of the purchase price. While a maneuver like this would naturally increase leverage upfront, the strong profitability and cash flow generation of the business should provide ample support to deleveraging over time. While Onex’s timing was unfortunate given its proximity to the onset of the pandemic, the U.S. airline industry in particular has shown its resilience and appears to have emerged on more solid ground than before.

Risks to investment thesis

Recession

The risk of an economic slowdown is hanging over Southwest and pretty much all airlines. Southwest is about as well-protected as any airline given its cost advantage and cash position. While a slowdown may encroach on Southwest’s ability to capture additional business traffic, its dominance in its longtime strategy should give it some wiggle room to performance reasonably well even if this takes longer than expected to materialize (or doesn’t materialize at all).

Elevated fuel prices

There is some chance that fuel prices remain high or even increase from recent levels. However, Southwest has a long-time fuel hedging program in place which has provided it with significant benefits in 2022 overall and relative to peers. Southwest, like many other U.S. airlines, achieved record gross and unit revenues in the third quarter, demonstrating a resilience in the face of higher fuel costs. In addition to its derivative contracts, the airline has nearly 500 firm orders and over 100 options on 737 MAX aircraft, which will form the backbone of its fleet in the coming years, delivering increased fuel efficiency and lower unit costs to supplement Southwest’s hedging program.

Labor situation

Southwest, like most U.S. airlines, has various employee unions with which the airline periodically negotiates compensation agreements with. Going into this year, the airline had several contracts open, with its mechanics as the only major group not in negotiations with the carrier. Southwest has made material progress on bringing these discussions to a mutually beneficial agreement. Earlier this month, Southwest reached an agreement with its customer service employees on a new five-year contract. This is the latest agreement this year, on top of previously agreed pacts with its aircraft appearance technicians, flight instructors, and dispatchers. A few contracts remain open, most notably with its pilots, who have no doubt taken notice of Delta’s new contract with its pilots. However, Southwest has been accruing costs already for both actual and anticipated pay increases, and this represented approximately 50% of the increase in CASM for the airline in its most recent quarter on a year-over-year basis. This shows a prudent management of the situation by the carrier.

Interest rates and inflation

Substantially all of Southwest’s outstanding debt is fixed rate in nature. Its convertible bonds fluctuate with price of its shares, but it maintains a net negative debt position. Rising interest rates increase interest earned on its cash and short-term investments and indeed Southwest expects interest income to exceed interest expense in 2023. The company should not need to raise any debt over the next 12-24 months, though it certainly could choose to do so if market conditions become more favorable. They may repurchase additional notes in the market, via tender offer or otherwise, as they did with some of their convertible notes previously. Either way, they are particularly well protected from the burden of higher interest rates for the foreseeable future.

Conclusion

Southwest has performed well through COVID and positioned itself to continue its success as it distances itself from the stress caused by the pandemic. Its financial strength is unmatched in the industry and the outlook for 2023 and beyond is reasonably attractive.

The takeover prospect is not necessary for an investment to be successful. The company’s unencumbered assets combined with its strong operating cash flows make it a potentially interesting target, at least in theory, though one that only could be pursued by a deep pocketed domestic investor or consortium of firms.

In the meantime, Southwest Airlines Co. will continue ticking along, with the prospect of substantial capital returns for patient shareholders. A price target for Southwest Airlines Co. of $45 equates to roughly fifteen times my more conservative forecast of 2023 earnings, not considering the cash or negative net debt position of the business.

---

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

---