Summary
- Management focused on improving efficiencies.
- 42 consecutive years of profitability.
- Company has been Consistently buying back Shares and thus returning value to shareholders.
- Total cash and short term investment exceed the total debt of the company. SouthWest is focused on reducing debt.
- Buying Airtran was a brilliant move and will increase SouthWest top line for the years to come.
Airline business is a capital intensive one and is highly competitive. The profitability in this business can get impacted by a number of factors like bad weather conditions, high fuel prices, overall decline in economy, airport closures etc. Despite these challenges Southwest Airlines (LUV) has been able to maintain profitability for past 42 consecutive years.
Business overview
Airline business is straight forward. Airline operators sell tickets and pay for the fuel, aircraft, salary of employees, airport fees. The difference between ticket sale and expenses is the profit. Airlines normally have a hub city and most of the flights originate from this hub city. For example United has a hub in Newark, NJ. If united has to fly its customers from point A to point B then either A or B will be the hub city. If neither A nor B is a hub city then there will be a connection at the hub city.
Southwest principally provides point-to-point service, rather than the "hub-and-spoke" service provided by most major U.S. airlines. The hub-and-spoke system concentrates most of an airline's operations at a limited number of central hub cities and serves most other destinations in the system by providing one-stop or connecting service through a hub. By not concentrating operations through one or more central transfer points, Southwest's point-to-point route structure has allowed for more direct non-stop routing than hub-and-spoke service.
This point-to-point route structure is a clear example of operational efficiencies which Southwest has developed. The management is on track to move Airtran from hub-and-spoke service to point-to-point service.
Operational efficiencies
Southwest is a low-cost airlines and in surveys when people were asked the most important factor when booking a ticket with an airline, the top answer was the Ticket Price. Southwest has a clear vision of keeping the price of tickets low and to achieve that have come up with innovative operational efficiencies.
- Southwest operates only Boeing 737 aircraft. Southwest's use of a single aircraft type has allowed for simplified
scheduling, maintenance, flight operations, and training activities.
- Southwest's point-to-point route structure includes service to and from many secondary or downtown airports such as Dallas Love Field, Houston Hobby, Chicago Midway. These conveniently located airports are typically less congested than other airlines' hub airports, which has enabled Southwest to achieve high asset utilization because aircraft can be scheduled to minimize the amount of time they are on the ground. This,in turn, has reduced the number of aircraft and gate facilities that would otherwise be required and allows for high Employee productivity.
- Fuel saving initiatives - Fuel is probably the biggest contributor to the cost of revenue for an airline. Every pound of weight added on the aircraft increases the amount of fuel consumed during the flight. Southwest has taken numerous initiatives to bring efficiencies in fuel consumption. They have a special section in their 2013 One Report where they have mentioned the initiatives taken in this direction.
Valuation
At the time of writing this article, Southwest is trading at price of $45 a share. The expected EPS for the year 2015 and 2016 is 3.50 and 3.75 respectively. Thus the forward PE for 2015 is 12.8. Given the track record of 42 consecutive years of profitability, I believe getting this stock at a forward PE of 12 is a bargain.
What's next for Southwest?
It's really hard to say how Southwest will grow over the course of next 3-5 years and I certainly have no idea what's on Gary's (Southwest Chairman) mind. But there are few things which I believe will drive growth.
- Routes served by AirTran will be made more efficient thereby reducing operational costs.
- Southwest can start servicing more domestic and international routes
- Southwest has some attractive schemes like bags fly free which no other airline is able to offer at the moment. This should attract more customers towards Southwest.
- Oil prices are likely going to remain low for 2015 and this should ultimately further add to the bottom line of the airline. This factor is common to all airlines.
Conclusion
Though Southwest has grown more than 240% in last 5 years, I see no reason for the growth to slow down. At a forward PE of 12, the stock is still attractive. Southwest is able to keep its ticket prices low despite giving free checked in bags and still maintain profitability. This has been possible by reducing operational cost year or year even though the revenues have been increasing steadily. All the factors mentioned above proves that Southwest is one well managed business which is providing exceptional service to it's customers at low cost and enhancing share holder value by regularly buying back shares. A low Debt/ Equity ratio of 0.14 and Cash and short term investments of $2.9 B further solidifies the belief that management is very careful of keeping the financial situation of the company in order.
