In Part 2 of my investment activity review for July, I review my analysis of a company that I’ve long admired but I never had a chance to buy into because the stock has always been pricey. In July some recent events caused the stock to fall down quite violently and I thought I should take a look at it using my 8 questions and see if there is still an opportunity.
Opened Position in Southwest Airlines (Ticker: LUV)
Before there was Westjet, JetBlue, and RyanAir, there was one discount airline to rule them all and that has been Southwest Airlines. Southwest created the whole category of discount airline and has been considered the best of breed in this space.
Question 1: What do they sell?
As always we got to our good friends at Reuters with their cheat note definition of Southwest.
“Southwest Airlines Co. (Southwest) operates Southwest Airlines. Southwest is a passenger airline that provides scheduled air transportation in the United States and near-international markets. The Company serves approximately 100 destinations in over 40 states, such as the District of Columbia, the Commonwealth of Puerto Rico, and approximately seven near-international countries, including Mexico, Jamaica, The Bahamas, Aruba, Dominican Republic, Costa Rica, and Belize. The Company added its first three destinations in Central America (San Jose, Costa Rica, Belize City, Belize, and Liberia, Costa Rica) and also commenced Southwest service to a fourth destination in Mexico (Puerto Vallarta). Southwest operates a total of approximately 704 Boeing 737 aircraft. The Company also added approximately 20 domestic nonstop destinations from Dallas Love Field. Southwest offers a total of 180 weekday departures to 50 nonstop destinations from Dallas Love Field.”
Southwest sells one of the core day-to-day needs which is transportation. They sell mobility, more specifically regional mobility. Before Southwest, airline travel was all about experience and amenities. Southwest came in a said, flying is really about utility and getting from point A to point B so it should be no different from taking a bus or a train. You get on board, the plane takes off and lands. You get off and move on. To achieve this Southwest had to streamline it’s business processes. Specifically Southwest pioneered some interesting functions in the airline game:
- They use only one type of plane, the Boeing 737, which saves the company millions in maintenance costs and other operating costs. Pilots only have to be familiar with one type of plane so training costs are lower.
- Focus on point-to-point direct flights instead of traditional hub and spoke formats which reduces filght delays and risks of missing connecting flights. Their on-time performance has consistently among the highest in the industry.
- They don’t offer tiered/class level service like fancy drinks, meals, slippers. Everyone gets the same level of service. Doing so again reduces costs for the airline to clean and restock their planes.
- They’re pretty upfront with their prices. Hidden fees are kept to a miniumum or are non-existant at all.
- The airline is unionized yet there has never been a strike in the company’s history. Customer service is a religion and it starts with the culture that empowers employees to take ownership of the solution and issues instead of relying on a bureaucracy.
Question 2: Who do they compete with?
Southwest while still considering themselves a “regional” airline competes pretty hard against other national US airlines like United and Delta along with other discount carriers like JetBlue.
Question 3: Who buys their products and services?
Travelling is core need for everyone. As with offering a discount value proposition, their core clientele tends to be smaller businesses that have tight budgets but rely on transportation to secure needed business in other parts of the country.
Question 4: Will they buy their product over and over again?
As long as there is required need for people to travel and travel cheaply, there will be a need for airlines.
Question 5: Do they make money?
Warren Buffet has often commented that the airline carriers are the worst businesses to run because their high capital and legacy costs just make it really difficult for them generate any consistent level of profit. They are also dependent on commodities like jet fuel being low enough to sustain any profit. It’s true and historically the airline industry has demonstrated a tendency to destroy shareholder wealth rather than create wealth and I’ve avoided them because of this. However when it comes to profitability, Southwest has challenged this notion and won handsomely. The company recently reported its 43rd consecutive year of profits. In the time I’ve been alive plus a couple of years, this company has made money.
In the last few years, the company has continued to generate Returns on Invested Capital in the 14-15 percent range which is higher than their estimated cost of capital which has come in around the 10 percent range.
Question 6: What do they own and who do they owe money to?
If you look at their balance sheet you wouldn’t sense that this a capital intensive type business. Debt/Equity comes in around 0.36 which is manageable. There isn’t very much in terms of intangible assets. The company has enough cash to pay it’s long term debt if it has to.
Question 7: How risky is their business?
Airline travel is a pretty cyclical business and is dependent on how the economy is going. In good times, money is available to travel. In bad times, budgets shrink and travel is limited. It’s also quite dependent on input costs such as jet fuel. Recently with oil prices cratering, jet fuel prices are at its lowest level in 5 years. As we’ve seen that can change pretty fast. The world is getting smaller too. Technology has reduced the need for us to be physically somewhere else. Fiberoptics allow us now to talk and share information with family and colleagues around the world in real-time. The world is also getting more dangerous. Terrorism always hangs over the airline industry there is always that risk that the bad people will instill a climate of fear that can hold people from flying.
The saving grace with Southwest is that it has developed a culture especially with its leadership that doesn’t just sit back on its laurels. It is quite in tuned with these risk elements and has an amazing track record (remember those 43 years of profits) of managing through various shocks in the market.
Question 8: Is the stock cheap?
The problem with quality, well-run, well managed companies sometimes is that they will be slightly more expensive. It’s a reason why I’ve never been able to buy Southwest. I’ve always thought it was pricy, but I kept it on my List hoping one day the price would come back and I can jump in.
Southwest reported in latest quarter that the company missed sales and profit estimates and provided pretty downbeat guidance for future earnings. Wall Street killed them, taking the stock down almost 11 percent which I thought was overkill. Even though the company missed estimates, they are still forecasting another year of profits. Part of it is the industry appears to be in a low cycle.
“With 'terrorist' incidents breaking out everywhere from San Bernardino to the south of France, it is perhaps no surprise that the world's airlines are struggling. But, as Bloomberg notes, over-capacity, rising fuel costs (so far this year), and weaker demand have hurt profits and crushed airline stocks to their worst year since 2008...”
Airline stocks appear to be travelling in some uncomfortable turbulence and has put a fair amount of pressure on their stock prices. For me, the 11 percent drop in Southwest despite the fact it is making money in a down market, along with the fact that it is a best of breed company make it hard for me to avoid. Eventually the market will turn around and Southwest will more than likely bounce back faster. So I used to the opportunity to open a small position in the stock. If it should fall further with no fundamental change in the business, I’ll add more to average the cost down.