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Keep Your Eyes on This Soaring Champion

March 07, 2014 | About:
Patricio Kehoe

Patricio Kehoe

7 followers

The airline industry is probably one of the toughest to maneuvre successfully. With over 180 bankrupt companies since 1978, and 82% of the domestic market currently concentrated amongst the top four carriers with strong pricing power, this is definitely one tough market space. However, the Texas-based low-cost airline Southwest Airlines Co (LUV) has managed to not only survive 40 years in the industry, but also consecutively deliver profits, thanks to its low fares, a 700 aircraft of all-Boeing fleet, and its utilization of second-tier airports like the Chicago Midway. So, let’s see why investment gurus Jim Simons (Trades, Portfolio) and Ray Dalio (Trades, Portfolio) deposited their trust in this airline, by buying its shares last quarter.

A Success Story

Specializing in short-haul routes via a point-to-point network that reaches 96 destinations throughout the U.S. has been one of the key factors for Southwest’s 40-year profit stretch. However, the firm’s lucrative fuel hedges were even more instrumental, earning it a 2$ billion cost advantage relative to the industry and increasing its market share to a current 22%. The airline’s business model, characterized by its point-to-point network and uniform Boeing fleet, have furthermore allowed to maximize flying time, while reducing inventory and training expenses, thus putting the company ahead of its competitors JetBlue Airways Corporation (JBLU) and Republic Airways Holdings Inc. (RJET).

But since competitors started to copy Southwest’s strategy, the company has turned to expanding into more congested markets in order to maintain its edge in the industry. Having entered a mature growth phase, the airline acquired AirTran in 2010 and will complete the transaction by retiring the brand this year. The purchase will help the firm launch its much awaited international service. Moreover, the firm will also be offering its service at New York’s La Guardia Airport, as well as another 37 locations with the Hartsfield-Jackson Atlanta International Airport as its crown jewel. The 30% increase in passenger fares since 2009, consequence of raised prices and fees, should also contribute to the company’s revenue, which reached $17.7 billion at the end of fiscal 2013.

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...To be continued

Q4 of fiscal 2013 was Southwest’s record quarter, topping off a very successful year. While revenue increased by 6.1% (closing the annual average at 17.3%), due to the 8% lower oil prices, operating margins expanded to 9.2%, boosting 2012’s 3.6% to a current annual average growth rate of 7.2%. According to analysts, this average will continue over the next five years, due to stronger growth and better airplane utilization. And although this average is below the historical high rate of 18%, capital spending will barely reach 5.6%, which is far less than the previous average. Furthermore, while the AirTran acquisition and integration will be 2014’s biggest hurdle for Southwest, the purchase will also add another $500 million in revenue, leaving the company’s average growth at 5% for the next five years.

2013’s free cash flow levels were also substantial, closing at $1 billion, and returning $600 million to shareholders via buybacks and dividends. I’m also impressed with management’s efforts in reducing 2011’s post AirTran buy debt levels so quickly, leaving the balance sheet in an extremely healthy position. Although the airline is currently trading at a whopping 96% price premium relative to the industry average of 13.8x, I’m very bullish about investing in Southwest, as its EPS are spotting a profitable 62.7% growth rate. Despite possible increases in labour and fuel costs, which could somewhat offset future success, I believe this firm is well equipped and strong enough to offset any medium headwinds.

Disclosure: Patricio Kehoe holds no position in any stocks mentioned

About the author:

Patricio Kehoe
A fundamental analyst at Lone Tree Analytics

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