Southwest Airlines Is a Long-Term Buy

Airline expanded internationally with acquisition of AirTran

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Apr 20, 2016
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Southwest Airlines Co. (LUV, Financial), a $30.07 billion market cap company, is a major passenger airline that provides scheduled air transportation in the U.S. The firm operates in almost 100 destinations across the U.S. Since 1967, Southwest Airlines has expanded inside and outside the U.S. For example, the acquisition of AirTran is a case of international expansion.

Southwest Airlines is one of the largest domestic airlines company in the U.S. The company has a low-cost structure that helped the firm’s earnings generation. Also, Southwest Airlines has some other advantages by maximizing aircraft utilization and employee productivity. This arrangement allowed the company to generate operating profits for more than four decades in an airline industry that has seen multiple bankruptcies.

We believe the passenger demand is increasing, while stable prices and lower oil prices are the primary drivers for the upcoming future. Moreover, competition is high and since the financial crisis, the pricing power played a crucial role. Some of the largest include Delta Air Lines (DAL, Financial), United Continental Holdings (UAL, Financial), US Airways Group (LCC, Financial), JetBlue Airways (JBLU, Financial) and SkyWest (SKYW, Financial).

The company has paid a dividend since 1976. Analysts at Barclays upgraded the company to "buy" with a price target of $48. Considering a median of $54.62, there exists about a 15.9% of upside potential from the actual closing price. Moreover, according to Yahoo! (YHOO, Financial) Finance, the estimated one-year target share price is $55, reflecting a future price appreciation of practically the same return.

Regarding valuation, the stock sells at a trailing P/E of 14.48x, trading at a premium compared to an average of 11.70x for the industry. To use another metric, its price-to-book ratio of 4.16x indicates a premium versus the industry average of 1.65x, while the price-to-sales ratio of 1.61x is above the industry average of 0.62x. The P/B ratio is close to 10-year high of 4.57x, and the P/S ratio is close to 10-year high of 1.76x. Although the stock looks overvalued according to those metrics, it is undervalued compared to its historical P/E ratio.

The stock price has an upward trend in the five-year period. If you had invested $10,000 five years ago, today you could have $39,262, which represents a 31.5% compound annual growth rate.

T Rowe Price Equity Income Fund (Trades, Portfolio) has initiated a new position with 1,281,300 shares. Other gurus including David Tepper (Trades, Portfolio), Jim Simons (Trades, Portfolio), Paul Tudor Jones (Trades, Portfolio), Pioneer Investments (Trades, Portfolio) and Barrow, Hanley, Mewhinney & Strauss have increased their positions in the stock.

On the other hand, David Dreman (Trades, Portfolio) and George Soros (Trades, Portfolio) sold out the stock, while PRIMECAP Management (Trades, Portfolio), RS Investment Management (Trades, Portfolio), Lee Ainslie (Trades, Portfolio), Joel Greenblatt (Trades, Portfolio), Ray Dalio (Trades, Portfolio) and Steven Cohen (Trades, Portfolio) have reduced their positions.

Final comment

I believe the entire industry will do well in the near term, but only the best ones will continue to grow. The stock has returned 9.6% on a year-to-date basis and almost 11% over the past 52 weeks.

Further, healthy operating profits, as well as the PE relative valuation, make me feel bullish on the stock. In addition, this is the first year since the AirTran acquisition in which we can see the benefits that would be a plus to operations.

Disclosure: Omar Venerio holds no position in any stocks mentioned.