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John Engle
John Engle
Articles (529) 

Southwest Airlines: Bailed Out, but Problems Remain

The Treasury has offered Southwest $3.2 billion in emergency financing in exchange for a few warrants

April 16, 2020 | About:

Airline stocks have taken a beating since late February, when panic over the Covid-19 outbreak crushed air traffic volumes. With its fleet essentially grounded and facing a rapidly depleting cash balance, Southwest Airlines Co. (NYSE:LUV) was rapidly approaching insolvency.

The Dallas-based discount air-carrier has proven itself to be a strong industry player, but even the best airlines have been humbled by the combined health and economic crisis. In March, Southwest had no choice but to join its peers in going hat in hand to the federal government in search of a bailout.

A generous offer

While the question of whether the federal government would offer airlines financial relief was hardly ever in doubt, its exact terms took a while to take shape. Government bailouts are not always favorable to incumbent managers or existing shareholders. During the last major financial crisis, General Motors Co. (GM) had no choice but to accept a bailout, but GM’s rescue came at the cost of its equity holders, who were wiped out through a bankruptcy restructuring. With that precedent in mind, many investors were fretful of what terms the government might demand of airlines.

Thankfully for shareholders, the Treasury Department has proven friendlier to the notion of preserving the existing equity of companies receiving bailouts. On April 14, Southwest announced that it had reached an agreement with the government in which it will receive $2.3 billion in grants, as well as a $1 billion low-interest loan backed by warrants that could dilute Southwest shareholders only minimally, even if fully exercised.

Southwest now has a lifeline that should see it through the worst of the crisis. However, its problems may be far from over.

Surviving the future

Like all airlines, Southwest will need to contend with a range of serious operational and market challenges that will persist. On April 7, Andrew Walker, a portfolio manager at Rangeley Capital, described the unforgiving operating environment facing airlines in no uncertain terms:

“The current operating environment for airlines is a disaster, but the short term headwinds aren’t the only issue facing them. There’s going to be a huge oversupply of planes for years coming out of this, there’s going to be a bunch of out of work air workers, and there are going to be a bunch of unused gates / travel routes given the decrease in demand. You know what that sounds like a great environment for? Starting a new airline with a clean balance sheet to compete. The thesis on airlines for the past few years was ‘merged into a rational oligopoly that won’t go into price wars again.’ An industry with massive overcapacity is ripe for price wars and / or upstarts with clean balance sheets.”

Southwest will likely face serious turbulence ahead, along with the whole airline industry. We are not out of the woods economically. Thus, while Southwest’s finances have been shored up, the company has some way to go before it is back on anything like a “normal” track. Over the longer term, Southwest will have to confront a very different market environment.

Verdict

Southwest Airlines has proven itself to be one of the most efficient operators in the industry and, as a pioneer of low-cost fares, it has proven that it can adapt and compete in tough markets. However, the economic challenges facing the industry going forward are cause for concern, in my view.

With the terms of the federal bailout now established, one major overhang on airline stocks, including Southwest, has been lifted. Southwest is likely to climb higher in the near-term. Even so, I recommend that investors approach this name only with great caution.

Disclosure: No positions.

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About the author:

John Engle
John Engle is president of Almington Capital Merchant Bankers and chief investment officer of the Cannabis Capital Group. John specializes in value and special situation strategies. He holds a bachelor's degree in economics from Trinity College Dublin, a diploma in finance from the London School of Economics and an MBA from the University of Oxford.

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