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Dilantha De Silva
Dilantha De Silva
Articles (156)  | Author's Website |

Southwest Airlines: Be Greedy When Others Are Fearful

There are multiple catalysts painting a positive picture for the airline

According to Warren Buffett (Trades, Portfolio), the best time to invest in the market is when there is fear resulting from uncertainties about the prospects for a company or the global economy. Empirical evidence reveals that this strategy has worked well for Berkshire Hathaway Inc. (NYSE:BRK.A) (BRK.B) for many decades, but being bold enough to buy stocks when nobody else wants to is easier said than done.

The airline industry is one of the business sectors that have been severely impacted by the global recession caused by the Covid-19 pandemic, and even Buffett dumped his entire stake in this industry earlier this year, suggesting the challenging times will not go away in the foreseeable future. This, however, should not be used as advice for all investors to follow when making decisions, as Buffett's investment objectives, risk appetite, constraints and the investment time horizon could be considerably different from a retail investor.

Carefully evaluating the prospects for the airline industry and Southwest's financial position suggests the stock is undervalued at the moment, in my opinion, and there are multiple catalysts in play that I think could drive the market value higher in the coming years.

Look out for the long-run impact of the recession

Consumer behavior has changed dramatically along with the preventive health measures introduced and implemented by health authorities around the world. For example, e-commerce sales have grown at a rapid pace as people seek to limit their exposure to public places, and Wall Street analysts and economists expect this industry to get a permanent boost resulting from these developments.

The key to analyzing the prospects for the airline industry is to evaluate the long-term impact resulting from the recession and the fear created by the pandemic. While there is no standard way to quantify this impact, one could always look at historical data to form data-backed assumptions about the future (though investors should note that the U.S. has no well-documented historical example to follow in terms of a pandemic-induced modern travel industry downturn).

A Morningstar study about recessions identified three elements that could impact the short-term behavior of consumers: habits, fear and sunk costs. Illustrated below is a summary of how these factors affect a few themes and industries in the short run:

Source: Morningstar

A change in habits and the heightened fear about personal safety are both at play in reducing travel and leisure activities of the global population at present, and this is not good news for the airline industry. This, however, is not an accurate representation of the long-term prospects for this multi-billion-dollar business sector. As illustrated below, every major economic shock since World War II and every pandemic in recent history have failed to produce long-lasting behavioral changes in consumer spending:

Source: Morningstar

Going by the past trends, it's reasonable to conclude that short-term troubles faced by the airline industry will eventually come to an end, and the companies that have what it takes to survive until then will be in a strong position to report stellar earnings growth during the aftermath of the global economic downturn.

The case for Southwest Airlines

There are many publicly listed airline companies in the United States, but I think Southwest stands out as one of the best picks because of a few reasons.

First, the company has a leading position in the domestic air travel market in the U.S. Traveling to international destinations carries a lot of health and bureaucracy risk, especially in the current times as passengers coming from the U.S. are expected to not only adhere to heightened safety precautions but also to follow international quarantine rules. Because of the complexity of these regulatory requirements and the uncertainty surrounding national policies pertaining to travel, airlines that generate the bulk of their revenue from cross-border flights will take much longer to recover than pure-play domestic carriers, according to a July report from the International Air Transport Association.

Source: The International Air Transport Association

Southwest, as illustrated below, has a leading position in 23 of the 50 most populous metro areas in the country and has a clear dominant position over its closest rivals. This will help the company recover faster than other airlines, which is likely to be reflected by the market performance of its stock in the coming months.

Source: Investor presentation

Second, Southwest's liquidity profile is second to none in the industry. The company had more than $14 billion in cash as of Sept. 30, and Southwest has so far raised more than $18 billion this year to navigate the challenging operating conditions. The company has prioritized surviving this recession over investing for growth in the last few months, which is the right way forward as there are many uncertainties ahead for the industry. According to company filings, more than $8 billion of investments have been abandoned this year to preserve cash, and these decisions have helped the company remain afloat. Below are some of the other measures taken by the company to improve its liquidity position:

  1. Reduced the salaries of board officers by 20%.
  2. Introduced a voluntary separation program and an emergency time off program to reduce the workforce by approximately 25%.
  3. Reduced discretionary spending.
  4. Temporary pay rate reductions were introduced for non-contract employees.

All these decisions were taken considering the dire situation of the industry and to safeguard the interests of shareholders of the company. Southwest can survive this challenging business environment for at least another year, and the macroeconomic outlook is very likely to improve in the next few months.

Third, Southwest is in a comparatively better position to realize operating efficiencies in the recovery period. Many factors determine the cost efficiency of an airline, and one of the primary metrics is the age of the airplanes owned by a company. A company with a relatively young fleet of aircraft is likely to incur low maintenance costs, and this is exactly the case with Southwest. Below are the average fleet ages of popular U.S. airlines:

Airline

Average fleet age

Southwest Airlines

12.7

American Airlines Group Inc. (NASDAQ:AAL)

12.1

United Airlines Holdings, Inc. (NASDAQ:UAL)

16.1

Delta Air Lines, Inc. (NYSE:DAL)

14.6

Source: AirFleets

Southwest's fleet of aircraft is older only compared to that of American Airlines, and these two carriers are ahead of the competition. Coupled with the expectation that Southwest will benefit from an uptick in domestic travel, a young fleet of aircraft will help the company keep operating costs in check during the recovery phase. Because of this reason, Southwest will be in a position to report better-than-average profit margins in the future, which could lead to a premium valuation for the company's equity securities in the market.

Fourth, the market outlook is improving even though the numbers are way off in comparison to 2019. Thanksgiving is considered a red-hot holiday for U.S. travelers, and a spike in air travel generally occurs during the holidays. Things were no different this time around as well, albeit a significantly lower number of Americans were traveling in comparison to the corresponding period last year.

Source: Barron's

The total travel throughput has been trending upward since April, and the recovery can be expected to gather momentum along with the success of pharmaceutical giants in developing a vaccine for Covid-19.

Takeaway

It takes courage to invest in troubled business sectors, but the most lucrative returns are reserved for those who are bold enough to be different from the rest of the market. Not all investors follow the same strategy, so any opportunity that seems lucrative to one investor might not necessarily fit another. Growth and value investors with a high risk appetite are likely to find Southwest attractive, whereas risk-averse investors are likely to find the risk-reward profile troubling.

Disclosure: The author owns shares in Southwest.

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About the author:

Dilantha De Silva
I am an investment professional with 5-years of experience in financial markets. I specialize in U.S. equities and incorporate a top-down approach to identify developing macro-level trends and the companies that would benefit from such trends. I am a strong believer that the best investment opportunities could be found in under-covered equities.

I currently work with leading financial publications including Refinitiv, Seeking Alpha, ValueWalk, GuruFocus, and TradeGrill to produce investment-related content.

I\'m a CFA level 2 candidate and an Associate Member of the Chartered Institute for Securities and Investment (CISI, UK). I am a registered candidate for the Chartered Wealth Manager program as well. During my free time, I enjoy reading.

Visit Dilantha De Silva's Website


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Comments

dukkipat
Dukkipat premium member - 1 month ago

Good post. I used to fly southwest every week prior to pandemic and I agree that it has the best chance to recover due to its strong dometic routes and relatively newer planes

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