Southwest Airlines Co. (LUV, Financial) is up over 100% since April last year, but the stock is still down 11% in the last 12 months because of the massive erosion of market value in the first quarter of 2020.
This should not come as a surprise considering the challenges faced by travel and leisure sector companies as a result of the pandemic. Back in November, there were some early signs of recovery, and I believe Southwest is the best pick among all airline companies because of its strong balance sheet and presence in the local market. I think there's reason to believe this is just the start of a bull run that could push Southwest stock into new highs in the second half of 2021.
The macroeconomic outlook is improving
The global Covid-19 pandemic has been the primary reason behind the decline of airline stocks, so a top-down analysis is required to identify potential inflection points. There are a few positive developments from this front to suggest Southwest will be in a good position to grow by the second half of this year.
First, there is the expected success of the vaccination program. As the below chart illustrates, the rolling seven-day average of daily new cases in the United States has declined sharply in the last few weeks to pre-November levels as the vaccine has rolled out, which is a very promising sign.
Source: The Covid Tracking Project
If infections continue to fall as they have recently, many Americans will feel more at ease to travel domestically, which should pave the way for Southwest to report strong revenue and earnings growth because of its focused presence in the domestic market. The carrier is widely considered as one of the most customer-friendly low-cost carriers as well, which is another positive.
Second, many airlines, including Southwest, reported growth in ancillary revenue per passenger in 2020, which is a good sign. Non-ticket sales such as onboard food and additional baggage services are the primary ancillary revenues earned by the airline industry, and strong growth from this front will be key to the recovery of this business sector in the latter half of 2021.
Source: Advisor Perspectives/U.S. Global Investors
Third, the record savings accumulated by U.S. households could drive the demand for leisure activities the recession begins to subside, and this is good news for Southwest Airlines. According to data from the Federal Reserve, household savings reached a record high of over $1.29 trillion last October, and the savings rate remains elevated at over 13% in comparison to the historical average of around 7%. Pent-up demand for travel will play a key role in Southwest's recovery.
A full recovery is not required for Southwest to turn a profit
One of the misconceptions about investing in beaten-down travel stocks is that these companies need to recover fully to pre-recession levels to report positive earnings. According to many Wall Street analysts, it would take at least a couple of years for Southwest to reach 2019 revenue levels, which is often used as a stand-alone metric to conclude the company is not a good investment.
This, however, is not an accurate representation of Southwest's future profitability, in my view. The company has significantly reduced its operating expenses. For the fourth quarter of 2020, Southwest reported a daily cash burn rate of $12 million, which is an improvement from the $16 million daily cash burn reported in the previous quarter. This goes on to suggest that Southwest has become much more efficient. During the fourth-quarter earnings call, Southwest president Tom Nealon said:
"We've shared this with you all before, but once we get back to operating revenues they're roughly 60% to 70% of what they were in 2019, we should be at cash breakeven. But until we get to that point, we'll continue focusing on managing our capacity, our inventory, our pricing, our costs, our operations. Those things that we control we will manage and control well."
The improving efficiency of business operations will enable Southwest to be cash-flow positive even if revenue recovers only 60%-70% of 2019 levels, which is a very promising sign. This needs to be factored into the earnings model before concluding Southwest is far from profitability.
Wall Street analysts are turning bullish
Southwest generates the bulk of its revenue domestically, and it would be reasonable to assume that domestic travel will recover much faster when the vaccination program achieves the desired results. Argus research believes this will be a catalyst for Southwest stock to reach new highs in 2021. In a research note sent to clients in early February, Argus analysts wrote:
"If the company's costs rise less than we anticipate, we would consider returning the stock to our BUY list. We are maintaining our long-term BUY rating based on the company's record of above-peer-average revenue growth, driven by its simple fare structure and reputation for generally good customer service."
Morgan Stanley (MS, Financial) is also bullish on Southwest for many reasons, and the return of Boeing (BA, Financial) 737 Max is one of the key points highlighted in its latest research report. Analyst Ravi Shanker wrote:
"LUV took delivery of 7 leased MAXes from Boeing in December, with another 34 already in storage. With a total of 41 MAXes now, we think this positions LUV well as the plane begins to fly again on March 11th (LUV believes they will be in normal operational mode by mid-April). With LUV already identifying older 737-700s with expensive maintenance profiles set for retirement, we believe this will allow LUV to enter the next recovery with lower structural operating costs."
The Wall Street consensus price target of $56.50 implies an upside of close to 13% from the closing market price of $50.05 on Feb. 5, but I think the stock is likely to head much higher if the recovery proves to be stronger than what analysts are expecting.
Takeaway
Southwest Airlines stock has rallied in the last few months, but the best is yet to come going by the expected recovery in travel later this year. Many uncertainties are surrounding the airline industry, but Southwest's strong balance sheet coupled with its improving efficiency paint a very promising picture of what the future holds for the company. Contrarian and value investors are likely to find this a compelling opportunity as the worst seems to be behind us.
Disclosure: The author owns shares in Southwest Airlines.
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