(Published on May 25 by Nicholas McCullum)
The airline industry has not historically been seen as the best sector of the economy for profitable investment.
This is due in large part to the poor operating histories of the companies in this sector. Most airlines have experienced bankruptcy at one point or another.
That’s why so many investors were surprised to see that Warren Buffett (Trades, Portfolio) had initiated significant stakes in a few of the largest domestic airlines. These companies have very different characteristics than Buffett’s typical holdings as he places a great deal of emphasis on downside protection in his common stock portfolio.
Buffett currently has multibillion-dollar stakes in the "big four" U.S. airlines with position sizes ranging from $2 billion to $2.5 billion.
Buffett’s largest airlines holding is Southwest Airlines (LUV, Financial). Really, this should be no surprise – Southwest has a much better history than many of its peers with 44 consecutive years of profitable operations.
Business overview and current events
Southwest Airlines is one of the "big four" U.S. airline companies and the largest low-cost airline in the world.
The company was founded in 1967 and commenced operations in 1971. Since then, Southwest has grown to a market capitalization of $36.3 billion.
As mentioned in the introduction, one of the remarkable characteristics of Southwest Airlines is its long history of profitable business. The airline business is incredibly cyclical and capital intensive, which has led to a multitude of bankruptcies over the history of this industry.
Source: Southwest Airlines Investor Presentation, slide 4
Southwest has never declared bankruptcy, a feat that many of its competitors (including "big four" members United [UAL], Delta [DAL] and American Airlines’ [AAL] predecessor U.S. Airways) have not achieved.
Further, Southwest Airlines has reported a profit in 44 consecutive years, meaning the company has never been close to bankruptcy.
2016 was no different. Southwest Airlines reported many record financial statistics including operating revenues of $20.4 billion, net income of $2.4 billion, operating cash flow of $4.3 billion and free cash flow of $2.3 billion.
Moving on, the next section will discuss Southwest’s growth prospects in detail.
Lately, Southwest has been investing heavily in two initiatives: fleet modernization and cost control.
While these initiatives are separate on the surface, they are really quite complimentary. Having a more modern fleet allows Southwest to be more efficient by improving fuel efficiency and having a higher average seat count per aircraft.
2014 saw Southwest completely eliminate the legacy 717 aircraft type. Further, the company has been steadily increasing the count of 800-class aircraft, which are essentially a 737 with an extended fuselage and seat up to 189 passengers – significantly above Southwest’s average 149 seats per aircraft.
Source: Southwest Airlines Investor Presentation, slide 9
Southwest’s fleet modernization initiatives have allowed the company to dramatically reduce one of its largest costs – fuel.
Aircraft fuel efficiency – which is measured in available seat miles per gallon, or ASMs per gallon in the following slide – have increased in each year since 2012 by low-single-digit percentages.
Source: Southwest Airlines Investor Presentation, slide 10
Southwest’s increased fuel efficiency, combined with low fuel prices driven by declining oil prices, have meaningfully reduced the company’s fuel expense and correspondingly increased profits in recent years.
The company’s ongoing investments in fleet modernization and cost controls will be the largest contributor to its earnings growth moving forward.
Competitive advantage and recession performance
The airline industry is what BuffettÂ calls a "commodity business" – an industry where the single largest differentiator between competitors is the price of the products and services that are provided to consumers.
Buffett has traditionally avoided commodity businesses because they lack durable competitive advantages. This was one of the (many) reasons why the markets were surprised at his investment in airline companies.
With that in mind, Southwest Airlines has a size-based competitive advantage that stems from being the largest low-cost airline provider.
Southwest is able to deliver low ticket prices while still maintaining a growing profit base.
Source: Southwest Airlines Investor Presentation, slide 6
Despite Southwest’s strong profitability record compared to its peers, many investors are still rightly concerned about how the company will perform in a recession relative to the broader stock market.
The global financial crisis saw a peak-to-trough earnings-per-share decline of 73.6% for Southwest Airlines. The company’s adjusted earnings-per-share trend during the last major recession can be seen below.
- 2006 adjusted earnings per share: 72 cents.
- 2007 adjusted earnings per share: 61 cents (15.3% decrease).
- 2008 adjusted earnings per share: 40 cents (34.4% decrease).
- 2009 adjusted earnings per share: 19 cents (52.5% decrease).
- 2010 adjusted earnings per share: 73 cents (284.2% increase).
As you can see, Southwest Airlines’ earnings per share declined steadily from 72 cents to 19 cents during the global financial crisis. This performance is much worse than many of the other companies covered on Sure Dividend.
With that said, Southwest Airlines’ performance during the last recession was much better than many of its peers in the airline industry. Many other players in this industry went out of business completely.
Further, the company’s current financial positioning make it well positioned to withstand any incumbent economic downturns.
Southwest Airlines currently has $3.3 billion in unrestricted core cash and short-term investments that it can draw on if profits become squeezed. The airline also benefits from a $1 billion line of credit that is currently fully undrawn and available for deployment.
Source: Southwest Airlines Investor Presentation, slide 11
Looking more broadly at Southwest Airlines’ financial statements and credit ratings reveal that this airline is significantly more creditworthy than any of its peers.
Southwest Airlines is the only major American airline to hold investment-grade credit ratings from each of the three major agencies – Standard & Poor's, Moody’s and Fitch.
Southwest Airlines’ credit ratings from these credit rating agencies are compared to its peers below.
Source: Southwest Airlines Investor Presentation, slide 12
Southwest Airlines also has a very manageable debt maturity schedule.
This is important because if all of Southwest’s debt matured in the same year, it would be much more difficult to refinance or pay off all of this debt simultaneously.
As it sits right now, a large proportion of Southwest’s debt is maturing in 2022 or later and the company’s debt prior to that period is well spread across years.
Southwest’s debt maturity schedule can be seen in detail below.
Source: Southwest Airlines Investor Presentation, slide 13
To conclude, there is no denying that the airline industry is notoriously susceptible to economic downturns.
For investors concerned with downside protection, Southwest Airlines is the best of breed in this industry, although still not as recession resistant as AAA-rated companies like Johnson & Johnson (JNJ, Financial) or Microsoft (MSFT, Financial).
Valuation and expected total returns
Future shareholder returns for Southwest Airlines shareholders will come from valuation changes, earnings-per-share growth, and the company’s current dividend yield.
Most of the companies in the airline industry trade at pessimistically low valuations because of their tendency to go bankrupt when the economy slows.
As we’ve seen, Southwest Airlines has actually performed quite well relative to its peers when recessions hit. This has impacted the companies' valuations – Southwest trades at a substantial premium to its "big four" peer group.
Southwest is trading at a meaningful valuation premium as measured by the price-earnings (P/E) ratio. However, it is certainly arguable that Southwest is a higher-quality business, having never declared bankruptcy and riding 44 years of profitable operations.
“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” – Warren Buffett
Judging from the quote above, Buffett has a preference for high-quality businesses. It should not be surprising that Southwest is Buffett’s largest airline holding.
However, investors should still be concerned with Southwest’s valuation. It is important to measure valuations both across companies (by comparing Southwest to its peers, as shown above) and within companies (by comparing Southwest’s valuation to its historical averages).
Southwest Airlines reported adjusted earnings per share of $3.75 in fiscal 2016. The company’s stock is currently trading at $59.58 for an adjusted P/E ratio of 15.9.
The following diagram compares Southwest Airlines’ current valuation to its long-term historical average.
Source: Value Line
Although elevated from its levels in more recent years, Southwest Airlines’ valuation is still noticeably below its long-term historical average.
Thus, it appears that valuation expansion will be a positive contributor to future shareholder returns.
The company also has a robust track record at compounding its bottom line.
Southwest Airlines has grown its adjusted earnings per share at a rate of 13.8% since 2001. The company’s earnings-per-share history can be seen below.
Source: Value Line
Looking ahead, I expect the company’s rapid historical growth to moderate slightly. Investors can reasonably expect Southwest Airlines to compound its bottom line at a rate of 8% to 10% over full economic cycles.
This earnings-per-share growth will be positively impacted by Southwest’s shareholder-friendly capital allocation. The airline delivers a large proportion of its growing free cash flow to its shareholders via dividend payments and share repurchases.
Source: Southwest Airlines Investor Presentation, slide 15
Further, Southwest’s shareholder-friendliness stands out from its peer group, as it is the only domestic airline with a multidecade history of returning excess cash to its shareholders.
This gives investors faith that shareholder returns will continue for the foreseeable future.
Source: Southwest Airlines Investor Presentation, slide 16
It should be noted that the airline recently announced a new $2 billion share repurchase program, which amounts to roughly 5.5% of the company’s current market capitalization.
Aside from valuation changes and bottom-line growth, the remainder of the company’s per-share total returns will come from its current dividend yield.
Southwest Airlines recently increased its quarterly dividend payment to 12.5 cents per share. This quarterly payout yields 0.8% on the company’s current stock price of $59.58.
Southwest is a low-yield dividend stock right now, but the company has meaningfully increased its dividend in recent years and this growth is likely to continue.
Southwest Airlines’ total returns will be composed of:
- 8% to 10% earnings-per-share growth (boosted by share repurchases).
- 0.8% dividend yield.
For expected total returns of 8.8% to 10.8% before the (likely positive) effect of valuation changes.
The airline industry is notorious among investors for its terrible historical performance during recessions and its abundance of high-profile corporate bankruptcies.
However, the industry has consolidated over time and today’s airlines are much larger and more stable than their historical counterparts.
Southwest Airlines stands out among today’s airlines because of its long history of profitable operations. The company has never declared bankruptcy, which is rare among airline businesses.
Thus, Southwest represents a best-of-breed opportunity to gain exposure to the rapidly consolidating air transportation industry.
Disclosure: I am not long any of the stocks mentioned in this article.
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