Southwest Airlines (LUV, Financial) has recently experienced a downturn in its stock price. Since the beginning of the year, it has lost nearly 24%, plunging from $66.30 to $50.50. The market pessimism was caused by higher fuel prices, higher competition and the recent accident in Southwest Airlines Flight 1380. But this is only a temporary challenge. This low price creates a buy opportunity for long-term investors.
Short-term challenges
The accident of Flight 1380, which caused the death of one passenger, was Southwest's first death in its 47-year history, and the first death on a U.S. airline since 2009. The accident definitely has had a negative influence in Southwest. In the first week since the accident, the company has experienced a decline of 0.5 to 1 point in revenue per available seat mile (RASM).
The lower RASM after the accident might be also caused by the company decreasing its marketing. For the second quarter, Southwest said that it expects RASM to fall by 1-3%. In addition, after retiring the oldest Boeing 737 fleets last year, the company is facing a shortage of new ones. Thus, in the past two quarters, it had to operate a suboptimal schedule.
Operating efficiencies will improve
The company has said that it expects the second quarter to be the bottom for RASM and for it to improve going forward. The company has ordered 40 single-aisle MAX 8 models for $4.68 billion to be delivered between 2019 and 2022. With new aircraft deliveries, Southwest will begin to get its fleet back in balance.Â
It moved five 737 MAX 8 deliveries from 2019 to the fourth quarter of this year. Because of the new order structure, Southwest’s annual fleet growth will be around 3%. Due to fleet replacement and expansion, Southwest’s capital expenditure could be $2 billion to $2.1 billion for the full year 2018. This can be considered both maintenance and growth capex as the new fleet would require lower maintenance expenses in the future, and it is also much more fuel efficient.
Southwest also re-optimized the schedule with these new aircraft and benefits from the new reservation system. Previously, the old system allowed a company solely to optimize revenue at the flight level, not at the itinerary level. With the new reservation system, Southwest can maximize revenue at the boarder level, by optimizing both connecting passengers and non-stop passengers. The company expects that the new reservation system can produce benefits of $200 million in 2018, mainly from enhanced revenue management capabilities. By 2020, this reservation system could generate $500 million in incremental annual earnings.
Airline operation depends less on oil prices due to hedging
Fuel cost is the largest expense in operating airlines. For the past year, an increasing oil price has meant increasing operating costs for airlines. For Southwest, in the first quarter of 2018, fuel charges accounted for 23.5% of the total operating expenses. Compared to the first quarter last year, the fuel and oil expenses, excluding taxes, climbed only 3%, from $2.03 per gallon to $2.09 per gallon. Other airlines such as Delta (DAL, Financial), United Airlines (UAL, Financial),and Spirit Airlines (SAVE, Financial) experienced the huge increase in fuel expenses. In the first quarter of 2018, Delta’s fuel costs surged by 22.2%, while United’s aircraft fuel expense jumped by 23.4%.
Southwest has been the most active in fuel hedging in the airline industry. Between 1999 and 2008, Southwest has reportedly saved more than $4 billion through its fuel hedges. This also helped the airline avoid significant losses in the energy crisis of the 2000s.
If oil prices keep rising, the company's hedge contracts will definitely work out, keeping the its fuel expenses under better control than its airline peers. If the oil price declines, Southwest's hedges will suffer. The low price means higher operating profit for the company, however, offsetting the declining value of fuel hedges.
Highest return and lowest cash flow valuation
What makes Southwest’s business sustainably profitable is the high and improving return on invested capital (ROIC). In the past five years, Southwest’s ROIC has risen consistently higher. Now it has the highest ROIC at nearly 29%, beating all of its airline peers. Delta ranked second with 15.8% ROIC. Spirit Airlines is third at 11.5, and United Airlines is fourth at 10.16%.
Southwest seems cheap with positive free cash flow compared to other airlines. Its EV/FCF is 23.16x, lower than Delta’s 36.43x. United Airlines and Spirit Airlines, on the other hand, are producing negative free cash flow, so the EV/FCF is not applicable.
What is Southwest’s stock worth?
In the past five years, Southwest’s free cash flow growth was 10.98% per year. We will assume similar growth in the next five years. After that the terminal growth will be only 3%. The discount rate will be 9%.
Recently, Southwest announced another $2 billion share repurchase authorization and increase its quarterly dividend by 28% to return more cash to shareholders. If Southwest uses all of its share repurchase authorization to buy back shares for an average price of $55, it will reduce its total share count to 537 million.
| Discount period | 1 | 2 | 3 | 4 | 5 | 6 |
| Â | 2018 | 2019 | 2020 | 2021 | 2022 | Terminal value |
| Free cash flow ($ billion) | $1.85 | $2.05 | $2.28 | $2.53 | $2.81 | $48.18 |
| Discounted FCF ($ billion) | $1.70 | $1.73 | $1.76 | $1.79 | $1.82 | $25.79 |
| Total NPV ($ billion) | $34.59 | Â | Â | Â | Â | Â |
| Total shares outstanding (million) | 537 | Â | Â | Â | Â | Â |
| Per share ($) | $64.37 | Â | Â | Â | Â | Â |
| Â | Â | Â | Â | Â | Â | Â |
| Growth in 5 years | 10.98% | Â | Â | Â | Â | Â |
| Terminal growth | 3% | Â | Â | Â | Â | Â |
| Discount rate | 9% | Â | Â | Â | Â | Â |
Following the discounted free cash flow model, the intrinsic value of Southwest Airlines is around $64 per share. That is 24% upside compared to the current share price.
