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Southwest Airlines (LUV) began as a regional domestic carrier operating out of Dallas Love Field (hence the ticker symbol). But it has added service to many cities throughout the United States, expanding primarily along the two coasts. The carrier is known for its low fares and no-frills service, which explains why revenues are below average, despite being one of the largest airlines in terms of passengers carried.

Operating efficiencies, however, have made Southwest one of the more profitable. Its model was put to the test during the recent economic downturn, which had been one of the most challenging periods on record for airlines. While many sustained losses, Southwest remained profitable.

Its performance has not gone unnoticed by investors. Southwest’s market value is one of the largest among publicly traded domestic airlines under our review, second only to Delta Airlines (DAL), which is only in the top spot because it merged with industry giant Northwest Airlines in 2008. Although this may normally imply that a stock is overvalued, we don’t believe that this is the case with LUV shares.

Deriving Strength From Efficiency
At the core of Southwest’s success is its point-to-point route network, which is more cost-efficient than the monopolistic hub-and-spoke structure employed by the majors. Additionally, the airline uses second-tier airports, where landing fees are lower and congestion is minimal, keeping costs down and shortening delays that would otherwise waste valuable resources. By selling tickets entirely online and eliminating travel agents from its sales channel, management has reduced annual selling costs to near zero from roughly $200 million 10 years ago.

Despite a still-sluggish economy, travel demand is decent. In the first eight months of the year, passenger traffic rose 2.7% over the comparable year-earlier level. During the same period, fleet capacity, which was already very low, fell an additional 1.0%. The percentage of seats filled consequently has risen by three percentage points, to 82.3%. This increasingly favorable environment, helped by rising consumer confidence, has allowed fare increases of more than 13%, on average, which should help lift Southwest’s top line by 17%, to a record $12.1 billion this year.

The high price of jet fuel is an ongoing concern, though. An effective oil-hedging program has been highly beneficial. But the airline’s fuel costs are still expected to rise by 22%, to more than $3.4 billion, in 2010. Assuming the price of oil doesn’t rise too much above current levels, Southwest should be able to produce a sizable profit advance next year.

Room To Grow
With just 14% of domestic capacity attributable to Southwest, there appears to be ample opportunity for expansion in the coming years. Moreover, the airline has demonstrated that, with its low-cost model, it is able to enter a new market and gain a healthy share. The pending merger with AirTran (AAI) would provide a healthy leg-up in that respect, since there is very little route overlap. The deal would add the important Atlanta market, which represents a gaping hole the network, and strengthen several other under-represented cities, such as New York, Boston, and Baltimore/Washington, D.C. Also, AirTran’s Caribbean and Mexico destinations would allow Southwest to finally make its move into international territories. We also favor the combination because it would add to earnings in the first year, excluding non-recurring acquisition costs.

While the economic risks are higher for this capital-intensive industry, Southwest Airlines appears to be the best positioned among the transport group airlines to weather the ups and downs of a changing economy.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.