Southwest Airlines Is The Most Attractive Airline Right Now (NYSE:LUV)

Southwest Airlines (LUV) has plunged 40% in the last two months due to the outbreak of coronavirus. As a result, the stock is now trading near its 5-year lows. While all the airline stocks have slumped due to the pandemic, investors should not rush to conclude that they have all become bargains. In this article, I will discuss why Southwest is the most attractive airline right now.

Business overview – coronavirus

Airlines are among the companies that are most severely affected by the outbreak of coronavirus. More than one billion of people worldwide are locked at home and the others have minimized traveling in order to reduce the probability of being infected by the virus. Consequently, air traffic has collapsed lately. To provide a perspective, an 80% drop in the U.S. air traffic was reported three weeks ago.

As there is no light on the horizon, Southwest recently announced that it will extend the cut of half of its flights until June 27th. It is worth noting that this period is normally one of the busiest periods of the year and hence the effect of the pandemic on the performance of the airline will be material.

On the bright side, the U.S. Government will offer a package of $25 billion in payroll grants in order to assist the domestic airlines in the ongoing downturn. Southern announced yesterday that it reached an agreement with the Department of Treasury. The airline will receive more than $2.3 billion in direct payroll support and a nearly $1.0 billion unsecured 10-year loan, which it will be allowed to pay off before maturity if it can afford to. As the amount of $3.3 billion is 19% of the current market cap of the stock, the importance of the support of the government is evident.

Moreover, it is unreasonable to expect coronavirus to cause a permanent global recession. Many pharmaceutical companies are in the process of developing an effective treatment and a vaccine and they will almost certainly achieve their goal sooner or later. Gilead Sciences (GILD) has exhibited the most promising results in the development of a drug so far while Johnson & Johnson (JNJ) may be able to produce a vaccine in early 2021. Overall, it is reasonable to expect people to gradually return to their normal lifestyle, the latest from next year.

On the other hand, airlines are among the most vulnerable companies to the ongoing downturn, as they burn cash at a fast rate and carry high debt loads. Consequently, if the ongoing downturn lasts much longer than currently anticipated, some airlines will face liquidity problems. Therefore, investors who want to invest in this sector should select only the companies that have a healthy balance sheet and thus they can endure a prolonged crisis.

Why Southwest is the most attractive airline

Airlines have always been highly cyclical and extremely vulnerable to recessions. Experience has shown that deep recessions have sometimes erased a whole decade of profits of some airlines and have led many airlines to bankruptcy. Most airlines tend to spend huge amounts on capital expenses in order to renew and maintain their fleet. As a result, they post negative free cash flows in most years while they also carry huge amounts of debt. This helps explain why most airlines are highly vulnerable to recessions.

To provide a perspective, American Airlines (AAL) has posted negative free cash flows in 7 of the last 10 years and has net debt of $54.5 billion, which is more than 30 times its annual earnings. As a result, American Airlines is highly vulnerable to the ongoing recession. It is thus not accidental that American Airlines has plunged much more than Southwest (60% vs. 40%) in the sell-off of the sector.

Southwest is a bright exception to the aforementioned norm for airlines. The company has consistently enhanced its average seat miles per gallon thanks to a series of initiatives it has taken. In addition, it has done its best to minimize its non-fuel operating expenses as well and hence it has a significant cost advantage over its peers.

Source: Investor Presentation

While this advantage has somewhat contracted in the last few years, it has remained material.

Thanks to its strong business model, Southwest is superior to its peers with respect to free cash flows and leverage. Southwest is the only major airline that has posted positive free cash flows every year in the last decade. It also has by far the strongest balance sheet in its peer group. It is the only airline with an A- credit rating whereas all its peers have ratings between B+ and BBB-. The importance of a healthy balance sheet cannot be overemphasized during downturns.

It is also remarkable that Southwest has remained profitable for 47 consecutive years thanks to its robust business model. This degree of consistency is unparalleled in the highly cyclical airline industry, which is characterized by excessive losses and some bankruptcies in every recession.

Expected return

Due to coronavirus, analysts currently expect Southwest to post a marginal loss of $0.08 per share this year. However, as mentioned above, the ongoing downturn is likely to begin to subside the latest from next year. As a result, analysts expect Southwest to post earnings per share of $3.96 next year and record earnings per share of $4.88 in 2022. As these earnings are much higher than the earnings per share of $4.27 that Southwest posted last year, it is reasonable to expect the stock to revert to the level it was two months ago the latest in two years from now.

This expectation may seem conservative, particularly given the analysts’ expectations for record earnings in 2022, but it is prudent to be conservative amid the uncertainty that results from the coronavirus crisis. If the stock returns to the level it was two months ago ($59), it will offer a 67% return to its shareholders, without including the dividends. This is undoubtedly an attractive expected return, even if it is achieved in three instead of two years.

Some investors will claim that the other three major U.S. airlines have plunged more than Southwest and hence they will offer a higher return if they revert to their pre-crisis levels. American Airlines, Delta Air Lines (DAL) and United Airlines (UAL) have plunged 60%, 60% and 66%, respectively. As a result, if these three stocks revert to their pre-crisis levels, they will offer returns of 150%, 150% and 194%, respectively. These potential returns are much higher than the aforementioned 67% expected return of Southwest.

However, it is critical to focus on the above mentioned advantages of Southwest, which render it a much safer investment than its peers in the ongoing downturn. If the coronavirus crisis lasts longer than expected, the other airlines will come under great pressure due to their leveraged balance sheets. Therefore, Southwest is the airline that offers the best risk-adjusted expected return in the current high-risk environment.

Final thoughts

While the broad market has retrieved more than half of its losses from the recent sell-off, the airline stocks have remained depressed due to their high vulnerability to recessions. Many investors will be enticed to invest in the most depressed airline stocks, expecting an extremely high return in the event of a full recovery. However, Southwest has a much better risk/reward profile thanks to its superior balance sheet and its low-cost business model.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Be the first to comment

Leave a Reply

Your email address will not be published.