Southwest Airlines Stock Remains A Buy (NYSE:LUV)

Southwest Airlines Experiences Major Flight Cancellations Across U.S.

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Southwest Airlines (NYSE:LUV) has ended 2022 impressively by registering the first quarterly profit (before special items) since the fourth quarter of 2019, before the COVID-19 pandemic. A while ago, management was projecting that 2022 would be the year that the company would perform close to the pre-pandemic levels but inevitably had to moderate its expectations and adjust its target, facing several potential headwinds.

A myriad of challenges

Capacity

The company had the ambition for 2022 to run at 100% of 2019 capacity levels, but in late January decided to set a more reasonable goal of just 4% below the operational capacity of 2019. Furthermore, the current expected capacity for Q1 is 10% lower than 2019, which means the company will have to work hard during the second half of the year to meet its target.

Southwest Airlines 2022 Guidance

Southwest Airlines Guidance for 2022 (Q4 report) (Southwest Airlines)

From the regulatory filing made on Tuesday the 15th of March, it became clear that Southwest anticipates the capacity in the second quarter of2022 to be just 7% below the one from 2019; meanwhile, the capacity for the second half of the year will be close to that of 2019.

This minor drop in capacity means that 2022 has a high chance of being another transformational year but this time with other factors taking a significant toll on performance.

Flight cuts and staff shortages

The aviation industry has experienced severe headwinds due to high fuel prices, staffing issues, and other supply chain restrictions. Southwest Airlines had to cut 14,500 flights from its March through May schedule due to problems with staffing.

The labor market in the U.S is tight, and the news about the labor shortage is nothing new. Spirit Airlines (SAVE) was among the first to face this challenge at the worst possible time when they had to cancel flights throughout the summer season.

A combination of flight delays throughout July, staffing shortages, technical issues, and an unexpected rush in demand resulted in more than 2,000 flights being canceled by the company. On certain days the number of canceled flights accounted for more than half of those scheduled by Spirit. The company took a lot of negative publicity on social media by the thousands of stranded passengers across the U.S.

To prevent a similar scenario this year, many companies are taking measures to cancel some flights and arrange staff to limit the chance of flights being cancelled.

Rising fuel cost

About a month ago, Alaska Air Group (ALK) was among the first to warn about another threat. Management expressed their concern about the Russian invasion of Ukraine and how it affected the fuel costs. They noted that the firm expects the average fuel cost to be between $2.60 and $2.65 a gallon compared to what was previously estimated at $2.45 to $2.50.

Although jet fuel prices are a significant cost factor, Southwest and its competitor Alaska will be less affected than the legacy airlines such as Delta (DAL), United (UAL) and American (AAL). According to the latest filing, Southwest has hedged approximately 65% of the total fuel. Meanwhile, Alaska has hedged about 50%.

The market understands how valuable these fuel hedges are and how much they can affect the bottom line. This is why I think both Southwest and Alaska trade at a much higher P/S ratio than their competitors.

Airline Stocks Performance

Airline Stocks’ Performance (Seeking Alpha)

Outlook and Valuation

As mentioned above, the company has taken steps to reduce its capacity. However, this is not necessarily a bad thing, but rather the opposite. It could further cement a much better year than the one before. Limiting the number of flights will only increase the proportion of hedged jet fuel and improve the bottom line.

Travelling was hit severely by the pandemic and battered on regular bases by travel restrictions or new virus variants. However, so far looks like humanity will win this battle too, and we may soon come back to what was ‘normal’. Analysts expect a substantial recovery in the sector.

To understand where the stock might be, we should look at long-term projections for the company. Southwest Airlines currently has a projected sales for 2024 of almost $27 billion, or 20% higher than those in 2019. Analysts also estimated earnings per share of 4.61 compared to $4.27 a share for 2019.

The company currently trades at about a 1.55 P/S ratio, followed by Alaska Airlines with a 1.06 P/S ratio. Both companies trade way higher in this metric compared to their competitors. Although the ratio may seem high compared to big names such as Delta, American or United airlines, we must not forget that it all has to do with the fuel hedges, which have the potential to play a significant role in the income statement.

Although Southwest may seem to cost twice as much as Delta in terms of P/S, there is still room for the stock to go higher in the next couple of years.

Aviation Industry P/S ratio

Aviation Industry P/S ratio (Seeking Alpha)

In 2019 alone, the stock traded from $45 a share to a firm ceiling price of $58.30, giving it a P/E ratio of 10.5 to 13.5.

Southwest Airlines Stock 2019

Southwest Stock 2019 (Yahoo)

If the company manages to match the market consensus for 2024, I believe that the stock could trade in the $50-$55 range, potentially going as high as $65 a share. Based on its current price of $42 a share, this would suggest more than 53% for upside potential in less than three years.

Risks

The company faces two significant risks in the future.

The first one is if the high jet fuel prices remain in the next couple of years. However, I don’t see this as a critical risk because if high fuel prices become the new ‘normal’, the airline industry will be forced to transfer most of these costs to the consumers. CEO Scott Kirby from United Airlines also mentioned the same thing.

The second major threat comes in the form of a new Covid variant. If the new virus poses a significant danger to people’s health, it could lead to further restrictions and, more importantly, loss of confidence in travelling.

Conclusion

Southwest is currently the best-prepared aviation company to weather any adversities during 2022. Although 65% hedged fuel is not like 100%, it can play a significant role in the income statement if jet fuel prices stay high and make the company a safe bet in the short term.

Despite the near-term noise, the company is a ‘Buy’. Southwest has a superb business model with substantial underlying competitive advantages, which will only bear fruits in the future.

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