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Storms won't ground Southwest Airlines stock
Despite closed airports, $70-a-barrel oil and the slow winter season ahead, Southwest Airlines shares are poised to climb more than 20%, thanks to a smart fuel bet and the companys strong financial footing.
By Robert Walberg
Airline stocks have been in a tailspin for over a month. And now, confronted with literal and figurative perfect storms, most of the stocks have established 52-week lows.
Not only did Hurricane Katrina trigger a slew of airport closures and flight cancellations, it sent the cost of crude oil soaring above $70 a barrel. The combination of fewer flights and higher jet fuel costs, just as the airlines are about to enter a seasonally slow period, could finally push several struggling carriers into bankruptcy.
But that's not all bad, especially if you are one of the few profitable airlines in the industry. Most of the long-haul carriers -- such as Delta Air Lines (DAL, news, msgs), Continental Airlines (CAL, news, msgs), Northwest Airlines (NWAC, news, msgs) and United Airlines, operated by UAL Corp. (UALAQ, news, msgs) -- are bleeding red ink with little hope of turning a profit any time soon.
Southwest Airlines (LUV, news, msgs) has bucked the trend, reporting a second-quarter profit of 20 cents a share. It also paid a dividend for the 116th straight quarter. With Southwest's stock down 8% since the start of June, the low-cost carrier is now at the right price to buy.
Hedging fuel, hogging customers
One thing that sets Southwest Airlines apart from the rest of the industry is that the company used its strong balance sheet to hedge against the possibility of rising fuel prices. It is about 85% hedged for the second half of this year at an equivalent price of $26 per barrel. Considering that crude spiked to $70.85 per barrel in Katrina's wake, that's an enormous cost advantage for Southwest. Look for the company to use that cost advantage to steal more market share in the months to come.
It's almost a certainty that one or more carriers will be forced into bankruptcy prior to year end due to the unexpected jump in fuel prices. For airlines, fuel ranks second behind labor as an expense, and whatever gains the companies managed to achieve on the labor front are easily being erased by fuel costs. American Airlines, AMR Corp. (AMR, news, msgs), recently noted that a one-cent jump in the cost of jet fuel per gallon translates into about a $29 million rise in annual fuel costs.
With more and more airlines in bankruptcy, capacity will decline. Thats good news for airlines that survive, as it will mean higher prices and improved margins. For example, if Delta is forced into bankruptcy in the next few months, Southwest would be ideally positioned to take share from the troubled carrier. The same is true if Continental fails.
Avoiding the endangered species
The sector simply can not continue to operate as is -- the losses are too great and the future too clouded. Downsizing is fast approaching, and Darwinian competition would serve Southwest well. Its relatively low debt burden, sterling financials, efficient operating model and proven management team make Southwest a likely candidate to emerge from the turmoil in an even better competitive position than it currently enjoys.
Related news and commentary on MSN Money
But that's the long-term view. Over the short-term, the stock, like other airlines', will continue to backpedal in the face of ever-higher energy prices. Fortunately, investors can expect some relief on that end as well. Crude has surged over 20% in just the past several weeks -- a pace it can't sustain. When oil prices start to correct back to the $60 per barrel area, airline stocks are apt to enjoy at least a modest bounce.
Though speculators might prefer to buy one or more of the airline companies on the endangered species list in an attempt to squeeze out a bigger short-term bounce, I prefer to buy only those stocks that I would actually want to own for the intermediate- to long-term. The only candidate to fit that bill in the airline sector is Southwest.
Higher fares still beat competitors
Though the company's less aggressive hedging position for fiscal year 2006 suggests that its costs will rise, management is already beginning to initiate modest fare increases to offset the jump in costs. Any further spike in energy prices would almost certainly result in additional fare hikes. Even with the higher rates, Southwest's fares are still discounted relative to its peers.
At present, the Street expects Southwest to earn 56 cents a share in fiscal year 2005 and 59 cents in fiscal 2006. Based on estimated earnings, Southwest's stock still isn't cheap, even after the recent drop. However, if you use an adjusted-enterprise-value-to- revenue model, Southwest currently trades in the middle of its historic range. Assuming a multiple of 220% of revenues, the stock has upside to the $16 to $18 area over the next 12 to 18 months -- or about 22% to 37% above today's price.
Considering the company's strong financials and competitive advantages within the troubled industry, that's a nice upside. As such I will use the recent weakness in Southwest to add it to my Street Patrol portfolio for tracking.
At the time of publication, Robert Walberg did not own or control shares of companies mentioned in this column.
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