Southwest Airlines Co. (LUV)

I did a presentation on Southwest airlines for a class, and I found information that makes me believe they will underperform the S&P 500 within the next two to four years.

In the past, Southwest has posted profits while their competitors have been suffering. Their success comes from hedging oil prices. By the year 2010, our case study reveals that they won't be able to hedge 100%. Rising fuel prices have been a heavy burden on the competitors, and Southwest's hedging strategy provided them a large advantage that made them profitable. When the company is unable to use this strategy, their stock will decrease in value.

My second concern with Southwest is that they have new market entrants to worry about. New and growing companies are using the same low cost structure that Southwest implements. One of these new companies is JetBlue airways. They have newer planes, and more amenities for customers such as individual televisions for each passenger and more leg room. I think that new competitors will be a threat to southwest and this will contribute to the stock underperforming the S&P 500 in the next two to four years.

Southwest consistently makes a profit amongst a sea of competitors who cannot. Their secret weapon is their people and their culture. In a word (or two) good management. Competitor after competitor has tried to copy them. So far, all have failed. Copying the use of 737's hasn't done it, neither has using point to point short haul routes or secondary airports. There is no "secret" to Southwest's success. Every major business school teaches it every semester. But, as one CEO of another excellent company once said, "I could leave my strategic plan on a plane and it wouldn't matter. My competitors can't implement it." What it takes is the will to manage well. It is so much easier to copy something...easy to copy. But, if it is easy to copy, it won't be a source of sustainable competitive advantage. And the sucker's draw is always there. We'll cut pensions, we'll threaten our employees...the standard approach to motivating and managing others that does so poorly but is so much easier to implement than empowering and respecting them.

My view is that the airline industry has underinvested for years. As a result, airplanes have gotten older and the American industry has notbeen replacing planes adequately. Southwest has one of the youngest fleets in the airline industry. They are profitable, trade near net tangible assets, and enterprise value to revenue ratio around 0.5 and growing revenue. They have unwound their hedge positions which cost them cash in the short term, but will result in immediate fuel savings for 2009.

Southwest has also performed poorly compared to the rest of the industry lately. In the past 6 months, LUV has fallen 50% while CAL has risen 100%. This changes the relative value of the two companies by a factor of 4. I expect the two to come back closer together.

Very well managed historically. They're snapping up new planes like crazy. They're experimenting with privately held (very private data) ATA on codesharing on Hawaiian routes while mgt. says they're studying international routes. They continue to expand US routes. The planes are always full. Margins are tight. Employees are happy. Etc. They're poised to gain some significant market share.

About the only airline I have actually enjoyed flying on. They do things right.

You just have to love an airline that always has full flights, flight crews that are generally fun to fly with, and short on frills. After all you are simply trying to get from place to place. They have a very nice frequent flyer program that is easy to understand. You can also get great rates when you order your tickets on line.

Even though futures contracts will end in the coming months/years, the business model is suited for all the changes in the airline industry. Complaints, baggage loss, delays, and service in general is much better than other airlines. The only other company that provides a similar service level is JetBlue, but since the company is much newer, I'd make my bet on Southwest. The stock has short term and long term growth potential. Good purchase price would be between 15 and 15.25. Short term, price will get to about 16.27 in the next few weeks, at which point you could sell for a healthy 3% gain. You could also hold for long term, since this is the healthiest airline in the market.

LUV is the only airline in the world where every employee can work on every on of its 400+aircraft aircraft. A huge cost benefit. It also has a history of hiring the best people in the industry at all levels and giving ALL EMPLOYEES the tools to make descisions. Every employee is a member of the profit sharing program that pays OUT every year so they are all owners.

People look at low pay as a measure of efficiency rather than high productivity. Southwest because of the elements noted above is 20-50% more productive than other airlines and likely to remain so.

PLUS they pay less for every aspect of the airline business. Less for new aircraft because the have bought about 1000 Boring 737 's. less for parts as all 737's use the same parts, less for fuel because of hedging and less for the money for all of the above because fuel, euqipment costs and labor are the largest cost items and have the lowest cost in all areas.

Expect them to grow the top line 12-15% every year and bottom line somewhat every year also, and keep buying new equipment with the cash generated to continue their growth

The analists understand this, most investors do not.

Southwest has been profitable every year for the last 35 years. And that is the reason, a simple plan, superior execution and the best people in the industry.

Passengers almost always get more than they expect on a LUV flight and often less than they expect elsewhere. Plus a cheerful and efficient crew.

Planes will continue to fly regardless of the market. Southwest appears to be in better position to get off the ground with less union long term commitments.

With the amount of business travel LUV sees, I think they'll be fairly well protected against a decline in air travel that other airlines might see. Thus, they should hopefully remain strong against the S&P.

when you can fly to vegas on $40 versus spending almost $80 or more to get there driving southwest will be the airline of choice. People will be traveling less but for now, this airline has a very good chance of becoming their airline of choice when they do travel. They have always had good prices and now, oil or not, unless they jack their price up a lot, they will still have flyers choosing them over other airlines with a $50 extra bag fee.

Price = $15.07. '07 value = $23.25 (15 X cash flow of 1.55/share) => 54% undervalued.
Avg annual appr 3-5 years = 14-24%.
Medium LT debt (3 x '06 net income)

Has spread out over the US and will be coding sharing with Cdn/Mex partners. Good management. Oddly enough, the projected revenue rebound seems to be a lot less in 2010 than CAL/DAL etc. Lack of overseas flights perhaps. Still, LUV excels in it's no frills field.

Denver...Chicago...Boston? Last i checked prices were way too expensive. LUV is a game changer.

Bad economy results in companies cutting back and going to lower costing fares equals more passengers for Southwest. Best run airline in the country.

increased traffic and routes with lower pricing than competitors due to high utilization combined with lower expenses

Southwest Employees love this company and so do I.

Think about airline consolidation. The Cash rich will start buying up others. Travel is about to see a huge boom. All we need now is a pre-screen or high-risk traveler security line. Minimize security time and airport waits. Maximize traveler quantity. Airports are the only way to travel. Crazy prediction: NASA will develop a huge advance in aircraft efficiency while heading back to the moon.

Gotta LUV this airline. Its people and management are phenomenal - they LUV to do two things: 1) fly people around safely and cheaply and, 2) make a profit. Yes, there are times they do not meet their goal in either catagory. But that makes them work that much harder the next year. Even if you do not like this industry put a little position down on the hard working people at Southwest Airlines - gotta LUV'em.

**Full Disclosure** No, I do not work for SWA but my company and I have done work for them. I have seen behind the scenes behind the ticket counter, back office, central ops, runway, to the maintenance hanger. And the people are truely phenomenal, and if anyone is going to make money in the airline business it is going to be LUV.