Whither Southwest?
This article is from the archive of The New York Sun before the launch of its new website in 2022. The Sun has neither altered nor updated such articles but will seek to correct any errors, mis-categorizations or other problems introduced during transfer.
Warren Buffett once described his foray into the commercial airline industry in 1989 as “temporary insanity.”
On top of that, the flamboyant chairman and founder of Virgin Atlantic Airways, Richard Branson, once remarked that the easiest way to become a millionaire is to start with a billion dollars and buy an airline.
Their message to investors seems clear: Shun the airline stocks!
An analyst at the investment research firm Morningstar, John Kearney, took note of Mr. Branson’s remark in a recent discussion of one institutional darling: Southwest Airlines ($16.71), king of the low-cost carriers.
Raising the question as to whether investors really want to invest in the darling of a dismal industry, he responded with a resounding “No!”
I am taking a look at Southwest’s investment merits in response to an e-mail from Michael Quinn, who recently wrote: “DD, How about a column on Southwest Airlines? I inherited 22,000 shares at a purchase price of $11 a share. My brother and my broker are pushing me like crazy to sell, telling me the high crude prices and fare wars will kill more and more airlines. What would you do?”
For starters, Michael, while those ballooning oil prices have pummeled the airline industry, it’s worth noting Southwest – which is on record with a projected 15% earnings gain next year – has used its strong balance sheet to hedge on its crude purchases. For example, with today’s oil prices at roughly $60 a barrel, Southwest, through 2005, is buying 85% of the fuel it needs at an equivalent price of $26 a barrel crude. Further, it has hedged 65% of its 2006 requirements at $32 and 45% of its 2007 needs at $31.
Still, while Mr. Kearney rates Southwest the “best in class” airline, he notes it’s an airline, nonetheless. And as such, he says, he would avoid this opaque, cutthroat industry altogether.
In making his case, the analyst kicks off with what he describes as “the horrendous economics” of the industry. He points in particular to high fixed costs, fluctuating fuel costs, strenuous labor relations, and an extremely price-sensitive customer base, which, he notes, is plaguing the airline industry like no other. That, in turn, he points out, makes it nearly impossible for even the most well-run airlines to deliver consistent and sustainable returns.
Mr. Kearney also observes that the industry’s anemic operating conditions are taking their toll on Southwest, in effect destroying shareholder value. He notes, for example, that in the four years prior to 2001, Southwest’s average return on invested capital was a respectable 12.5%. But in the last four years, the average annual return has been slashed by more than half to a lackluster 5.6%.
The analyst believes the company’s trend of value destruction and seesaw earnings over the past five years should go on for the foreseeable future. But he adds that even if he’s wrong on his outlook, Southwest, trading at about 24 times consensus earnings estimates and sporting a 40% premium to the multiple of the S&P 500, is not particularly attractive from a valuation standpoint.
An equities strategist at Morningstar, Paul Larson, notes that as he looks at airlines today, the bloated legacy carriers are toast, while Southwest still bests the upstart discounters by a decent margin. Further, he points out, with competitors going bankrupt left and right, Southwest is gobbling up market share while positioning itself for a major profit rebound when the tide turns.
Still, Mr. Larson, who takes note of Mr. Buffett’s “temporary insanity” plea, says he always gets a chill down his spine when he hears the words “investment” and “airline” in the same sentence. Even though he notes Southwest looks cheap to him and carries a four-star rating from Morningstar, he observes, “I don’t know if I could ever bring myself to be an owner in such a brutal industry.”
He never said it directly, but his bottom line thinking seems clear: Whatever airline stock investors fly, they’re flying in hurricane weather. In brief, that makes the flight more accident-prone. So why fly at all?