How Sensitive Is Southwest’s Stock To Oil Prices?

+21.38%
Upside
29.25
Market
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Southwest Airlines

Traditionally considered a laggard by investors, the US airline industry has been in a sweet spot lately given the plummeting global crude oil prices. As jet fuel costs constitute nearly one-third of an airline’s total operating expenses, the 50% drop in oil prices over the last year has accelerated the bottom line growth of all major US airlines. One of the top gainers from the steep fall in oil prices was Southwest Airlines, whose stock price more than doubled in the last ten months. Our current price estimate for Southwest stands at $47 per share, assuming a gradual recovery of oil prices over the next two to three years. In this article, we will discuss different oil price recovery scenarios that can significantly impact the airline’s current valuation.

See our complete analysis for Southwest here

Base Case: Gradual Oil Price Recovery

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Since July of last year, crude oil prices have plunged from over $110 per barrel to $45 per barrel in January of this year on weak global demand, led by slow growth in the Chinese economy, and surplus oil production due to the rising tight oil production in the US.  In addition, the Organization of Petroleum Exporting Countries’ (OPEC) decision to maintain its current production rates has further aggravated the demand-supply mismatch. While the decline has weighed heavily on oil producing companies in the US, it has been extremely profitable for most of the US airlines, particularly Southwest. In 2014, the Dallas-based airline’s net profit more than doubled to $1.1 billion due to a decline of almost half a billion in its fuel expenses. As a result, the low-cost carrier’s fuel expenses (as a percentage of passenger revenue) declined from 34.5% in 2013 to 30% in 2014.

Over the last few weeks, crude oil prices have increased to $60 per barrel, showing signs of recovery due to the large cutbacks on production by major oil companies. We currently expect oil prices (Brent) to average around $75 per barrel this year and gradually increase to $85 per barrel over the next two years, lower than the average oil price of $100 per barrel in 2014. Hence, in our base case scenario, we forecast Southwest’s fuel costs as a percentage of revenue to fall from 30% in 2014 to 25% over the next two years before reverting back to its 2014 levels by the end of our forecast period.  Consequently, the airline’s EBITDA margin is expected to improve from 23% in 2014 to more than 26% in the next couple of years and, thereafter, fall back to its historical levels in the later years of our forecast period.

See our Base Case Scenario for Southwest here

V-shaped Oil Price Recovery (-29%)

If we look at a more optimistic oil price scenario, where we presume that demand for crude oil will improve significantly due to increased economic activity in China and, concurrently, tight oil production in the US will decline, there could be a possibility of a sharper, V-shaped recovery in oil prices. Moreover, if the OPEC decides to change its current stance and cut its production, we estimate crude oil prices to reach over $120 per barrel by the end of our forecast period. In that case, we estimate Southwest’s fuel costs to rise sharply and revert back to its pre-2014 levels, i.e. greater than 34% of its revenue, by the end of our forecast period. Accordingly, the airline’s EBITDA margin will fall drastically from 23% in 2014 to a little more than 18% by the end of our forecast period. Thus, our price estimate for Southwest would fall to $34 per share, 29% below our price estimate in our base case scenario.

See our analysis for V-shaped Oil Price Recovery for Southwest here

Source: Form 8-K, Southwest Airlines, 23rd April 2015

Sustained Decline in Oil Prices (+27%)

Contrary to our V-shaped recovery scenario, if demand for oil does not improve either because of a continued slowdown in the Chinese economy or due to the use of alternative fuels owing to technological advancements, oil prices will take longer than expected to recover. Additionally, if the OPEC continues to operate at its current production levels, or alternatively plans to increase its production rates to eliminate competition and increasing its market share, the global oil market will experience depressed oil prices for a prolonged period. If this scenario becomes a reality, we estimate Southwest’s fuel costs to drop to 25% of its revenue by the end of our forecast, boosting the airline’s profits to new heights. In this case, the EBITDA margin will escalate to 29% in the next couple of years before stabilizing at 27% in the outer years of our forecast period. Driven by this, we arrive at a price estimate of $60 per share for Southwest’s stock, an upside of 27% to our current price estimate for the airline.

See our analysis for Sustained Decline in Oil Prices for Southwest here

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