Coverage Launch: $14 Trefis Price Estimate for Southwest Airlines (LUV)

by Trefis Team
-16.69%
Downside
35.23
Market
29.35
Trefis
LUV
Southwest Airlines
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Southwest Airlines (NYSE:LUV) is the largest airline in the United States, based on domestic passengers carried. Southwest Airlines operates more than 3,100 flights a day, as of December 31, 2010, utilizing a fleet of 548 Boeing 737 aircraft. Southwest Airlines currently serves 71 cities in 36 states. It also provides freight services with in the United States, and the company competes with American Airlines (NYSE:AMR), Delta Airlines (NYSE:DAL), and U.S. Airways (NYSE:LCC). In September 2010, Southwest announced plans to acquire AirTrain Airways, which is expected to close in Q2 2011.

Launch of Coverage on Southwest Airlines; $14.10 Price Estimate

We’ve broken down our analysis of Southwest Airlines into two main business segments:

1. Southwest Passenger Flights

2. Freight, Service Fees and Other Revenue

U.S. Airline Industry at a Glance

Commercial aviation helps generate more than $730 billion in economic activity and supports almost 11 million U.S. jobs. As the U.S. and world economies begin to recover from the recent economic downturn, the aviation sector will make a strong contribution in revitalizing the job market. The U.S. airlines industry suffered a major setback in 2008 due to the recession that reduced both business and leisure air travel. Most major airlines showed a negative EBITDA margin in 2008 and 2009 except for Southwest Airlines, which managed to remain profitable for 38 consecutive years, a feat unmatched in the commercial aviation industry.

Since then, the U.S. economy has been slowly recovering which has led to an increase in demand for air travel in 2010 and consequently higher average fares. Traffic demand is highly correlated with economic growth and consumer spending accounts for nearly 70% of economic activity in the U.S. Goldman Sachs predicts that U.S. GDP will grow at about 2.7% in 2011 and 3.6% in 2012. This should lead to strong demand in airline travel.

Increasing fuel prices pose a challenge for all the airlines. Fuel costs represents roughly one-third of operating expenses of airlines. Growing demand of fuel oil in emerging economies and increasing tension in the Middle East poses a great risk to profitability of airlines.

Southwest’s Niche … A Low Cost Structure

The major strength of Southwest lies in its low cost structure. Adjusted for state length, Southwest has lower units costs on average than most major carriers. Its low cost structure is facilitated by its reliance on a single aircraft type, Boeing 737, that helps reduce the maintenance capital expenditure, its operationally efficient point-to-point route structure, and its highly productive employees.

Southwest provides point-to-point, rather than hub-and-spoke services. The hub-and-spoke system concentrates most of an airline’s operations at a limited number of central hub cities and serves most other destinations in the system by providing one stop or connecting service through the hub. Any issue at a hub such as bad weather or security problems can create delays throughout the system. By not concentrating operations through one or more central transfer points, its point-to-point route structure allows for direct non-stop routing than the hub-and-spoke model and therefore better enables it to control delays and total trip time.

Another key to its financial success is its fuel hedging programs where the company agrees to secure future fuel contracts at a particular price. Southwest Airlines hedges more oil than any other airline, which has ensured the lowest prices on jet fuel following the spike in oil prices in 2007 and 2008. Continued cost management will help Southwest remain a profitable airline and industry leader supporting our $14.10 valuation, which is around 16% ahead of the market price.

Last September Southwest announced plans to acquire AirTran Airways, which is set to close in the second quarter of year. In late February, the Federal Aviation Administration (FAA) approved the deal, which will allow the acquisition to close.  We will write more on this acquisition in subsequent notes.

See our full analysis for Southwest Airlines.

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