Southwest Airlines Stock Takes Off

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Southwest Airlines Stock Takes Off

By Richard Robinson, Ph.D., Equities Analyst

The European Central Bank’s (ECB) long-anticipated bond-buying program helped lift the three major indices last Thursday.

But the move higher wasn’t entirely about Mario Draghi’s €60-billion ($68.4-billion) open-ended QE program . . .

Lower fuel prices also made their presence felt on the exchanges, and transportation companies with exposure to lower fuel costs are seeing their margins increase significantly.

In fact, one popular airline saw its stock take off on Thursday . . .

Indeed, shares of Dallas-based Southwest Airlines (LUV) flew more than 8.4% higher Thursday on relatively heavy volume.

LUV shares closed the day at $45.35, or $3.52 higher, with more than 19.7 million shares changing hands. This compares to a typical volume for the airline of 8.6 million shares.

The chart below shows LUV as the top S&P 500 stock in 2014 with a 138.8% increase.

On Thursday, the shares jetted higher after the airline reported better-than-expected fourth-quarter results, due to increased passenger traffic and a sharp drop in fuel costs.

But, make no mistake, it was the drop in fuel costs that was responsible for the outperformance last quarter.

Southwest announced that fuel costs fell 14.1% year over year to an average of $2.62 per gallon.

Interestingly, LUV’s fourth-quarter results didn’t reflect the true cost savings from lower fuel prices because the company failed to anticipate the steep decline in oil prices.

You see, the key to Southwest’s success has been fuel hedging. Essentially, the airline enters into a contract where it bets oil prices will either go up or down.

And in the last quarter, Southwest was on the losing side of the hedge, costing the low-fare leader $0.03 per gallon in unfavorable cash settlements from fuel derivative contracts.

But investors can expect further improvements in fuel prices in 2015 . . .

Based on the company’s fuel derivative contracts at today’s prices, first-quarter fuel costs will run $1.90 per gallon in Q1 2015 – a 38.3% discount over Q1 2014 fuel prices.

These lower fuel prices will result in a year-over-year savings of approximately $500 million in fuel costs.

And this is despite the remaining net liability in fuel derivative contracts of $234 million in 2015 – and a $1.1-billion liability through 2018.

Solid Financials Send This Stock Soaring

A look at the company’s financials makes it easy to understand how Southwest Airlines has managed to maintain a 42-year history of profitability.

In the fourth quarter, Southwest reported total revenue of $4.6 billion, a 4.5% increase over the same quarter a year ago.

The company reported record fourth-quarter net income of $404 million, or $0.59 per diluted share. This compares to Q4 2013 net income of $236 million, or $0.33 per diluted share.

Load factor, a key passenger traffic metric for airlines, improved to 82.0% from 80.4%, beating expectations of 81.8%.

And the airline indicated that passenger revenue rose 2.6% compared to the year-ago quarter, as well, and it expects first-quarter 2015 passenger revenue to rise by another 6%.

I calculate a price target on Southwest stock at about $51.50, which means investors could see a run-up of just over 13.5% from today’s price.

This is why I love LUV.

Good investing,

Richard Robinson

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By Richard Robinson