Analysis Context & Disclosure
Semi-annually I cycle through my universe of companies that I would like to own and update my intrinsic value for the company. It is now time for Southwest Airlines to be updated.
In the case of Southwest Airlines I have been a shareholder for about 18 months. The holding currently represents a partial position in my portfolio and I would to add to it at the right price.
Let’s see if now is the right time.
Southwest Airlines Co (NYSE: LUV) is a passenger airline that provides scheduled air transportation services in the United States and near international markets.
The airline’s distinguishing feature is that it only operates one type of aircraft – the Boeing 737 (there are a number of variants of this one aircraft type). As of December 2017, the company had 706 aircraft and it served 100 destinations in 40 US states, the District of Columbia, the Commonwealth of Puerto Rico, as well as 10 near-international countries, including Mexico, Jamaica, the Bahamas, Aruba, the Dominican Republic, Costa Rica, Belize, Cuba, the Cayman Islands, and Turks and Caicos.
The company was founded in 1967 as Air Southwest. The name was changed to Southwest Airlines in 1971 when the company went public with an Initial Public Offering. The company last raised equity in 1992. The company has been profitable for the last 45 years. This is extremely unusual in this Sector.
At the end of 2017, Southwest Airlines, according to the US Department of Transportation was the largest domestic air carrier in the US as measured by the number of domestic originating passengers boarded.
The company currently only has one reportable operating segment but it does break-down revenues into 3 sources (the proportion of total 2017 FY revenues is shown in brackets):
- Passenger Revenue (90%).
- Freight Revenue (1%)
- Other (9%).
Southwest Airlines has primarily grown organically by increasing the number of cities that it services. Throughout its history there has been 3, relatively small, acquisitions – the last of which was in 2010.
The cornerstone of Southwest Airline’s overarching strategy has been a focus on cost. The company is very efficient and management has been historically very “process” focused which has ensured that the company had the lowest comparable operating cost.
This is still the case today where the company has the lowest operating cost per available seat mile of the 4 major US domestic airlines.
The low cost operating model comes about by:
- Only having one aircraft type which leads to:
- Greater volume purchasing power with the aircraft supplier.
- Lower levels of maintenance spares.
- Lower crew training costs.
- Operating a point to point service and not the “hub and spoke” model operated by its competitors.
- Better scheduling with a focus on high levels of aircraft and crew utilization.
- A focus on fuel efficiency through fleet modernization and operating pathways.
Southwest Airlines initially offered high frequency services to a small number of cities radiating out of its home base in the state of Texas. Over time this concept was expanded and today it offers direct flights to 675 city pairs. International flights were added in 2014 and in 2019 the company will begin services to Hawaii. The company’s average flight length is currently 754 miles with an average duration of 2 hours.
The company’s strategy has hardly changed over the years. The key strategic imperatives today, according to management, are:
Grow revenues through:
- The addition of new routes.
- Improved customer service.
- Optimized pricing (a new revenue management system has been implemented at a cost of $500M).
- Extend the customer loyalty program (Rapid Rewards). Control costs by:
- Improving operational reliability.
- Fleet modernization to improve fuel efficiency and reduce maintenance costs.
Southwest Airlines had an impeccable air safety record until April 2018 when an engine exploded in service and sprayed shrapnel into the cabin of a plane killing a passenger. The plane landed safely after the incident. The National Transportation Safety Board hearings into this incident commenced this week.
Following many years of rising fuel prices, the airline sector since 2014 has enjoyed relatively low fuel prices. Over the course of 2018 there has been an increase in fuel prices of approximately 13% (year on year). As fuel constitutes approximately 20% of total operating costs (depending upon the prevailing price) this has caused a recent decline in operating margins. This has resulted in a decline in the share price of companies such as Southwest Airlines over the last month.
RECENT SHARE PRICE ACTION
Source: Yahoo Finance
The chart indicates that over the last year the Southwest Airline share price has declined by just over 5% and has lagged the S&P500 index by close to 23%.
HISTORICAL SHAREHOLDER RETURNS
The data from Morningstar shows that Southwest Airlines and the Airline sector has been under-performing the S&P500 index for last 3 years. However, over 5 to 10 years, the story changes and Southwest Airlines has out-performed both the index and its Sector by a wide margin.
Domestic Airline Market Overview
The Massachusetts Institute of Technology (MIT) is also a very useful source of Airline industry data. The MIT operates a Global Airline Industry Program which compiles data from the sector and makes it publicly available.
I have used data from both of these sources in developing the following charts:
Total Market Volume
The Airline sector measures available capacity in terms of the number of seats available for passengers. It then multiplies this number by the number of miles flown by the aircraft when they are available to carry passengers. This metric is called Available Seat Miles ((ASM)).
When an available seat is used by a fare-paying passenger the number of miles traveled by the passenger becomes a measure of volume called Revenue Passenger Miles ((RPM)).
The Airline sector has relatively high fixed costs, an important operating metric for the airline operators is therefore the Load Factor or how full the aircraft are.
The following chart shows the total volume of passengers carried in the Domestic US market and the load factors of the aircraft since 2006:
Source: Bureau of Transportation Statistics
From the data, we can calculate the compound annual growth rate ((CAGR)) in passenger miles. For the last 10 years it was 1.4% but more recently over the last 5 years it has been 3.8%.
Over the last 10 years the Load Factor has increased from around 80% to just on 85%.
The data is fairly consistent with my understanding of the Airline sector. The sector is mature therefore total sector growth will be close to the overall growth of the economy. The sector is also cyclical. When the economy is strong, demand will be strong and conversely when the economy is weak, demand will be lower. Demand bottomed just after the Global Financial Crisis ((GFC)) and has been rising over the last few years as the US economy has gained strength.
The Airline sector has never been overly profitable. The GFC put more financial stress on already weak companies and, as a result, the US Domestic Airline market has been going through a consolidation phase as a result of a series of mergers and acquisitions. The number of major US domestic airlines has now been reduced to 4 – Southwest Airlines, Delta (NYSE: DAL), American Airlines (NASDAQ: AAL) and United Airlines (NASDAQ: UAL).
The following chart shows the market share of these 4 airlines since 2006:
Source: Bureau of Transportation Statistics
Although the US Domestic airline market has been growing at a CAGR of 3.8% for the last 5 years the data reveals that the 4 major airlines have been growing at a combined 5.5%.
The data also reveals that Southwest Airlines has the largest share of the US Domestic airlines market (based on Passenger Seat Miles).
Impact of Jet Fuel prices on Airline Revenues and Costs
In 2017 Southwest Airlines spent 18.6 cents on jet fuel and oils for every $1 of sales revenue. Over the last 10 years this ratio has been as high as 36 cents when the price of oil peaked in 2011. Outside of labor costs, fuel and oils are the 2nd largest cost element for an airline.
The following chart shows the relationship between passenger revenues, operating costs (measured in dollars per available seat mile) for Southwest Airlines and the average price of WTI oil since 1995:
Source: Southwest Airlines’ 10-K filings
The relationship between Southwest Airlines’ Passenger Revenue per Available Seat Mile, Operating Cost per Available Seat Mile and the average price of oil is reasonably common across the Sector.
The key information from the chart is easier to understand if we graph the difference between Revenue and Cost per ASM and overlay the average price of oil:
The data indicates that typically when the price of oil is relatively low then operating margins are high. Similarly if the price of oil increases then operating margins are reduced.
To further highlight the relationship between the price of oil and the proportion of fuel costs captured by the airline’s sales revenue I have produced the following chart: using data from 1994 to 2018:
Source: Southwest Airlines’ 10-K filings from 1994 to 2018
The chart and the corresponding regression statistics demonstrate that 93% of the variation in Southwest Airlines’ Fuel Expense to Revenue ratio is determined by the price of WTI crude oil.
For valuation purposes this is a very important relationship. If we are confident about the airline’s revenues we can then use the WTI Oil Futures market to forecast the expected airline’s fuel expense ratio. More on that later.
Key Information Takeaways from the Sector Data
The key information takeaways are:
- The demand for airline travel is heavily influenced by the health of the economy.
- The Sector is mature with a 10 year volume CAGR of 1.4% and a 5 year volume CAGR of 3.8%.
- The Sector is consolidating. The 4 major airlines have increased their share of the US domestic market from close to 50% to nearly 70% in the last 10 years. The 4 major airlines are growing faster than the Sector as a whole – thus the market share of the 4 major airlines will continue to increase.
- The price of jet fuel is a key determinant of the Sector’s profitability. Margins are squeezed (and even go negative) when the price of fuel is high but margins can be expanded when the price of fuel declines.
Southwest Airlines’ Key Financial Metrics
For the 4 largest US-listed airlines I have used their published financial reports to generate a comparison of their financial data.
Reported Pre-Tax Operating Margins & Revenue Growth
For the last 5 years Southwest Airlines’ revenues have had a CAGR of 4.4%.
Source: Author’s summary of Southwest Airline’s 10-K filings
The chart shows that although passenger revenues have been on a strong growth trajectory for over 20 years, operating margins are clearly cyclical. The swings in reported operating margin which take place through the cycle are quite dramatic.
I have prepared a table showing the historical reported Operating Margins for Southwest Airlines’ publicly listed major competitors for the last 12 years:
Source: Author’s summary of data from company 10-K filings..
Note that this data is lifted straight from the reported company Financial Statements. No adjustments have been made for abnormal (or one-off) costs or for the impact of operating leases. More on that later.
How Does Southwest Airlines Generate Higher Margins than its Competitors?
The data indicates that Southwest Airlines’ reported operating margins are generally higher than its competitors (except for a period between the years 2011 and 2013 when Delta reported higher margins). The question might well be asked – why is this so?
The answer must be in one, or a combination, of the following 3 areas:
- Its operating model generates higher revenues per available seat mile.
- Its operating model has a lower cost.
- It is capitalizing more expenses than its competitors (hence reporting lower expenses).
Let’s go through each of these possible reasons to see if we can draw any obvious conclusions:
Passenger Revenue per Available Seat Mile
The data suggests that for the last 5 years the Sector has had relatively little price inflation, with Southwest in particular, having slightly lower prices, on average, than 5 years ago.
Source: Bureau of Transportation Statistics
The data gives insights to the outliers amongst the 4 major airlines. Delta has the highest passenger revenue per passenger seat mile whilst United Airlines has the lowest with Southwest and American being in the middle.
It is fair to assume that Southwest Airlines’ higher margins are not coming from charging higher average prices than their competitors.
Cost per Available Seat Mile
Airline costs per available seat mile have fallen over the last few years as the price of jet fuel has declined. Operating costs have fallen by close to 10% across the Sector over the last 5 years.
Source: Bureau of Transportation Statistics
The data shows that Southwest Airlines appears to have a clear cost advantage over its competitors. Having the lowest cost base is a major competitive advantage in a commodity industry – this should lead to higher returns on capital.
How Does Southwest Airlines Achieve its Low Cost?
As the airline industry is very asset intensive, perhaps the answer might be in the average Load Factor per Available Seat Mile. Could Southwest Airlines manage to fly their planes more fully loaded than their competitors?
Source: Bureau of Transportation Statistics
Interestingly the data indicates that Southwest Airlines typically operates with lower Load Factors than the average Domestic US airline. The industry as a whole has been increasing its load factors (I’m sure regular passengers can attest to this) but this is in fact an opportunity for Southwest Airlines to further improve.
Although this data does not tell us what proportion of an aircraft’s available hours are spent flying (which may be an important source of capital utilization) it does indicate that Southwest Airlines’ lower cost does not come from operating planes with a higher proportion of occupied seats.
I have created the following chart which shows the Block Hours per airline. A Block Hour is defined as the time from the moment when the aircraft doors are closed at departure of a revenue flight until they open at the arrival gate following its landing.
Source: MIT Global Airline Industry Program
The data indicates that after a few years of a downward trend in aircraft utilization across the Sector, it appears that this trend has now plateaued and for some airlines, an improving trend has commenced.
Southwest Airlines appears to be now improving its average aircraft utilization and it is doing this from a position of strength with its current industry leading position.
An airline essentially has 2 major cost buckets – labor and fuel. These 2 cost buckets would typically comprise between 50 to 60% of the total airline’s operating cost. Let’s see how each of the major airlines stack up on these metrics.
I have created a chart showing the average Available Seat Miles flown per gallon of fuel. The table excludes the impact of Regional flights for those airlines who operate non-jet services. The table was created using Main-line data by dividing the amount of fuel used into the Available Seat Miles. In this particular instance a higher number represents the more efficient use of fuel:
Source: Author’s compilation from each company’s 10-K filings.
The data clearly shows that the Southwest Airlines’ fleet is, on average, more fuel efficient than its competitors and that this would be contributing in a significant way to their low cost position in the Sector.
Given the relatively limited data that is publicly available I have chosen to use a very broad measure of labor efficiency (nevertheless it gets to the bottom-line of productivity).
I have calculated the Available Seat Miles per Labor Dollar by dividing the total Available Seat Miles by the total reported Labor expense from each company’s Income Statement.
In this instance a higher number represents higher efficiency:
Source: Author’s compilation from each company’s 10-K filings.
This is a very gross measure of labor productivity at an aggregate company level. Nevertheless the results are quite interesting.
It should be noted that the American Airlines’ result in 2013 looks to be an outlier with the financial results being impacted by the recent acquisition of US Airways – the ratio corrects over the next few years.
In summary it would appear that all the airlines are suffering from year on year declining productivity. I find this to be surprising and it would be interesting to speculate as to what might be causing this but the answer is beyond the scope of this article.
What is most surprising is that the data indicates that Southwest Airlines has the lowest labor productivity of the four airlines. Given the historic focus by Southwest Airlines’ management on process efficiency this clearly represents an opportunity to at least pull back closer to the rest of the Sector.
A quick way to look at a company’s capital efficiency is by calculating the ratio of Sales Revenues to Net Capital (where net capital is book equity plus book debt plus operating leases less cash, marketable securities and equity investments).
I created the following table from the most recent 10-K filings of the 4 major US domestic airlines:
Source: Author’s compilation from 2017 company 10-K filings.
The data indicates that Southwest Airlines is the most efficient capital allocator in the Sector. It is able to generate the highest level of revenues from the net capital invested in its business. This would indicate that Southwest Airlines is probably not capitalizing expenses in any significant manner.
Low Operating Costs are the Source of Southwest Airlines higher Operating Margins
The data indicates that Southwest Airlines is able to generate Sector leading margins because it has the lowest operating cost. Its low cost position is being generated by its sector leading fuel efficiency, asset utilization and capital efficiency but it is sacrificing some margin because of its relatively lower labor productivity.
The key issue is will future management have the discipline to maintain this position?
Restatement of Operating Income
In preparation to do some valuation work we need to clean up some of the reported Financial Statements in order to make them more useful.
The Airline Sector is a major user of operating leases. Operating leases are a disguised form of off-Balance Sheet financing. My valuation will use a Discounted Cash Flow ((DCF)) approach based on the Free Cash Flow to the Firm.
Because we do not include Interest Income received in our cash flows we must be consistent and eliminate any Interest Expense as well. The reported Income Statement contains an interest expense component in the operating rents paid by Southwest Airlines. For this reason we need to re-state the Operating Income in order to ensure that we are being consistent.
Operating Lease Restatement
This adjustment requires the creation of an Operating Lease Asset which is equivalent to the present value of the Operating Lease Debt. The value of the asset is then amortized over the life of the operating lease and this is reported as an expense in the Adjusted Income Statement.
The value of the Operating Lease Asset can be calculated:
Source: Author’s calculations from Southwest Airlines’ 2017 and 2016 10-K.
From Southwest Airlines’ published 2017 10-K we can now calculate the restated Operating Income:
Source: Author’s calculations from Southwest Airlines’ 2017 10-K.
This means that the restated 2017 Pre-tax Operating Profit increases by $700 M and the restated pre-tax Operating Margin increases from 16.6% to 19.9%.
Return on Invested Capital ((ROIC))
This metric is trying to estimate the return on the company’s operating assets which can then be used to determine whether the company is allocating capital efficiently.
Return on Invested Capital = After Tax Operating Profit/Invested Capital
A number of adjustments need to be made to the Balance Sheet in order to get a “true” picture of how profitable Southwest Airlines’ operating assets really are. Unfortunately this becomes a little technical for those without an understanding of accounting.
We have already adjusted the Operating Income for the impact of Operating Leases and now the Operating Income needs to be taxed.
For the 2017 year, Southwest Airlines’ reported effective tax rate was low due to the implementation of changes to the US tax codes. For this calculation I have used a notional effective tax rate of 22% (which should be close to Southwest Airlines’ long term tax rate).
Now we need to clean up the Invested Capital.
First we start with the premise that it is the Invested Capital reported at the end of the previous year that generates the earnings in the current year. We do not use the invested capital reported at the end of the current year (2017) but instead use the reported 2016 numbers.
We need to establish the book value of invested capital used to fund the operating assets. In this instance, we take the total equity in the company’s Financial Statements and add the total debt. In the last section we established that Operating Leases are really debt. We add the value of the Operating Lease Debt to the reported total equity and total debt.
We need to subtract the non-operating investments from this total because the benefits from these investments are not include in the Operating Profit. This means that the value of the Cash and Marketable Securities and Equity Investments are all eliminated from the Invested Capital.
We also need to look at what acquisitions the company has recently made. Invariably these acquisitions create an item on the Balance Sheet called Goodwill. There is an argument that Goodwill represents the over-payment for productive assets but there is also a counter-argument that elements of Goodwill also represent future growth investments. I think that there are merits on both sides of this argument so I am going to hedge my bets on this issue.
If a company has Goodwill on its Balance Sheet, I eliminate 50% of it and subtract that value from the company’s total capital. However, I then progressively add-back the discounted Goodwill to the Invested Capital over the remaining forecast period in my model because all of the growth benefits should have been consumed by then.
Finally, we need to check what asset write-offs the company has made over the last 10 years. Companies attempt to expunge the record of their past mistakes by writing down the value of their operating assets. Unfortunately, shareholders have funded these investments and they need to be accounted for. I estimate the after-tax total of these write-offs and add it back to the Invested Capital.
In the case of Southwest Airlines there have only been write-offs in 2 years over the last decade for a total of $35 M (this is very impressive compared to the write-offs which have been made by its competitors).
You may ask why I have gone to all of this trouble in making these adjustments? The answer is – in Valuation one of the key questions to be answered is – what is the difference between the company’s return on invested capital relative to its cost of capital and if there are excess returns – how long will they last? This will be revealed later on.
So for Southwest Airlines the invested capital to use for the 2017 Return on Invested Capital is calculated as follows:
Source: Author’s calculations.
I have used this approach to restate Southwest Airlines’ Operating Income and Invested Capital for the last 10 years. It is shown graphically on the next chart:
Source: Author’s calculations.
We are nearly ready to do some valuation work but there is one important metric left to consider. In order to develop a long term Cost of Capital for Southwest Airlines it is often insightful to understand what the typical capital structures are in the Airline Sector.
A useful metric, which is relatively easy to calculate, is the Adjusted Book Value of Debt to Market Value of Equity ratio. This metric is calculated by adding the Book Value of Debt to the Book Value of Operating Leases and dividing by the company’s Market Capitalization:
Total Adjusted Book Value of Debt/Market Value of Equity
This metric is used to estimate the amount of leverage that a company is applying to its Balance Sheet.
Source: Company 2017 10-K and 3rd Quarter 10-Q filings.
The data clearly demonstrates the financial strength of Southwest Airlines relative to its domestic competitors. Its Balance Sheet is very conservatively geared and probably could sustain an increase in leverage.
This means that Southwest Airlines’ current Cost of Capital is higher than it may need to be. A higher cost of capital leads to a lower valuation.
Issues Facing Southwest Airlines
I think that Southwest Airlines has a small number of issues which require management’s attention. These issues must be carefully evaluated and balanced against the strategies which have delivered the company’s outstanding performance to date:
- Can the company continue to grow without sacrificing its aircraft strategy (clearly the decision to operate only one aircraft type has been an important element of achieving its low cost position)?
- Can the company improve its cost position further particularly with respect to labor productivity which is showing a worrying negative trend?
- Should the company increase its leverage and return more funds to its shareholders?
The most positive note about the first 2 issues is that management is well aware of them. This was acknowledged by Gary Kelly, Southwest Airlines’ Chief Executive Officer when he made the following comments at Southwest Airlines’ 3rd Quarter Conference Call:
“We have a stronger, much more prosperous, but a more complex airline. In some cases, there are costs associated with driving higher revenues. But the main point that I want to make is that our focus with our strategic efforts has clearly been on transforming the airline and driving more revenue along with operational reliability and customer service.
But eventually, I think all of us at Southwest knew that the time would come where our initiatives would need to zero in on efficiency and productivity and just overall cost control. And clearly that time has arrived and cost will be our number one priority.”
Source: Seeking Alpha
Southwest Airlines’ Investment Thesis
Southwest Airlines has Sector leading operating margins and returns on invested capital. This demonstrates the strength of its competitive advantages or “moat” (interestingly Morningstar attributes no moat to the company – I think that they are wrong).
The company has a wide moat relative to its competitors but I suspect that over time this moat will be slowly competed away. The moat’s strength is based purely on its low cost positioning which can be replicated.
The company has benefited from excellent management (potentially best in class) over many years. They have made sound decisions regarding the company’s strategy and capital allocation.
Even with excellent management the company is no match for the cyclical nature of the Sector in which it operates. The only comfort is that the company’s financial performance will not plumb the depths that will befall its competitors during these inevitably difficult periods for the US economy. This is evidenced by the fact that the company has to date experienced 45 years of continuous profitability in a Sector dominated by bankruptcies and mergers due to poor financial performance.
I expect that the company can continue to grow faster than the economy over the next 2 to 3 years before slowly declining to the same rate as the economy by year 5. I am essentially declaring at that point that the company has reached maturity.
The Airline Sector is close to peaking in this part of the economic cycle. We have seen margins recently decline as the cost of fuel has increased from its own cyclical low point. The price of fuel is a key assumption for any airline valuation. I don’t possess any special insights into the future price of oil. I have relied on the guidance of the oil Futures market to forecast where the price of oil is expected to head.
Unsurprisingly the forecast is for the price of oil to return to its long run average (see the CME Group oil futures quotes) over the next few years (around $59 per barrel).
Over the next 5 years I expect that operating margins will slowly decline to their mature, stable levels. The key variable in the expense line is the price of oil. I have locked this in as stated above. Although management will work hard to improve labor productivity I have forecast that the Labor Expenses/Revenue ratio will remain at the current levels. There will be little change in the other cost elements.
The Operating margin will remain as Sector leading due to management’s cost discipline.
I have created a regression equation based on historical data which links the reported Operating Margin to my calculated Adjusted Operating Margin (the adjusted margin is used in the Valuation Discounted Cash Flow).
Although I haven’t factored in any acquisitions into my model, it is possible that Southwest Airlines could make an investment outside of the US. They certainly have the Balance Sheet capacity for it. The target would need to be a relatively small, focused operator capable of implementing the Southwest Airlines’ operating strategy. A discount operator in Europe or Asia would be a potential fit but I note that the lack of profitability in these markets may make this option potentially academic. So an acquisition is possible but unlikely to happen.
Discounted Cash Flow Methodology
The DCF is relatively straight-forward. A Free Cash Flow to the Firm approach is used with a 3 stage model (high growth, declining growth and maturity). The model only seeks to value the cash flows of the operating assets. The valuation has been performed in $USD.
Key Assumptions in Southwest Airlines’ Valuation
- Revenues will grow at 4 ± 2% for the next 2 years before growth begins to decline to GDP (3.19%) at the end of year 5.
- Operating Margins (which have been adjusted for the impact of operating lease expenses) will decline from the current level (18.5%) over 5 years to 17.0 ± 2% into perpetuity. The Adjusted Operating Margin equates to a reported Operating Margin of 14.8% (the 2017 reported Operating Margin was 16.6%).
- Capital productivity (as represented by Δ Sales / Net Capital) will decrease from the current level of 1.7 and settle at 1.45 ± 0.3 (between the current Sector average and Southwest Airlines’ historic performance).
- The current Return on Invested Operating Capital (around 31%) will decline over time before settling at 10 ± 1% in perpetuity. This will be above the cost of capital thus reflecting the strength of Southwest Airlines’ moat. The long term tax rate is expected to settle around 22% (Southwest Airlines is predominantly a US business).
- The assumptions relating to the Cost of Capital using the Capital Asset Pricing Model are:
- The unlevered beta was determined by running a screen for Airline companies on GuruFocus and adjusting for individual company leverage in order to determine a Sector average. The result was 0.92
- The current Cost of Equity is estimated to be 8.85% based on a US dollar risk-free rate of 3.186% and an Equity Risk Premium of 5.89% (I have used Damodaran’s November mature market ERP of 5.76% and adjusted for country risk in proportion to the estimated company revenues by region).
- The company’s pre-tax Cost of Debt is estimated to be 4.32% based on an S&P credit rating of A3/A- with a corresponding default spread of 1.13%
- Based on these inputs, the current Cost of Capital is estimated to be 8.12%.
- Due to the high uncertainty associated with the cyclical nature of the Airline Sector I have allowed the mature Cost of Capital to increase to 8.75 ± 0.5%. This means that the mature Cost of Capital will be higher than the median of all US listed companies.
- There are no Management Options to value.
- There are no Equity Investments to be valued.
Discounted Cash Flow Valuation
The output from my DCF model is:
I also developed a Monte Carlo simulation for the valuation based on the range of inputs for the valuation. The output of the simulation was developed after 30,000 iterations.
The Monte Carlo simulation can be used to help us understand the major sources of sensitivity in the valuation:
- 74% comes from the Operating Margin.
- 17% comes from the Stable phase Cost of Capital.
- 5% comes from the Revenue.
The Monte Carlo simulation clearly demonstrates that the value driver in my valuation scenario is the Operating Margin. This variable most effects the valuation and is the greatest source of risk in the valuation.
The simulation indicates that at a discount rate of 8.75%, the valuation for Southwest Airlines’ equity per share is between $55 and $83 per share with an expected value around $68.
How Do I Use the Monte Carlo Simulation?
I in fact use it for help me to determine when to both buy and sell stock.
On the Buy side I use the simulation to generate my purchasing margin of safety. I am a very conservative investor. I only purchase stock in the bottom half of the valuation – typically I like to buy my first tranche around the 20th percentile. I then like to buy as the stock goes lower, typically adding another tranche every time the price dips around 2-5%. I generally buy a full stock allocation over 4 transactions – starting at the 20th percentile.
Conversely on the Sell side. I start to progressively sell down my holding starting around the 80th percentile. I typically sell 10% of my holding initially and continue to sell 10% of my holding every time the price rises 5%.
I know from bitter experience, pricing is often not very rational. This approach allows me to continue to capture the benefits of any momentum that may be built into the stock price whilst at the same time bank some of my profits.
For completeness I also like to complete a relative valuation for my stock.
GuruFocus was used to generate a list of comparable companies. The list contained the 10 largest airlines in the North American market by market capitalization.
A range of financial ratios were calculated for these companies and they were used in developing a series of linear regressions for various market multiples using their companion variables.
The table below shows the regression coefficient of determination for each of the multiples tested:
Generally speaking the results were pretty good. The regression whose multiple had the highest coefficient of determination is the EV/EBIT multiple. This multiple was used to estimate the relative valuation for Southwest Airlines.
EV/EBIT Regression Statistics
An EV/EBIT regression was developed using the independent variables:
- Next year’s consensus sales growth forecast (consensus forecasts from Yahoo Finance),
- Return on invested capital
- The interest cover ratio.
The regression statistics were:
At the time of writing this article, the EV/EBIT multiple for Southwest Airlines was 8.83 (Source: GuruFocus).
Using the regression coefficients and the current metrics for Southwest Airlines (as supplied by GuruFocus) we can calculate the regression EV/EBIT multiple:
The calculated regression multiple is 8.38 which is lower than the actual multiple of 8.83.
This indicates that on a relative basis compared to other airlines, Southwest Airlines is expensive.
We can convert the regression multiple into a share price using the following calculation:
The predicted EV / EBIT multiple equates to a share price of $47.40 and therefore since Southwest Airlines’ current price is higher than this the conclusion is that the stock is currently relatively expensive.
Southwest Airlines appears to be currently priced below my estimate of the company’s intrinsic value but on a relative valuation the company is currently priced slightly above my estimate.
I rely on the intrinsic valuation ((DCF)) because I believe it to be the more rigorous estimate.
Based on this assessment I believe that the stock is a BUY but with some caveats.
Airline stocks are very cyclical. Typically the time to buy these companies is in the trough of a recession and then to “lighten” up on them as their earnings peak in the later stages of the economic cycle. My valuation is the expected long term intrinsic value for the company based on my expected long term view of the Sector. It is inevitable that the market price for this company may be lower as the US economy “rolls over” at some time in the future. Investors with a long term horizon may choose to wait for a lower price.
Thanks for reading my article. All questions and comments will be responded to. Best wishes and good investing. Rob Barnett
Disclosure: I am/we are long LUV.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.