Should Southwest Airlines Co. (LUV) Be the Next Warren Buffett Buy?

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Warren BuffettSouthwest Airlines Co. (NYSE:LUV) offers many features that should appeal to growth, income, and value investors, and yes, even Warren Buffett.

Although Buffett has been leery of investing in airlines since he fared poorly back in the early 1990s with US Airways Group, Inc. (NYSE:LCC), here are some of the reasons that Southwest Airlines should be attractive to the “Oracle of Omaha,” in addition to Foolish investors.

Airlines like Southwest perform a basic, needed function in an economy with a strong consumer base.  Warren Buffett favors these types of companies over high-tech entities.  As but one example, in 2009 Buffett bought Burlington Northern Sante Fe railroad for $34 billion to add to the portfolio of Berkshire Hathaway Inc. (NYSE:BRK.A).  Airlines are just as needed in a modern, functioning economy as railroads.  Consumers use the airlines just as they do products from H.J. Heinz Company (NYSE:HNZ), which Buffett just spent billions for in a deal.  There are many things that a railroad does better than an airplane, just like there are many vital economic needs that can only be satisfied by air travel.

Southwest Airlines is “the wonderful company” in the air travel industry.  Buffett has said that, “It is far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”  In the passenger airlines sector, that is Southwest.  It has been the only domestic airline to be profitable every year since 1973.  Southwest also transports more domestic passengers than any other carrier every year.

As the table below shows, while US Airways, Delta Air Lines, Inc. (NYSE:DAL), and United Continental Holdings Inc (NYSE:UAL) all had a negative profit margin over the last five years, Southwest Airlines was making money for its shareholders!  It is also worthy of note that, unlike all of the legacy carriers in the United States, Southwest has never been forced to file for bankruptcy.

In filing for bankruptcy, those airlines were able to dump billions in expenses.  Southwest has never done that, which means it has performed far better than the others, as the table below shows.

Metric Southwest Airlines US Airways Delta Airlines United-Continental
Profit Margin 2.50% 4.60% 2.80% (1.90%)
5-Year Profit Margin TTM 2.00% (2.00%) (5.00%) (4.20%)

Source: The Motley Fool CAPs

Southwest Airlines has a strong cash position.  That is appealing to Warren Buffett when considering an investment. The price-to-cash per share ratio for Southwest Airlines is just 2.85.  That means there is more than $4 in cash for each share of the stock that is trading around $11.60.  By contrast, Berkshire Hathaway, the company for which Buffett is Chief Executive Officer, only has a cash per share ratio of 5.10.  At 12.10, the price-to-free cash flow of Southwest Airlines is also far superior to that of 20 for Berskshire Hathaway.

Buffett looks for investments that will pay him to be an owner.  He wants cash to be generated from his holdings so that he can use it to buy other assets.  Southwest Airlines does this through the payment of a dividend.  As the table below shows, Southwest Airlines is the only major carrier to pay a dividend.  The low, low dividend payout ratio of Southwest Airlines should appeal to Buffett as it means there is plenty of earnings remaining to increase the dividend, initiate a stock buyback program to raise the share price, or fund a special dividend to reward the shareholders.  As an investor, Buffett has a history of forcing management to return cash to its shareholders, in one form or another.  Southwest Airlines has a very strong cash position as detailed in the previous paragraph, so it could easily disperse funds to its shareholders through a variety of mechanisms.

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