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Is Southwest Airlines a Good Stock to Buy?

Investors hate the airline industry. Bankruptcies are frequent and companies are exposed to fuel costs and demand for travel, two risky macro factors. Southwest Airlines (NYSE:LUV) used to be an exception to the rule. The company began as a regional airline serving the Texas area with low-cost service and has grown the number of airports its services over time. At the end of 2007 the stock was up nearly 60% from where it was 10 years earlier; in this time frame US Airways, United Airlines, Northwest Airlines, and Delta Air Lines all filed for bankruptcy- twice in the case of US Airways. A variety of business tactics such as preferring less crowded secondary airports in a given region and aggressively hedging fuel costs allowed it to succeed in a difficult environment for the airline industry, and its customer service has regularly contended for the #1 spot on customer satisfaction surveys.

David Shaw

More recently Southwest has been struggling. In the last five years its stock price has slipped nearly 50%, in line with Delta Air Line Inc (NYSE:DAL) and far underperforming the S&P 500. While it appears safe from bankruptcy with no net debt on its balance sheet, its stock price currently sits square at book value and the former market darling now carries a forward P/E of 8. LUV is not particularly popular among hedge funds, with its two largest holders being more quantitative funds that may have held their positions on technical factors. D.E. Shaw owned 5.3 million shares and Renaissance Technologies owned 4.6 million shares, making the stock in both cases about 0.1% of the funds’ 13F portfolios (see what else D.E Shaw and Renaissance Technologies own).

Southwest reported its second quarter results last week and the news was bright. Excluding special items that reduced net income, the company beat earnings and more than doubled earnings per share from the second quarter of 2011. Including these items, net income was still up by a considerable margin. This was largely due to strong revenue growth. CEO Gary Kelly announced that the company would continue its plans to return more cash to shareholders through buying back stock as well as continuing LUV’s small dividend.

Southwest’s closest peer is its copycat rival JetBlue (NASDAQ:JBLU), which has a lower market cap at $1.5 billion. JetBlue was founded about fifteen years ago and has similarly focused on developing itself as a low-cost, low-service regional airline. In its first quarter it delivered strong revenue growth and reported earnings of nine cents per share compared to one cent per share in the first quarter of 2011. It too is expected to grow its earnings this year, with analyst expectations implying a forward P/E of 7. JetBlue also trades at a slight discount to book value, possibly because it does carry net debt and may be more exposed to poor business conditions than Southwest. JetBlue’s and Southwest’s stock prices have been highly correlated so far this year and are both up about 3-4%. Southwest can also be compared to major airlines such as Delta Air Lines, Inc (DAL) and United Continental Holdings Inc (NYSE:UAL), which trade at even lower at about three times their forward earnings estimates.  Both of these airlines have large debt liabilities and, as mentioned, are coming off of bankruptcies in the medium-term past.  Both also took net losses in the first quarter.  We think that any of these stocks could be an interesting long-term value play for an investor who is hedged against increases in oil prices and against a U.S. recession. However, we aren’t very optimistic about these stocks in the short-term because these are extremely cyclical stocks and we haven’t full felt the effects of a global slowdown. We don’t consider these stocks as “short candidates” but we wouldn’t initiate a position unless they get 20% cheaper.

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