THE INTRINSIC VALUE OF SOUTHWEST AIRLINES

You have high capital expenditures, you have labor unions. You name it. All the things that you, as a stock investor, might say, this is something that would create certainty and a really bad track record. This is not something that likes to be invested in. You definitely would have good reasons not to like this, but something happened.

This happened last quarter of 2016. Warren Buffett and other respected investors just like Bill Miller suddenly bought into four major airlines in the U.S. despite all the problems that we always hear about airlines. Whenever I saw that, I was thinking, “What is going on? This is not supposed to happen.”

This is really what happened: The airline industry has become more and more concentrated over the years. This is not good for consumers. When the industry is concentrated, it basically means that there is less competition. While that is not good for consumers because it typically means higher prices, it’s very good for stock investors because they are the owners of the company and they reap the benefit regarding higher dividends and higher capital gains of their portfolio.

To understand this, let us talk about the different types of markets. Let me provide the example of restaurants in a food court. In the food court, the prices vary slightly and even if one person might want Italian food and another person a burger, or you might even see two different Italian restaurants competing next to each other with slightly different products.

If you think about it, restaurants do not have a lot of pricing power. As soon as they raise prices, people will just eat in another place. There are so many competitors out there and knowing that the barriers to entry for new restaurants are just so low, everyone can go into that industry. Restaurants in the food court – that’s a tough industry to be in.

In other words, to make a decent profit, you really need to be able to differentiate yourself and to create barriers of entry. And if we still talk about food, something like McDonald’s will be top of the class. They have a great business. But interesting enough, it is not because of the food. That’s not really where they make their money. They do that through real estate and through branding.

They have pricing power that allows for somewhat higher margins at least for food, which is not necessarily high. But it is still a fierce industry to compete in.

Looking at airlines, you might argue that it is a very similar product that you have between airlines. After all, you go to point A to point B, right? If Southwest Airlines raises their price, another company will just hold a steady price and capture market share, right? Well, it’s not that simple in the airline business. That is bad for you as a consumer but great for you as an investor.

In the Airline Industry, you have so-called hub cities. So, if you’re in Dallas or Fort Worth, you’ll likely fly American. If you are in New York or New Jersey, you’ll typically fly United. For Chicago and other megacities, you would have these as hubs for Southwest Airlines or Atlanta for Delta.

These huge airlines have the best point and time of the day to fly, and it can be difficult to find competing airlines. So again, less competition means that you’ll have higher prices, which is good for you as a stock investor.

Think about how much an airline would gain form raising their prices, especially if you don’t have other options. Say the price of a ticket is $100, and the cost is $80. The gross profit would then be $20. But if you just raise the price to $120, you would have doubled your gross profit from selling that one ticket. So that just tells you something about how impactful it is.

One of the ways to think of the new competitive situation is really to look at some of the key factors in the industry. Let’s talk about the Load Factor first. The Load Factor is basically how many seats in the plane do we fill per mile. Now, this is the Load Factor for North America. As you can see, it’s getting very, very interesting. Over the past 15 years, it has gone up to from 70% to 80%. I mean, this is huge.

Whenever you go up from a load factor in the 70s to the 80s, it is not a corresponding increase in profit. It is a lot, lot more. Almost all the cost of the flight fuel, staff, depreciation on the aircraft, it’s all the same regardless of how many people on the aircraft. Sure, it’s slightly more expensive to serve food for a few more people, but it’s almost the same. The biggest expense is really for operating that plane in itself.

So that increase in load factor is really almost all profit. Let’s continue talking more about some of the industry-specific indicators. The price of oil constitutes between 15% and 30% of operating expenses in the airline industry, and this is really a key change in the business, in the landscape of oil and how that has changed.
A key change in the business and the landscape of the oil price and the way it has been changed is really because of the oil sand and fracking in North America. You just have so much more supply that has been released into the market and even though that the oil price is extremely volatile – it goes up, it goes down you just generally see a shift that has been to the advantage of the airline business.

If you have a fundamental shift in your cost for any business, that would go back and benefit the shareholders. There are also other factors that I’d like to point out here that really has a big impact on the profitability for you as a stock investor. One of them is that the oil contracts are running out for the current staff.

So, back in the days, the contracts were extremely lucrative. They were so lucrative that the generation now that is about to retire and has started to retire, they are making three times as much as if you are hired today. They just had very, very different contracts. Contracts that could not be changed or they will only be changed slightly with all the restructuring that is running out now for Southwest Airlines but also for other airlines.

Another interesting thing is that the U.S. does not have privately owned airports. Now, this can change, but it means that whenever you see this demand pouring in, you can’t necessarily meet that with the supply, which basically means that you will have higher prices. You just see a mismatch here. And even if it weren’t to be allowed to build a huge airport and they could even find the real estate to build these huge airports around the bigger cities, it will still take a lot of time to pan out. What we see right now is just more demand than supply, and that’s beneficial for you as a stock investor.

The point here thus far is not to say. This is the winner in the airline industry. The point of what we’ve talked about until now in terms of looking at the industry-specific indicators that is to say we’re looking to get as much tailwind as we can. If this is genuinely a good industry, yes, then we want to be invested in that industry. And then we can look at, okay, do we have a specific stock in mind that you think might even outperform the industry.

The stock that I would like to talk about is Southwest Airlines. The stock ticker is LUV, and after Delta Airlines, it has the second-highest market cap of airlines in the U.S. Southwest Airlines operates primarily in the United States and in nearby international markets, and for the 44th consecutive year, the company has been profitable. That is just unheard of in the airline business.

One of the things I would like to talk about specifically for Southwest Airlines is the very unique culture. They have this saying that they rank employees first, customers second, and shareholders third. They say that by treating the employees right, they will treat the customers right, and in turn that will result in higher profits for the business. I know that something like culture sounds very intangible.

But if you look at the next slide here, you will see the customer satisfaction. This is customer satisfaction for Southwest Airlines whenever it comes to the aircraft itself, boarding, baggage, flight crew, everything. You will see that this is not just a snapshot. Southwest Airlines, time and time again, is just top of the class whenever it comes to customer satisfaction, and I think it boils down to how they treat their employees and then in turn, how the employees treat the customers. It is just very, very hard to change customer satisfaction because to do that, you will need to change the culture of the business, which is just very, very difficult to do.

So, let’s look at some of the numbers. So, these are some of the numbers that I’m looking at whenever I’m analyzing a stock. I won’t go through all of them, but I will highlight a few things for you to look at.

The first thing to look at is the revenue which you see up here. The revenue has just shown a very, very good trend. And even though Southwest Airlines has also been making minor acquisitions, they are primarily growing organically. You don’t necessarily want to buy into a company who has to buy competitor after competitor to grow. They should have a business model that just works really well for them and then grow based on that. You can just see the topline, the revenue. Everything trickles down for the revenue.

A growing topline is really one of the things that you should be looking at. Next, I’ll look at the margins – and I’ll both look at the gross margin and the operating margin. As you can see here, over the recent years, you have seen generally that they have improved. A lot of that has to do with the oil prices that we’ve talked about before, which is just so fundamental to the cost. Remember, historically, it’s between 15% to 30% of the cost. So, it has a dramatic impact. Remember, the margins are how much money are they making off the topline, which again is why it is so important that you have a growing topline.

So, let’s look at how much money is returned to you as a shareholder. This is the free cash flow. The free cash flow can be returned back in different ways.

Generally, you can look at the dividend, which you see up here and you can see a very nice increase. It’s buying back shares. As you can see here, the shares outstanding are less and less – basically means that the earnings that you have been allocated to fewer stocks, so for you who is owning one stock. You would get a higher portion of the income, and it is also reinvesting the money back in the business which can be used for higher topline growth – more and more revenue coming in.

Generally, you see a very healthy trend in the free cash flow. Okay, so having all these numbers in mind, let’s go into our intrinsic value calculator. This is a calculator we use here on The Investor’s Podcast, and I’ll be sure to make a link here to the video in terms of where you can find it, and you can learn more about it. But this is more to show you what kind of process can you go through to find the expected return of a stock. The numbers that you see up here – that is the free cash flow that we’ve talked about before, which is basically returned back to you as a shareholder. We are going to input our historical data. Then, we have to come up with three different scenarios.

So, we have a high growth scenario, a most likely scenario, and a least likely. Then we have to look at what will happen in the future. You know one thing is what happened in the past. That’s all well and good, and that can explain a lot of things but what is really going to happen in the future, so we have three different scenarios that we each assign a likelihood of happening. I’ve chosen 10%, 5%, and 0%. Depending on your stock, depending on your analysis, even if Southwest Airlines to you might come up with something that is different.

As you can see here in our model, we start with around 1,800. That was our starting point. If we scroll up, we can see this is the last input that we had. This is the free cash flow for 2017. We can change that if we want to. We could say, what is a more normalized free cash flow? It gets a bit trickier if we do that. But if we go in and look more about the specific company and if we say: “Well there’ve been some deferred taxes they’ve been investing hell in the fleet.” The free cash flow is probably a bit higher.

It’s completely up to you if instead of 1,800 you would say you know two billion perhaps slightly more. But you need to have a starting point. So, let’s just use the historical data here and say it’s around 1,800 and then we can talk about the three different cases. So, if we start with our base case or most likely, what do we expect to happen. Well if we look at what some of the research shows, demand is expected to stay strong. In general, U.S. airline traffic is expected to increase by more than 3% annually for the next 15 years, and demand is increasing based on improving living standards, increasing population, and airlines continuing to add new routes and on the serve markets.

Another thing is that Southwest Airlines will not only capture U.S. air travel, but they’re also expanding international right now. We’ve seen revenue growth over the past ten years of 8% annually for Southwest Airlines and very little declining market. Keeping all that in mind, I used 5% here. Again, if you want to use 3%, 4%, 6%, it is really up to you. I’ve decided to use 5%. I find it somewhat conservative, but I like to be conservative and assigned it a 50% probability.

Now, let’s talk about the high growth case. So, for the high growth case here, I chose 10%. I assigned it a probability of 25%. So, what should happen for this to materialize? We have seen double-digit growth in the net income for Southwest Airlines for the past ten years. We’re looking at how much money is returned back to you as a shareholder.

We’re not looking at anything else in that, and we tried to come up with a projection. Another case here why you would see a higher growth for a company like Southwest Airlines is that you will see with the new generation with millennials. Business and leisure are just more and more tied together. They travel a lot, go on a lot of vacations, and bring their work with them on their “workations,” as some people call it. We just see this general trend here. So, that might be one of the reasons why you see a high growth. You have a new competitive situation as we saw at the beginning of this video that might even worsen for the consumer.

But again, that is good for you as a shareholder and higher prices on tickets and more profits for you as a shareholder. Southwest Airlines’ international presence is still relatively small. Currently, it only represents 4% of the revenue. It is a growing segment. It’s up more than 69% in just two years. And it’s a huge focus point for Southwest Airlines. Even though that load factor again (that is how many seats you’re filling per miles), even though their margins are slightly lower, this is a very interesting point where I do expect Southwest Airlines to become more profitable. So, that is a high growth case. Again, 10%. You might use a different number. I use 10% with a likelihood of 25%. My lower band that you see up here. I chose to be completely flat. I think that is likely to assign a 25%.

I don’t think it’s highly likely and this is not just looking at how has it been historically. If you look at all that tailwinds that you have, not just from the business itself, but from the industry as such. This would really be a very pessimistic view.