A Look at Southwest

I realized after posting yesterday that the move to get out of Cosi might seem rather odd without a corresponding move to get out of Southwest Airlines in my other portfolio given that both have performed so poorly. As such, I thought it’d be a good time to get some thoughts down about Southwest Airlines which I own in Portfolio B as part of my strategy to attempt to buy depressed stocks on a quasi-value/quasi-mean-reversion strategy.

So, despite a relatively disappointing earnings report and cautions about softening demand in domestic flights, why am I still bullish on Southwest? The stock has fallen since I bought in the mid 15s at the beginning of the year, and it is now trading in the mid 14s. At the time, I thought I had timed a good technical buy and that the stock was ready to run similar to my buy of Coach (COH) earlier. It was trading at an Forward P/E of under 20 which is a rarity for Southwest and it’s current P/E was also historically low. The only hitch in all this was that historically Southwest was known for strong growth and thus justified a slightly higher than industry average P/E. Softening demand and a relatively poor first quarter hurt the stock and it has since continued to fall along with its valuation ratios.

The decision to hold at this point is predicated on what kind of company Southwest is. Is it still a fast growing, low cost carrier? Or, is it now an old-school domestic airline who’s innovative strategies are being mercilessly copied by faster growing competitors? Recent results coupled by the fact that sexier, low-cost airlines like Jet Blue and Virgin have started to heat up the competition might point to the latter. To make matters worse, even Southwest’s industry leading oil hedging practice can’t keep costs down low enough for it to grow earnings at the torrid pace it used to. I might be truly worried about this if it weren’t for the fact that Southwest has such a reputation for strong management, innovative strategies, and a track record for profits.

I like that management has reiterated that it believes that, while difficult, 2007 earnings growth targets are still attainable. While it has called into question how it might grow in the years following 2007, it has taken the necessary steps to keep Southwest Airlines an industry leader. It has already signed a deal to with Galileo to syndicate fares and inventory to travel agents throughout North America and will finally begin offering tickets to be purchased outside of the Southwest website. Is this bad? Are they giving up control over their customers by lowering search costs and, to a degree, switching costs? Maybe, but Southwest has the best reputation in the industry for Customer Service and I believe that this will only open doors for them to win over new loyal customers.

Management has also begun looking into non-ticket revenue streams including upmarket services to be offered for a fee on board flights like internet or personal entertainment. Further, it has already expanded services back into San Francisco for this summer and it has its eyes set on further route expansion within the United States to take advantage of United Airline’s and US Airway’s reduction of domestic service. Looking even further in the future, the company has infrastructure and code shares in place and is doing market research into expanding its flights outside of the United States likely to Canada and Mexico and one can only assume that this is the precursor to the eventual transformation from domestic airline to full-service airline.

These changes seem to signal a departure from Southwest’s very unique operations and would point to the airline eventually looking very much like the competitors it has so willingly bucked over the last decade. This may lead one to believe that the airline’s growth story is finally coming to a close and it has begun to grasp at straws. I, however, see something else. Management remains in place and has a track record for being innovative, industry leaders. It has put its money where its mouth is and taken steps to boost equity returns via a huge stock buyback plan ($800 million total and including a recently committed $500 million). Reliance on this kind of capital policy to placate shareholders is never a good thing, but it is a good sign that management continues to put shareholder’s first.

Southwest is the #6 airline by passenger load in the United States and this is in comparison to airlines offering international flights. It is the #1 airline by passenger load among domestic airlines and has lead the industry in cost saving measures and airplane efficiency for years. While oil has cut into its cost advantage, the company remains fundamentally the same. While its nascent growth drivers may seem to be running out, it has not even begun to take advantage of the many revenue and growth streams that other airlines have and I trust management at Southwest to do so in exactly the same innovative manner that it has approached running the airline with for years. Worst comes to worst, Southwest has fallen to a relatively fair valuation on a price ratio basis compared to other large airlines in the United States. If the growth story is over, there isn’t a lot of downside in investing in a profitable, mature company with what seems to be a pretty shareholder friendly disposition. And, there’s a lot to be made if Southwest can prove the doubters wrong and jump back on its growth horse.

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