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| Table of Contents |
| Intro and Overview |
| Introduction |
| Company Overview |
| Valuation and Trends |
| Valuation |
| Key Trends and Forces |
| Competition |
Valuation
LUV has historically traded at a premium multiple to its peers, because it is the only airline that has consistently remained profitable (until the latter half of 2008). This profitability has itself become an advantage for the company - it has historically been the only airline with the balance sheet strength to be able to afford serious fuel hedging contracts, and therefore lock-in oil prices when prices are low, which has become another reason for the company's profitability and trading multiple.
Because most other airlines are riddled with debt, it doesn't make sense to compare LUV to its competitors on the basis of P/E. Instead, Enterprise Value to EBITDA, which is capital structure neutral, is a more appropriate valuation comparator.
Key Trends and Forces
Available Capacity Drives Growth
The total supply of available seats is a key indication of airline growth, as increases in available seats are driven by additions of new aircraft and routes. Seat supply is tracked as Available Seat Miles (ASM), the total number of available seats times the number of miles flown. In 2007, Southwest's ASM increased by 7.5%, driven mainly by an the addition of 39 new planes to its fleet and added flights.[1] However, because of higher fuel expenses and declining demand, Southwest joined the rest of industry by cutting capacity for early 2009. The company announced in August 2008 that it will cut 196 flights and add 6 new routes in Q1 2009, a net of 190 flights cut which reduces its ASM by about 6%.[2] These cuts will only decrease the number of flights however, not the actual amount of cities served.[2] Furthermore, Southwest has reduced its expansion plans for 2008, with plans to expand its fleet by only 7 aircraft during the year, compared to an average of 34 new aircraft annually between 2005 and 2007.[3] As a result, Southwest only plans to increase its ASM by 4% to 5% in 2008.[4] In 2008, Southwest announced plans to expand its service to Minneapolis and New York La Guardia.[5] Luv's move into La Guardia is particularly crucial as New York is the largest domestic air market and is frequented by Luv's coveted business travelers.[5]
Southwest Seeks to Attract Business Consumers to Increase Revenue
Business travelers are attractive to airlines because they are less price sensitive than leisure travelers, and because business traveler demand is less cyclical than that of leisure travelers. For example, economic downturns may lead leisure travelers to cancel their vacation in the Bahamas, but business travel is impacted less dramatically.
Unfortunately, Southwest has had limited success attracting business customers. Southwest's single-cabin service makes it difficult to attract lucrative business executives seeking business-class seats. Additionally, Southwest's limited route map makes it difficult for a company to use Southwest for all its travel needs, and most companies choose a single favored carrier. In 2007, Southwest implemented its Business Select offering, which allows passengers to be among the first passengers to board the aircraft.[6] Business Select fares cost an additional $10 to $25 in order to guarantee a prime spot onboard the aircraft.[7] This incentivizes business travelers as they no longer have to wait in long lines before boarding.[7] Southwest believes that this initiative will boost its revenue by about $100 million in 2008.[7]
Southwest's Low Operating Expenses Enable Low Fares
Airline operating costs are measured in Cost per Available Seat Mile (CASM). Southwest has the lowest ex-fuel operating costs of any U.S. airline, largely due to its operating strategies that lead to faster turn-around times between flights, more flying time per pilot, and fewer total employees per aircraft.[8] This allows Southwest to undercut competitors' prices while still remaining profitable.
First, Southwest's point-to-point service allows for more direct nonstop routing than the traditional hub and spoke system, which minimizes connections, delays, and total trip time.[9] As a result, about 78% of Southwest's customers in 2007 flew nonstop.[9] This point-to-point system enables Southwest to offer frequent, conveniently timed flights to its markets. For example, Southwest offers 30 daily roundtrips between Dallas Love Field and Houston Hobby.[9] Additionally, Southwest serves mainly secondary airports in the markets it operates in like Chicago Midway (instead of O'Hare) which are less congested than larger hub airports. This helps Southwest maintain its turnaround times of 25 minutes, compared to the industry average of 35 to 60 minutes.[10] Lastly, Southwest's homogenous fleet of Boeing 737s simplifies the company's scheduling, maintenence, and training for its aircraft which help reduce their operating expenses.[9]
In 2006, Southwest employed 68 employees per aircraft, compared to an average of 75 for other low-cost carriers like JetBlue Airways (JBLU).[11] Furthermore, Southwest reduced the amount of employees per aircraft to 66 in 2007 which helps the company save on wage and compensation expenses.[8] As a result of these strategies, Southwest's operating margin is higher than its competitors, as the company earned $10.94 in operating profit per passenger in 2006, compared to the industry average of $6.56.[11]
Hedging of Oil Prices Leads to Significant Cost Savings
| Year | % of Oil Needs Hedged (Projected) | Hedged Price per Barrel |
|---|---|---|
| 2008 | 65% | $49 |
| 2009 | 50% | $51 |
| 2010 | 25% | $63 |
| 2011 | 15% | $64 |
| 2012 | 15% | $63 |
Southwest's key to financial success is its fuel hedging, where the company agrees to future fuel contracts that secure a particular price. Although the company's average price per gallon of jet fuel has increased from 72 cents in 2003 to $1.70 in 2007,[13] Southwest's fuel hedges have allowed the company to prolong its profitability. For example, Southwest's average cost per gallon of jet fuel was $1.98 in Q1 2008, compared to the industry average of $2.60 to $2.65.[14] In 2007, Southwest's fuel expenses increased by 10.4%, which was attributed to an 11.1% increase in costs of jet fuel per gallon.[14] However, this increase was minimal compared to other airlines, as Southwest's price per gallon of jet fuel in 2007 reflected prices of $50 per barrel of oil, when oil was often $100 per barrel during the same period.[14] For example, in Q1 2008 Southwest's fuel expenses increased 20%, compared to AMR's 50% increase in fuel costs.[15]Overall, the company believes that its hedging program saved the company $686 million in fuel expenses in 2007, and an estimated $3.5 billion between 1999 and 2008.[14][16]
As a result of different hedging strategies at each of the major airlines, oil fluctuations impact each of them differently. Southwest hedges more oil than any other airline, which has ensured the lowest prices on jet fuel following the spike in oil prices in 2007 and 2008.[16] In 2008, Southwest has 70% of its fuel needs hedged at $51 per barrel, while most other major airlines have only between 20% and 30% of their fuel hedged at an average $100 per barrel.[15] For example, Southwest's significant hedging led to its price of $1.98 per gallon of jet fuel in Q1 2008, while American Airlines (AMR) paid $2.73 per gallon as it hedged only 27% of its fuel needs.[16][15]
Southwest's hedging contracts extend until 2012, although the amount of oil hedged drops steadily after 2009, with only 15% of its oil needs in 2012 hedged at $63 per barrel.[14] As a result, Southwest will become more vulnerable to fluctuations in fuel prices as its contracts mature.
International Expansion Promotes Growth
In 2008 Southwest announced plans to expand its U.S. only service to include flights to Canada and Mexico.[17] In July 2008, Southwest announced a code-sharing agreement with WestJet Airlines to offer flights from the U.S. to Canada in late 2009. Under the code-sharing agreement, the airlines will sell tickets on each other's flights and share the revenue. WestJet will handle the flights across the border, connecting to Southwest flights at U.S. airports in which both airlines operate. In November 2008, Southwest entered into a similar agreement with Volaris airlines to offer flights between the U.S. and Mexico starting in 2010.[17] Southwest's code-sharing agreements are lower risks because they enable the company to expand its service without adding aircraft and employees.[17]
Southwest has also continued to expand domestically, and in March 2009, it began offering flights in Minneapolis-St. Paul. [18] This expansion marked the first time since August 2007 that the airline added a new city to its services [19], and with flights to Chicago Midway Airport, Southwest aims to take market share from Northwest Airlines, which merged with Delta Air Lines in October 2008. [20] (Read more about Southwest's competition...)
References
- ↑ LUV 2007 10-K, pg. 19
- ↑ 2.0 2.1 Wall Street Journal
- ↑ LUV 2007 10-K, Item 6, pg. 17
- ↑ LUV 2007 10-K, Item 7, pg. 18
- ↑ 5.0 5.1 "Southwest Adds Flights to New York City" Home & Away Magazine 11/28/2008
- ↑ LUV 2007 10-K, Item 1, pg. 5
- ↑ 7.0 7.1 7.2 "Southwest seeks to put business travelers first" LA Times 11/8/2007
- ↑ 8.0 8.1 8.2 MIT Airline Data Project
- ↑ 9.0 9.1 9.2 9.3 LUV 2007 10-K, Item 1, pg. 4
- ↑ "Loading an Airliner is Rocket Science" New York Times 11/14/2006
- ↑ 11.0 11.1 Bureau of Transporation Statistics
- ↑ Data from The Simplified Investor
- ↑ LUV 2007 10-K, Item 1, pg. 1
- ↑ 14.0 14.1 14.2 14.3 14.4 LUV 2007 10-K, Item 7, pg. 21
- ↑ 15.0 15.1 15.2 "Southwest Airlines reaps benefits of fuel hedging strategy" LA Times 5/30/2008
- ↑ 16.0 16.1 16.2 "Airlines try to hedge oil costs to stay in business" International Herlad Tribune 6/30/2008
- ↑ 17.0 17.1 17.2 "Southwest plans to sell travel to Mexico" CnnMoney.com 11/10/2008
- ↑ LUV 2008 10-K, Item 1, pg. 1
- ↑ USA Today. Southwest Airlines to begin Minneapolis-St. Paul service in 2009.
- ↑ Star Tribune. It's a done deal: Delta owns Northwest.
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