Why I Bought LUV


Have I completely lost my mind?  Despite writing a post back in February about why I won’t buy an airline, I went ahead and did it.  This month I purchased six hundred shares of Southwest Airlines (stock symbol: LUV) with a little of our excess cash.

They say you can’t buy love, but I just did!

(Fair warning — this is a post primarily about investing.  If investing doesn’t interest you, please check-out some of my other posts on saving, food, or raising kids after financial independence.)

If you asked me 10 years ago if I’d ever make an investment in an airline, I would have told you “Hell no! I’m not stupid!”  Well, now I’m finally stupid enough to do it.

In the past, market forces could easily destroy airline profitability on a mere whim — A small change in fuel prices could send an airline crashing into bankruptcy.  Thankfully my investment in Southwest is built around the hypothesis that airline economics have changed.

So what changed my mind?  Let me explain…

 

Variable Costs

Outside of the fixed costs of running a business, most businesses have variable costs which can dramatically alter the profitability of the firm on any give day — Labor, cost of goods, raw materials, extra bacon-shrimp-tacos, fuel, etc.

For airlines, the biggest variable costs are labor, and fuel.  In order to stay profitable, an airline like Southwest must manage these variable costs very carefully.

For most airlines, labor is a major expense.  Pilots, mechanics, ground crews, and flight attendants don’t come cheap.

Labor is the single largest variable cost for airlines.  Airline labor is mostly unionized and dealt with using long term labor contracts.  This makes labor costs fairly stable over time, and fairly competitive across all airlines.  Labor costs are unlikely to change, and this was not a major factor in my purchase decision.

Fuel is typically the second largest expense for airlines.  As you probably know, fuel prices are notoriously volatile!  Those swings in jet fuel prices are part of the reason why why airlines have historically had such a poor economic reputation.

 

Lower Oil Prices Mean Profits

As I wrote about in the previous piece on airlines, shale drilling technology has unlocked a lot of extra hydrocarbons very close to home (and around the world).  Not only does this mean a plentiful supply of cheap oil, it also means lower jet fuel prices for the foreseeable future.

Let me explain why  — In one tentacle, we have all of this new oil set to be pumped from the shale basins of America at a price that can be very competitive with the middle east.

On another tentacle we have OPEC trying to restrict oil exports to artificially inflate prices (err… OK guys, it doesn’t seem to be working).  And finally, we have a declining demand for gasoline in the United States (cars are getting more efficient, and more electric cars are now sold).  All this leads to a growing supply and stagnant demand for oil-based fuels.

While I can’t predict the future, the economics of the situation indicate excess supply brought on by new technology.  This means “lower for longer” oil prices that could last quite for a very long time.

Fuel price stability is a big positive for airlines — it means they’re suddenly a net-profitable business despite decades of poor economics.

passenger service net income
U.S. Scheduled Service Passenger Airlines Net Income 2011-2015 from the Bureau of Transportation Statistics.

 

Efficiency Gains

Lower fuel prices are one thing, but did you know that airlines have continually gotten more efficient over the years?  Plane technology has been constantly improving, which makes airlines less and less reliant on fuel prices:

jet fuel efficiency
Jet efficiency continues to rise as plane technology increases efficiency. Seat-miles per gallon of fuel continues to rise.  Chart from EIA.gov

Southwest is set to see a big improvement in fuel efficiency over the next few years due to the new 737 MAX series of planes.

According to Boeing, this new aircraft is 14% more fuel efficient because of new engines and aerodynamic design changes.  While that might not sound huge, we must remember these planes are constantly flying.  Those fuel savings add-up quickly when you’re burning jet fuel all-day.

737 max
The 737 MAX, the newest and most efficient aircraft from Boeing.

Southwest just received its first 737 MAX this week, and has another 200 planes ordered.  New planes are expensive, and this is going to suck up A LOT of money.  The plan is to replace the entire Southwest “Classic” fleet with these more efficient planes.  For investors this appears to be money well spent.

How much money are we talking?  It depends upon the model, but anywhere from $92 million to $119 million per plane.  If we assume the average cost is around $100 million per plane, those 200 planes are a $20 billion dollar commitment toward greater fuel efficiency.

Holy tentacles!  That’s a huge amount of money to invest, and a major financial commitment!  If we use airline operating margin as a rough indicator of airline efficiency, here’s where ‘efficiency’ stands today among major U.S airlines:

airline operating margins

Southwest and Alaska Airlines are the standouts.  Southwest is already among the most efficient of the major U.S. airlines, and they’re making a huge move into these more efficient planes.  This should mean Southwest’s efficiency advantage is set to continue with this big investment in the 737 MAX.

Southwest customers should continue to see low ticket prices (technological advances usually flow to the customer, not to the bottom line), and the company should see higher passenger-mile growth as a result.

Why?

Airline customers are very price sensitive — customers typically purchase the lowest cost ticket available.  If Southwest can keep prices lower than competitors, customers will continue to use Southwest’s planes in growing numbers… i.e. revenue growth should continue.

 

Continued Outperformance

Despite being an airline, Southwest has maintained continuous profitability for over 44 years (even through the Great Recession).  Part of this impressive statistic is because of Southwest’s major competitive advantage — being a low cost provider.  In fact, it’s well known that Southwest has the ability to force competitors to lower fares.

While this economic moat isn’t impenetrable, the company looks set to defend this advantage in upcoming years with continued efficiency gains.

Ultimately this competitive advantage led to Southwest’s outperformance vs. the S&P 500 over the last few decades.  I see no reason why this outperformance can’t continue.  The low fuel prices I mentioned earlier are simply additional “fuel” for this competitive advantage.

Despite that, Southwest stock is only up 4.7% for the year.  Major investors like Warren Buffett even own stakes in the company and yet it still only sells for 15 times earnings.  Meanwhile, the S&P 500 sells for 24 times earnings.

Even with a history of outperformance Southwest isn’t selling at a big premium.  Call me crazy, but this doesn’t strike me as an overly expensive price to pay for an outperformer.  It’s right inline with LUV’s historical valuation:

LUV PE ratio

What’s Not To Like?

With Southwest Airlines there’s a lot to like — solid profitability, good returns on invested capital (ROIC), low debt levels, big share buybacks, and growing market share.  That’s all really positive stuff!

The company is even something of a natural hedge in my portfolio — When energy companies do poorly, airlines do pretty well.  Conversely, when energy companies are doing well, airline earnings come under increased pressure.   My investment portfolio is “energy heavy” right now, so Southwest provides a “counterbalancing” earnings potential.

There is one thing I don’t like about the company however — Southwest’s 1% dividends are tiny compared to my other individual stock holdings (like LYB).  Remember, I live off the dividend income from my investments!  Income is important to me.

That said, the company has plenty of room to grow in the dividend department, and it’s been doing so in recent years.  Over the past four years, dividends have grown from $0.13/share to $0.50/share.  That’s an incredible growth rate.

Will it continue?  Only time will tell!

What do you think?  Have I completely lost my marbles by investing in an airline?

 

[Image Credits: Flickr, Southwest, Wikipedia]

24 thoughts on “Why I Bought LUV

  • September 2, 2017 at 4:48 AM
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    All the cool kids are doing it. Buffett, me… We were the little airline that could and we have now proven that we can. First max was delivered this week and many more to come. Congrats on your purchase and I promise to do my part to keep us profitable.
    Miss Mazuma recently posted…Spreading the FIRE

    Reply
    • September 2, 2017 at 3:32 PM
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      Hey, thanks! That profit sharing program probably doesn’t hurt either! 😀

      Reply
  • September 2, 2017 at 4:49 AM
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    No, it’s good timing Tako. Warren would approve! What remains to be seen is if we are post the consolidation phase in the airline industry and its becoming a well oiled oligopoly with some clear differences between full service airlines and discount airlines. LUV is in the best of breed among the airline industry. Good luck.
    Ten Factorial Rocks recently posted…Pursuit of Happiness

    Reply
    • September 2, 2017 at 3:35 PM
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      Totally agree, they’re one of the best of the bunch! I think further domestic consolidation is a possibility. For example: Southwest and Alaska have little overlap in their city coverage. The would make a great combination.

      Reply
  • September 2, 2017 at 5:00 AM
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    A very nice analysis Mr. Tako! It seems like a reasonable investment.

    One question though…

    “Remember, I live off the dividend income from my investments! Income is important to me.”

    What does it matter whether you live off dividends or from the capital gains that result from selling a little of the stock? I’m FIREd and I pay absolutely no attention to dividends.
    Mr. Freaky Frugal recently posted…Books for free!

    Reply
    • September 2, 2017 at 3:53 PM
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      Good question — but the answer is not simple. We could talk about it for days. In the case of Southwest, they spend an incredible amount of money on share buybacks instead of dividends… which is frequently a ruse to cover-up unnecessary stock dilution by management (I’m not saying that’s the case with LUV however). Buybacks also tend to occur at exactly the wrong times.

      An investor might only be receiving $0.50 in value from a dollar spent on such a buyback. Dividends are at least a little more straightforward — a $1 dividend is always going to be $1.

      The best value for investors will typically be found when the business can reinvest money back in the business at high returns on incremental invested capital… which is easier said than done.

      Reply
      • September 3, 2017 at 3:40 AM
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        Mr. Tako – Thanks for clarifying.

        Since we could talk about it for days, maybe this is a good topic for a future post?

        Reply
  • September 2, 2017 at 5:36 AM
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    Agreed! I LUV Southwest and have written a post about the airline. They continue to provide on time, well priced service and for an airline that is all I need (Hh and safety. They are safe which is a big one up in the sky). I think it is a good stock to have. I do wonder if Harvey will effect oil prices for the short term.

    Reply
    • September 2, 2017 at 3:55 PM
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      I watch oil prices like a hawk, and I haven’t noticed a huge problem. It’s refined product prices that are jumping in the short term.

      Reply
  • September 2, 2017 at 6:01 AM
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    You made a great case for Southwest Airline stocks! I personally like to fly Southwest because of the low price, the free luggage policy, and the flexibility they give customers to change the flight date. Sometimes there are better deals out there on the internet. Some of them are good, and some come with hidden fees.

    My husband and I are big fans of the company. I will definitely consider purchasing their stocks one day. 🙂

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    • September 2, 2017 at 3:56 PM
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      Awesome! Keep flying Southwest to keep those dividends coming!

      Reply
  • September 2, 2017 at 8:00 AM
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    Great analysis and good call. I’ve never flown Southwest Airlines but I’ve always read and heard they had their act together. I like Alaska but won’t buy individual stocks until I’m in your shoes and no longer working. I’ve been traveling quite a bit for the past three years with my job. I rarely see flights that aren’t completely booked now. Sucks for passengers. Good for airline profitability.

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    • September 2, 2017 at 3:58 PM
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      We mostly have Alaska up in my part of the world, so I’m very familiar with them. They’re both outstanding airlines.

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  • September 2, 2017 at 10:45 AM
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    I’ve also invested in an airline company – only 50 shares, but it’s still the only thing in my portfolio that’s in the green right now 😛 I invested in it because of constantly high quality. It’s the airline I prefer to use myself. I didn’t go into as thorough an analysis as you’ve done here, but so far so good. Plus the dividends I get from them are nice.

    I do know some airlines that have gone under, but I think as long as you’re not betting against the odds, it’s a sound investment (one that you should keep an eye!).

    Reply
    • September 4, 2017 at 10:09 AM
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      How long have you been investing…

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      • September 4, 2017 at 10:18 AM
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        Was that question for me or for Ms. Raggedly Rich?

        For my part, I’ve been investing for around 20 years.

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      • September 6, 2017 at 9:37 AM
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        I’ve been investing for… mayyybe two years. Not very long. My portfolio had about 12% return on the index fund, and 4% on my dividend stocks after the first year. It’s not anywhere near there right now, but the airline stock I’ve had for almost 2 years and it’s still paying dividends / offering a better return than bank saving accounts.

        Reply
  • September 2, 2017 at 1:28 PM
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    I invested over $3k in Spirit (the discount airline) last year and it dropped right after I brought it. Thankfully it rebounded quite a bit and I made a good return (30%). Like you said, the energy sector was down and I thought Spirit would be a good bet.

    Reply
    • September 4, 2017 at 10:19 AM
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      Spirit is an airline on the move. They’re a lot smaller than Southwest, but you should still do pretty well!

      Reply
  • September 3, 2017 at 11:46 AM
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    Interesting that people are jumping on the bandwagon because Buffet decided to invest in airlines. I do see a surge in airline profits in the future because oil is cheap and there are so many budget airlines to make travel more affordable than ever. That being said, I still wouldn’t invest in a specific stock…especially since the dividends are way too low for it to be attractive. But if it’s a small % of your portfolio, it shouldn’t be a problem. Anything that’s speculative and within 5% won’t really do that damaged. And you might be handsomely rewarded! Only time will tell…

    Reply
  • September 3, 2017 at 7:49 PM
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    Great analysis! I’m curious about this statement “technological advances usually flow to the customer, not to the bottom line” – Is that something you have observed? Just curious as I haven’t heard that position before.

    Reply
    • September 6, 2017 at 8:32 AM
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      It’s a pretty well known business phenomenon. Buffett has been talking about it off-and-on since the 1950. Books like The Innovators Dilemma have studied the basic principal in detail. Technological advancement does not (in most cases) lead to profit growth for investors.

      Reply
  • September 4, 2017 at 12:49 AM
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    Thanks for sharing your thought process on LUV! Makes a lot of sense, so I don’t think you’ve lost your marbles quite yet…hah. It’ll be interesting to watch. I think Southwest does a lot of things right operationally, which is quite counter intuitive for most airlines.
    Michael @ Financially Alert recently posted…Financial Update Report – August 2017

    Reply
    • September 4, 2017 at 10:22 AM
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      We’re in agreement — they do *a lot* of things right, which is one of the key reasons why I invested (but didn’t really mention in my post). I focused mostly on the industry profitability variables and competitive advantages, but operational excellence is also very important.

      Reply

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