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!
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…
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.
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.
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:
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.
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:
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.
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.
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:
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?