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What's wrong with Southwest?
By Vaughn Cordle, CFA / May 2007
Southwest has a big problem. Its share price has underperformed the broader stock market. The
S&P500 index has returned almost 40% over the last 5 years, while Southwest is lower by 17%. Bottom
line: Shareholders are not being properly rewarded.
Poor share price performance has been driven by deterioration in the earning power of the firm.
Earnings power has deteriorated since 2000 as yields fell and the asset base grew 2-3 times faster
than industry average. First quarter 2007 operating income decreased 14.3% compared to first quarter
2006.
Inflation-adjusted domestic yields [in 2006$] are 25% lower today than they were in 2000, which has
resulted in about $12 billion less domestic revenue—the sum of mainline and regional revenue—for
the industry. Our recent industry analysis shows that there has been a major structural change in the
industry, reflected in a 27% reduction in domestic revenue as a percent of GDP ratio in 2006 from 2000.
The airlines have had to reduce capacity— aggregate industry domestic capacity shrank 3.5% last
year—in order to prop up unit revenue, resulting in a 12% load factor increase in the same time period.
Moreover, we are forecasting $700 million lower domestic revenue this year because of decelerating
GDP growth, which is estimated to remain below trend though 2008.
Many have argued that excess capacity does not exist in the airline industry, but this is why the majors
have reduced domestic capacity over 20% since 2000. Still, while domestic capacity shrank 3.5% in
2006, it is estimated to grow 2-3% this year.
In early 2004, we made the case that Southwest's valuation multiples would contract as the growth
component of its market value (i.e., the franchise factor) becomes a smaller component of its total
market value over time. Southwest's P/E has contracted from 35 in 2000 to 22 currently, and it will
continue to move toward its base or no-growth P/E, which is approximately 10 (the reciprocal of its cost
of equity capital). In other words, as the company grows, the market value of its future business will
become an ever smaller component of its base or current operation’s market value. 55% of
Southwest's current market value is based on new business opportunities and this appears too high
given the company’s capacity and earnings growth.
Southwest's current share price is overvalued if the company cannot deliver on the 15% earnings per
share growth rate target. Hence, there is a need for Southwest to take some type of action to improve
shareholder returns. Southwest's CEO will have no choice but to get aggressive with corporate
financial strategies to enhance shareholder value. This is what the majors have been doing for years
and is one of the key reasons why massive write-offs have occurred in recent years. The alternative is
to do what I call a "leap frog" strategy, which involves buying another airline, or a "gap up" in capacity
growth, which is a fairly aggressive move for a company that has historically been super-conservative.
Gary is no Herb, and I suspect he can no longer be conservative if he wants to keep his job.
The company has about $3 billion in excess equity on the balance sheet, and this provides options that
other airlines do not have. A leveraged buyout is one option by which to increase shareholder value in
the short run. If this option is exercised, the company will eventually be valued similar to that of a typical
airline, which means that its days as a Wall Street darling are over: Shareholders will get a one-time
payoff, and future share price appreciation will move along at the rate of the industry as a whole.
The company can increase its share repurchase plan to reduce excess equity on the balance sheet
and the share base. This will increase the share price because it reduces the denominator in the
earnings-per-share ratio and improves the spread between the cost of capital and return on capital.
Moving toward a more optimal blend of equity and debt will expand firm value multiples because it
lowers the cost of capital. The after tax cost of debt is less expensive than equity and Southwest has too
much equity on the balance sheet.
Southwest's total flight operations costs for its fleet of B737s, when compared to all U.S. airlines that
operate B737s, is 16% lower when numbers are stage-length adjusted. The following table sheds light
on why Southwest is a more profitable airline. Southwest’s ownership costs are 55% of the average of
all other B737 operators because it owns outright 80% of its aircraft and does not have large interest
and rent expense costs.
Southwest's labor costs eat 34% of every dollar of revenue produced versus an industry average of
25%. At the low end, labor’s take for United, Northwest, Delta and US Air is between 18% and 23%.
However, because of higher productivity and offsetting ownership costs, Southwest can afford the
highest paid labor. Southwest's pilots, as an example, are the best paid in the industry, but total pilot
costs are only 96% of the industry average. Over the next few years, Southwest's labor cost
disadvantage will narrow as other major airlines are forced to increase labor compensation.
When all aircraft types are included, Southwest’s operating costs are about 25% lower than that of the
majors. However, fuel hedge benefits account for the bulk of Southwest’s earnings and, as these fuel
hedges roll off, the company will be forced to raise fares—about 8%—if they are to maintain the growth
in earnings that they hope to achieve. Given a weak economy and after a series of fare hikes over the
last two years, higher fares will result in lower load factors and lower unit revenue growth. Higher fares
at this point will also force some of the major airlines to pull down even more domestic capacity as
traffic growth slows and even falls in some markets.
Southwest’s recent load factors have been negative year over year, which reflects a capacity growth that
exceeds traffic growth. This means that the ceiling for price elasticity of demand has been reached in
many markets, which is not a good thing for Southwest or the industry. If Southwest or the industry
raises fares too fast, traffic and load factors will fall, which in turn could result in lower unit revenue
growth and earnings.
By Vaughn Cordle, CFA / May 2007
Southwest has a big problem. Its share price has underperformed the broader stock market. The
S&P500 index has returned almost 40% over the last 5 years, while Southwest is lower by 17%. Bottom
line: Shareholders are not being properly rewarded.
Poor share price performance has been driven by deterioration in the earning power of the firm.
Earnings power has deteriorated since 2000 as yields fell and the asset base grew 2-3 times faster
than industry average. First quarter 2007 operating income decreased 14.3% compared to first quarter
2006.
Inflation-adjusted domestic yields [in 2006$] are 25% lower today than they were in 2000, which has
resulted in about $12 billion less domestic revenue—the sum of mainline and regional revenue—for
the industry. Our recent industry analysis shows that there has been a major structural change in the
industry, reflected in a 27% reduction in domestic revenue as a percent of GDP ratio in 2006 from 2000.
The airlines have had to reduce capacity— aggregate industry domestic capacity shrank 3.5% last
year—in order to prop up unit revenue, resulting in a 12% load factor increase in the same time period.
Moreover, we are forecasting $700 million lower domestic revenue this year because of decelerating
GDP growth, which is estimated to remain below trend though 2008.
Many have argued that excess capacity does not exist in the airline industry, but this is why the majors
have reduced domestic capacity over 20% since 2000. Still, while domestic capacity shrank 3.5% in
2006, it is estimated to grow 2-3% this year.
In early 2004, we made the case that Southwest's valuation multiples would contract as the growth
component of its market value (i.e., the franchise factor) becomes a smaller component of its total
market value over time. Southwest's P/E has contracted from 35 in 2000 to 22 currently, and it will
continue to move toward its base or no-growth P/E, which is approximately 10 (the reciprocal of its cost
of equity capital). In other words, as the company grows, the market value of its future business will
become an ever smaller component of its base or current operation’s market value. 55% of
Southwest's current market value is based on new business opportunities and this appears too high
given the company’s capacity and earnings growth.
Southwest's current share price is overvalued if the company cannot deliver on the 15% earnings per
share growth rate target. Hence, there is a need for Southwest to take some type of action to improve
shareholder returns. Southwest's CEO will have no choice but to get aggressive with corporate
financial strategies to enhance shareholder value. This is what the majors have been doing for years
and is one of the key reasons why massive write-offs have occurred in recent years. The alternative is
to do what I call a "leap frog" strategy, which involves buying another airline, or a "gap up" in capacity
growth, which is a fairly aggressive move for a company that has historically been super-conservative.
Gary is no Herb, and I suspect he can no longer be conservative if he wants to keep his job.
The company has about $3 billion in excess equity on the balance sheet, and this provides options that
other airlines do not have. A leveraged buyout is one option by which to increase shareholder value in
the short run. If this option is exercised, the company will eventually be valued similar to that of a typical
airline, which means that its days as a Wall Street darling are over: Shareholders will get a one-time
payoff, and future share price appreciation will move along at the rate of the industry as a whole.
The company can increase its share repurchase plan to reduce excess equity on the balance sheet
and the share base. This will increase the share price because it reduces the denominator in the
earnings-per-share ratio and improves the spread between the cost of capital and return on capital.
Moving toward a more optimal blend of equity and debt will expand firm value multiples because it
lowers the cost of capital. The after tax cost of debt is less expensive than equity and Southwest has too
much equity on the balance sheet.
Southwest's total flight operations costs for its fleet of B737s, when compared to all U.S. airlines that
operate B737s, is 16% lower when numbers are stage-length adjusted. The following table sheds light
on why Southwest is a more profitable airline. Southwest’s ownership costs are 55% of the average of
all other B737 operators because it owns outright 80% of its aircraft and does not have large interest
and rent expense costs.
Southwest's labor costs eat 34% of every dollar of revenue produced versus an industry average of
25%. At the low end, labor’s take for United, Northwest, Delta and US Air is between 18% and 23%.
However, because of higher productivity and offsetting ownership costs, Southwest can afford the
highest paid labor. Southwest's pilots, as an example, are the best paid in the industry, but total pilot
costs are only 96% of the industry average. Over the next few years, Southwest's labor cost
disadvantage will narrow as other major airlines are forced to increase labor compensation.
When all aircraft types are included, Southwest’s operating costs are about 25% lower than that of the
majors. However, fuel hedge benefits account for the bulk of Southwest’s earnings and, as these fuel
hedges roll off, the company will be forced to raise fares—about 8%—if they are to maintain the growth
in earnings that they hope to achieve. Given a weak economy and after a series of fare hikes over the
last two years, higher fares will result in lower load factors and lower unit revenue growth. Higher fares
at this point will also force some of the major airlines to pull down even more domestic capacity as
traffic growth slows and even falls in some markets.
Southwest’s recent load factors have been negative year over year, which reflects a capacity growth that
exceeds traffic growth. This means that the ceiling for price elasticity of demand has been reached in
many markets, which is not a good thing for Southwest or the industry. If Southwest or the industry
raises fares too fast, traffic and load factors will fall, which in turn could result in lower unit revenue
growth and earnings.
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