Southwest: Great airline, bad investment

By Robert Walberg

It's a rough time to be the best-run airline in America.

Southwest Airlines' (LUV, news, msgs) shares are seriously underperforming the rest of the major carriers despite the company's year-over-year top- and bottom-line growth. Its shares have remained relatively unchanged since August versus an average gain of an astounding 100% for the often-floundering legacy carriers like American Airlines parent AMR Corp. (AMR, news, msgs), Continental Airlines (CAL, news, msgs) and United Airlines parent UAL (UAUA, news, msgs).

Few would argue that Southwest's consistent record of sales and profit growth, even during industry downturns, is an incredible achievement and a testament to management's vision and talent. So should investors reward the company?

There are several reasons to be cautious. Southwest has been aggressively hedged against rising oil prices over the past couple of years, locking in fuel prices well under $40 per barrel. That spared Southwest the squeeze from higher energy prices that hit other carriers. Unfortunately, those hedges are ending, so Southwest faces higher energy costs even though crude prices have fallen. Meanwhile, the rest of the sector is now paying considerably less for jet fuel than it did a year ago.

Cheaper fuel is little help

Considering that every 1-cent increase in the price of jet fuel costs the industry about $190 million annually, according to the Air Transport Association, you can see how cheap fuel helps the carriers' bottom lines. Obviously, lower fuel prices over the long term will be a boon to the entire airline sector, but for the next six to nine months Southwest isn't likely to benefit much.

Southwest also faces pressure on its margins from discounters like AirTran Holdings (AAI, news, msgs) and Jet Blue Airways (JBLU, news, msgs). These and other regional and short-haul carriers have moved aggressively into Southwest's domain, putting pressure on pricing. Meanwhile the bigger airlines pushed through 10 price increases last year alone. The legacy carriers are generally enjoying higher ticket prices and lower fuel costs, while Southwest is stuck with little pricing power and a relative jump in fuel costs.

That's two strikes against Southwest. Now for strike three: Shares of the legacy carriers are advancing amid expectations of increased consolidation, but nobody suggests that Southwest might be part of a deal. US Airways Group (LCC, news, msgs) is working hard to buy a reluctant Delta; United and AMR are rumored to be interested in gobbling up Continental. There's even talk on Wall Street that struggling Northwest Airlines might be a target.

Not in the merger game

What you don't hear is any buzz around the discounters -- not even industry leader Southwest. It doesn't matter that Southwest is in the best financial position to actually make an acquisition. For now, what counts is being in the consolidation game, and on that front LUV simply isn't getting much love.

With three big strikes against it, Southwest is out of favor with investors. Surprisingly, valuations aren't all that favorable going forward, even after the huge discrepancy in price action over the past several months. Based on forward-earnings estimates for fiscal 2007, Southwest trades at nearly twice the average price-earnings multiple of the legacy carriers (17 times versus an average of 9.1 times) despite a considerably slower growth rate and less favorable margins.

Southwest remains the best-run airline company in the country and still sports the best financials in the industry by far. That said, it isn't the best investment candidate for the year ahead, thanks to a confluence of one-time factors that should keep the stock grounded relative to its long-haul competitors.

At the time of publication, Robert Walberg did not own or control shares of any company mentioned in this article.