Southwest Airlines

Moat: 2/5

Understandability: 2/5

Balance Sheet Health: 3/5

A major U.S. airline, Southwest is known for its low-cost model, point-to-point network, and focus on domestic travel, but increasingly for its significant financial exposure.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Business Overview

Southwest Airlines (LUV) operates as a major passenger airline, offering primarily point-to-point service rather than the hub-and-spoke model used by many major carriers. This allows Southwest to efficiently transport passengers without the need for layovers, often keeping costs low by utilizing secondary airports. Southwest’s network is focused on the U.S., including international destinations in Mexico and the Carribean. The airline’s primary business consists of transporting passengers, cargo, and providing other related services.

Revenue Distribution:

  • Passenger Revenues: Primarily driven by air traffic liability with tokens and loyalty credits, which is largely tied to passenger demand and the pricing set by the company.

  • Cargo & Other: A smaller component of revenue, encompassing freight, ancillary products, and other items.

Trends in the Industry:

  • Intense competition: The airline industry is highly competitive with many legacy carriers and low-cost alternatives.

  • Volatile fuel prices: Jet fuel constitutes a large portion of an airline’s expenses, making companies sensitive to price fluctuations.

  • Labor costs: Unionized work forces and high training standards create a large expenditure category.

  • Technological disruption: Evolving from traditional booking methods to online platforms and direct access to consumers.

Margins:

  • Operating margins vary due to the volatility of fuel costs and pricing. Lately, Southwest’s margins have been under pressure.

  • The airline industry is known for thin margins and high leverage, especially those dependent on long-term debt financing.

Competitive Landscape:

  • Low-cost airlines: Southwest has faced growing competition from other low-cost carriers such as Spirit and Frontier.

  • Legacy carriers: Competition also comes from major airlines that operate on a hub-and-spoke model, including United, Delta, and American.

  • The industry is consolidating, and mergers & acquisitions are common

  • Pricing and route strategies are major factors for gaining competitive advantages.

What Makes Southwest Different:

  • Point-to-point network: Unlike many hub and spoke airlines, Southwest focuses on direct point to point flights, allowing for more flexibility and potentially lower cost.

  • Low-cost model: Focus on efficiency, avoiding many traditional airline expenses. This typically yields lower prices for customers.

  • Simplicity: Only operates one aircraft type, which keeps costs low and operations simple.

  • Rapid Rewards loyalty program: A program that allows members to earn points on every dollar spent with the airline or its partners, it makes the program very sticky.

Financials In-Depth

  • Revenue Growth:
  • Southwest has been experiencing increased revenue, primarily in passenger revenues.
  • Revenues in 2023 have experienced a significant improvement, largely driven by a rise in air fares.
  • In 2023 Q4, revenues increased by 10.9% year-over-year with passenger revenue increasing by 9.6%, and increased by 15.3% for the full year, with passenger revenue increasing by 16.7%.
  • The Company has had double-digit revenue growth for most of 2023, and believes it will continue that.
  • Profitability:
  • Southwest is generating positive net income after an extremely negative period during Covid.
  • While passenger revenues have increased, the Company is still seeing a decline in operating margins due to higher fuel prices, lower yields, and increased wages and benefits costs.
  • The company’s performance appears to be stabilizing in 2023, but the company continues to face rising operational costs, such as labor and maintenance, as well as increasing fuel prices.
  • Net loss for the nine months ended September 30, 2023 was $448 million.
  • Net income for the first quarter of 2023 was $186 million, and $360 million for second quarter, compared to a combined net income of only $138 million for the first nine months of 2022.
  • Balance Sheet:
  • LUV has a high debt to equity ratio, a result of many years of financing expansion through borrowing.
  • Cash balance was approximately $12.7 billion, as of Sept 30, 2023, a significant amount.
  • Total liabilities are about $28 billion.
  • Debt due in one year is roughly $5.9 billion. Long-term debt is about $9.9 billion.
  • Stockholder’s equity was at $10.5 billion for September 30, 2023.
  • The company has a fair share of off balance sheet items, especially leases and fuel contracts, which have created some controversy.
  • Capital Structure:
  • The company uses both debt and equity to finance its operations, with a focus on keeping debt manageable. The company is currently trying to get its debt ratio back to pre-pandemic levels, which has resulted in a decrease in leverage, at the cost of slower expansion.

Key Observations from Latest Earnings Calls

  • Focus on Efficiency and Revenue Optimization: The leadership’s ongoing aim is to improve operational performance and efficiency and also to continue to increase revenue.
  • Challenges from Cost Increases: The company is dealing with higher operating costs, including higher labor costs, fuel expenses, and maintenance costs.
  • Impact of Boeing MAX Delays: The company is having to manage its strategy due to unexpected delays in receiving new aircraft from Boeing. This could affect their growth trajectory.
  • Strong Demand and Future Growth: Southwest continues to see strong demand and believes they are well positioned for the future and for future growth.
  • Focus on Customer Experience: The Company continues to invest in customer experience including wifi, digital self service solutions, and others.
  • Emphasis on Profitability: Given a volatile macro environment, profitability and maintaining financial discipline is a key focus for management.

Risks

  • Fuel Price Volatility: The company is heavily exposed to fuel costs, which can fluctuate. Hedging can mitigate some volatility but it is not a perfect solution. If fuel prices significantly increase, it can severely impact LUV’s bottom line.
  • Competition: Southwest faces competition from both legacy and low-cost airlines. Competitors might decide to lower prices or take market share from the company.
  • Economic Downturn: Reduced consumer spending and travel demand can adversely impact revenues.
  • Labor Issues: The airline industry is highly unionized, and disruptions could have a significant impact on revenues and operations. Contractual agreements and wage negotiations could become major issues.
  • Boeing MAX Issues: Boeing has had multiple issues with the MAX platform, which is what SW uses. Further delays or issues can lead to significant reduction in its operations and thus revenue.
  • Debt: LUV has a pretty high amount of debt which they must pay off. Higher interest rates in the economy may further make debt more onerous.

Moat Assessment

  • Limited Moat: Southwest does have a slight advantage in its cost-cutting measures, but this moat is narrowing as competitors are implementing similar strategies. The company’s point-to-point strategy allows for some degree of efficiency, but it’s not a revolutionary approach.
  • Brand Recognition: The brand is relatively strong but it’s not very important in customer decisions, and other alternatives are always available.
  • Lack of a Strong Network Effect: Although the airline does operate across the country, its benefit is limited. Because it’s a domestic airline, its network isn’t necessarily international, thus it does not see the network effect advantages of large, global airlines.

Moat Rating: 2/5 LUV has some advantages, but they are not significant and are slowly being eaten away by competitors.

Understandability Rating: 2/5 While Southwest’s core business model of low-cost travel and point-to-point network is simple, the detailed mechanisms of its operations, especially around fuel hedging, financing, revenue recognition, and the relationship with airline regulators make it a more complex business than many other airlines.

Balance Sheet Health Rating: 3/5 Southwest’s balance sheet is okay, it has a good amount of cash and its debt levels while high are manageable. The debt/equity ratio remains high from the past years of funding operations. The company needs to be mindful about its current debt and focus on paying back debt to reduce its leverage.