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Pros and Cons to Buying Southwest Airlines Co (LUV) Stock

Southwest Airlines Co. (ticker: LUV) enjoys a loyal customer base. But the question is whether investors should feel the same kind of passion for LUV stock.

Launched on June 18, 1971, Southwest has packed a ton of air travel experiences for its loyal consumer base for more than 47 years. The airline is widely viewed as one of the most consumer-focused companies in the U.S.

Marketing research company J.D. Power ranks Southwest as the top-rated low-fare airline in its 2018 North America Airline Satisfaction Study. Southwest also ranks No. 5 by U.S. News & World Report for its airline rewards program.

[See: 7 Airline Stocks to Buy, Sell or Hold.]

But Southwest stock has encountered headwinds in 2018, with slower revenue growth and higher company costs. Looking forward, Southwest hopes to leave some of its heavy turbulence behind as 2018 draws to a close. But reasons for optimism appear limited.

LUV Stock at a Glance

Southwest’s share price stands at $53, down from nearly $67 per share at the beginning of 2018. The stock is trading at the lower end of its 52-week trading range ($47.10 to $66.98.)

The stock’s dividend is modest at 1.2 percent and the consensus one-year target share price is $68 per share.

The third quarter painted a better financial picture for Southwest with revenues clocking in at $5.58 billion, a 5.1 percent year-over-year improvement over the $5.3 billion posted in the third quarter of 2017. Revenue per available seat mile, a key financial metric for airlines, was up 1.2 for the quarter, against a 1.6 percent decline in the first six months of 2018.

One fly in the ointment for Southwest, and for all airlines, is the price of oil. Fuel prices rose steadily for the first three quarters of the year. The challenge for all airlines when prices rise is to pass those energy costs onto passengers. But there’s only so high the low-cost airline company can raise prices in the midst of battling higher business costs. In its Q3 briefing, Southwest reported an expected 3 percent hike in non-fuel costs in 2019, which triggered a bout of anxiety among Wall Street analysts.

One research note from Raymond James cited the cost hike as a “negative surprise,” while Stifel cited the news as “way above our expectation of flattish.”

For an airline that prides itself on low prices, rising costs are a big red flag for the professional investing class, and a big reason why LUV’s share price has been challenged lately. If oil prices can stay lower (at this writing, oil has fallen to $50 per barrel), then that will help Southwest’s bottom line.

[See: 10 of the Best Stocks to Buy for 2019.]

Pros to Buying LUV Stock

Despite the cost issue, some industry analysts are bullish on LUV stock going forward over the long term. “Southwest stock is undervalued right now and will trade higher, at a market-beating pace, over the next three to five years,” says Tim Beyers, a senior analyst with The Motley Fool.

Beyers cites three big reasons for his call on LUV:

Exceptional management with a conscience. Southwest is the rare carrier that puts passengers above profits in everything it does. “Putting passengers first is what leads to sustained profits,” Beyers says. “Accordingly, we love that the company is a leading voice in the conscious capitalism movement.”

Fewer airlines equal fewer fare wars. While high fuel prices are and always will be a drag on airline profits, and that includes hyper-efficient carriers such as Southwest, the fundamental economics of airlines are much different today than they were 10 years ago, he says. “Fewer carriers means less route by route competition, which means less temptation to start a profit-destroying fare war for passengers. As an industry, the airlines have roughly matched capacity to demand so that load factors … are routinely 80 percent or higher.”

Newer fleet equals defense against fuel drag. Southwest, for its part, has always been better prepared for tough times because of its low-cost leverage. “Flying one type of jet to reduce maintenance costs, flying point to point to avoid overspending on developing a hub, and choosing bare jets without in-flight entertainment, all while excelling at service, are big positives,” Beyers says. “Southwest has genuine fans, which is unusual for an airline and helps sustain demand through every cycle. Plus, to capitalize, the company is upgrading its fleet to Boeing’s 737 MAX.”

Cons to Buying LUV Stock

Other investment professionals are more downbeat on Southwest, citing weaker financials compared with other airline competitors.

“Southwest is not the best in class company amongst their peers,” says Robert Spivey, director of research at Valens Research, in Cambridge, Massachusetts. “Southwest’s uniform accounting return of 8 percent is healthy, but significantly surpassed by their best-in-class peer, Delta ( DAL).”

Southwest has consistently tried to differentiate itself from its peers with marketing taglines like “bags fly free,” Spivey says. “However, Southwest is very much in the business of generating incremental revenue through various non-ticket fees, as much as Delta and others do. Delta generated 13.7 percent of its revenue in 2017 from ancillary fees, like baggage check fees, early boarding fees and other fees. Southwest was not far behind, generating 8.8 percent of their revenue from ancillary fees in 2017, up from less than 5 percent as recently as 2013. These include fees for options like upgraded boarding among other fees.”

The Bottom Line on LUV Stock

Despite recently beating expectations by reporting a 16 percent increase in third-quarter profit on higher revenue, shares of LUV are largely in decline because management warned of higher costs next year, investment experts say.

“While other airlines struggle to maintain a consistent business model, LUV’s business model is being a low-cost provider which is generally a good space to occupy,” says Robert R. Johnson, a finance professor at Creighton University in Nebraska. “However, while other airlines have recently successfully upsold customers to premium offerings in order to increase revenue, that strategy is not available to Southwest due to its identity as a low-cost provider.”

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There are some indications that airline industry valuations are attractive. “For example, Warren Buffett’s Berkshire Hathaway ( BRK.A, BRK.B) has positions in four airlines,” says Johnson, referring to Southwest, Delta Air Lines, American Airlines ( AAL) and United Continental Holdings ( UAL). “Historically, Buffett has been a critic of the airline industry.”

Yet Johnson isn’t sold on Southwest in the immediate future.

“For the long term, LUV looks to be an attractive holding for the patient investor,” he says. “The short term, however, may be a bit rocky.

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Pros and Cons to Buying Southwest Airlines Co (LUV) Stock originally appeared on usnews.com



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