My thesis is that there is a solid chance Southwest Airlines (LUV) will outperform the S&P 500 over the next five years.
One of the reasons Southwest caught my eye is that it is listed in 100-Baggers by Christopher Mayer. The data date is 12/31/71 and it reached 100x in just 9.5 years. In other words, an investment of $10,000 in December 1971 turned into $1 million in less than 10 years. The total return is shown as 5,478 and that is through the book’s copyright date of 2015. It is remarkable that a company in a tough industry with a bourbon-loving founder produced these kinds of prodigious shareholder returns over the years.
Southwest Airlines has some parallels with low cost carriers [LCCs] JetBlue (JBLU) and Alaska Airlines (ALK) in terms of cost structure. They have some similarities with legacy carriers Delta Air Lines (DAL), United Airlines (UAL) and American Airlines (AAL) regarding the number of passengers served.
Among U.S. airlines, Southwest is at the top of the list for enplaned passengers:
Image Source: BTS
There are plenty of obstacles for the airline industry in general and Southwest in particular. Investors must grapple with the large percentage of labor and fuel costs. The cyclical and capital-intensive characteristics of the industry are a challenge. The recent MAX groundings hit Southwest especially hard. I believe Southwest has a lot going for it despite these issues. Their return on capital in recent years has been excellent. Their loyalty revenue has been growing nicely and their cost structure helps keep things steady outside of labor and fuel.
Southwest sticks with 737s in their fleet and this has economic benefits as smaller planes are more expensive on a per-seat basis. Glory Lost and Found by Era Seth Kaplan and Jay Shabat talks about the disadvantages of smaller planes:
There’s no such thing as low-cost 50-seat service. Small jets inherently have high costs per unit, simply because there aren’t so many units. Like a 150-seat jet, they have two pilots and two fuel-burning engines and require roughly as much maintenance, but these costs can only be spread among a third as many passengers.
The 2018 10-K explains some advantages Southwest enjoys:
The Company’s strategy includes the use of a single aircraft type, the Boeing 737, the Company’s operationally efficient point-to-point route structure, and its highly productive Employees. Southwest’s use of a single aircraft type allows for simplified scheduling, maintenance, flight operations, and training activities.
The 2Q19 10-Q fleet table shows that some of the 737s seat 143 and others seat 175. The MAX 8 grounding is a big concern, especially as Southwest is trying to expand to Hawaii:
Image Source: 2Q19 10-Q filing
Before starting JetBlue, David Neeleman worked at Southwest briefly after Morris Air was acquired. Neeleman’s high airline industry acumen is discussed in Flying High by James Wynbrandt and it is surprising that he made a mistake in deciding to do a $3 billion deal for Embraer (NYSE:ERJ) 190s:
The single-aircraft structure JetBlue adopted has, among other things, helped it to control costs, as the same strategy did for Southwest and Morris Air. That made it all the more surprising when, in June 2003, Neeleman once more went against expectations and announced the company had placed an order for 100 Embraer 190 aircraft—a medium-range, 100-seat jet—with an option to buy 100 more.
Fast forward to the 2018 10-K and we see that the amalgamation of Embraer and Airbus (OTCPK:EADSY) was vexing for JetBlue. We have a $362 million “special item” fleet transition cost as the Embraer E190s are phased out:
While the Embraer E190 has played an important role in our network since 2005, we determined during our fleet review that the A220-300’s economics would allow us to lower costs in the coming years.
We expect to begin reducing flying with our existing fleet of Embraer E190 aircraft beginning in 2020. The phase out is expected to continue gradually through approximately 2025.
In the end JetBlue learned the hard way that it can be costly having disparate types of planes in the fleet, especially smaller 100 seaters like the Embraer E190.
Competitors with complex fleets have higher expenses for training pilots. Glory Lost and Found talks about difficulties with respect to different types of aircraft at Delta:
But the downsides of having so many fleet types—some of which, in Delta’s case, served roughly the same purposes—are extreme scheduling complexity, diseconomies of scale and a diminished ability to manage irregular operations. Imagine a 737 flight cancels because of a mechanical problem, and there’s a similarly sized spare MD-88 at the airport. Problem is, the 737’s pilots can’t fly the MD-88. And fleet complexity means enormous time and money spent training pilots.
A nice part of the 4Q17 Southwest earnings call is when CEO Gary Kelly talks about the fact that load factors have gone up over the years. The large network today is still not exactly like the legacy networks with respect to hubs and spokes but it has moved a bit in that direction:
So the net result of that is we are carrying more connecting traffic. We’re carrying some of it more on purpose, if you will, as opposed by accident in the old days, but there is still a very — a real serious focus on point-to-point non-stop that’s the way our network planners — that’s the philosophy and that is the strategy. I did want to use it is an opportunity though to complement them, because the load factors have gone up 20 points to 30 points over 20 year to 30 year time period. And it’s not because they have converted us to a hub and spoke operation where we’re more dominated by connecting traffic.
Later in the call, Commercial EVP Andrew Watterson says they intentionally connect a little over 20%.
Southwest and their competitors have benefited greatly from the internet. Customers improve efficiencies by booking flights directly online. Glory Lost and Found explains how the spend on travel agent commissions has declined:
Technology also played a giant role in reducing the industry’s non-aircraft cost base, most importantly in the area of ticket distribution. In 2000, 25 percent of Southwest’s ticket sales came from its website. In 2010, the figure was 78 percent. In 1999, American spent almost $1.2 billion on travel agent commissions alone, helping it secure $18 billion in revenue. By 2011, it spent $100 million less to secure $24 billion.
Salaries, Wages And Benefits
Having a large U.S. labor force is a concern given the continuous rise of healthcare costs. Looking at the 2Q19 10-Q, six-month salaries, wages, and benefits were $4 billion which was about 42% of the $9.6 billion operating expenses.
At the 2019 J.P. Morgan Aviation Conference J.P. Morgan CEO Jamie Dimon noted that the labor cost advantage for Southwest is not what it used to be and he asked about the Hawaii expansion given the fact that it isn’t a high yield market. Southwest CEO Kelly responded:
I think our salaries, wages and benefits are about 40% of our total operating costs. And your facts are obviously correct. We never sought to have our low cost advantage by paying low wages. That’s never been the strategy.
When you look at – I’ll just pass on fuel for a second, you look at everything else. Last time I looked, Tammy, we’re the low cost producer there. So that’s where the business model and our people really bring our competitiveness to bear. So all in, we still have a low cost structure. We don’t depend on low wages to achieve that. And I think that will continue to be sustainable going forward.
CEO Kelly goes on to say that as the number one airline in California, Southwest needs to go to Hawaii because it’s where Californians vacation. Given the importance of the loyalty program, I think this makes sense because offering free airfare to Hawaii is an enticing proposition. Later in the conference JPM CEO Dimon asks about answering to a single shareholder implying maybe something will come of buyout rumors.
Fuel And Oil
Fuel and oil for the first half of 2019 was $2.2 billion for Southwest which was about 23% of the $9.6 billion operating expenses.
The 2015 to 2019 period has been significantly better than the 2011 to 2014 period with respect to jet fuel prices and this is one reason why net income and free cash flow have been high since 2015:
Image Source: EIA [monthly]
Page 136 of Glory Lost and Found mentions that Southwest saved almost half a billion dollars with hedges in 2004 and another $1 billion in 2005. But that’s in the rear-view mirror and one can’t be certain about the success rate of future hedges. Despite hedges, the airline industry can be handcuffed when fuel prices rise. Southwest’s acquisition of AirTran went through on May 2, 2011 and it was mentioned in the 3Q13 earnings call that higher oil prices after the deal were a factor with respect to trimming flights in Atlanta and the entire domestic route system.
Sources Of Revenue
Loyalty revenue has become extremely important for the airline industry over the years. The American 2Q19 10-Q shows $1.7 billion for six-month “Loyalty revenue – travel” and $1.2 billion for “Loyalty revenue – marketing services.” The “travel” number of $1.7 billion is part of the larger $20.7 billion passenger revenue while the “marketing services” number of $1.2 billion makes up most of the $1.4 billion “other revenue.”
In the case of Southwest, I don’t see “other revenue” broken out between loyalty and non-loyalty but their description of this segment emphasizes loyalty and I think it is similar to American where the bulk of the number is loyalty. The Southwest 2Q19 10-Q shows six-month revenue as follows:
$8,726 mn Passenger non-loyalty
$1,158 mn  Passenger loyalty – air transportation
$347 mn Passenger ancillary sold separately
$10,231 mn Passenger sub total
$87 mn Freight
$741 mn  Other
$11,059 mn Total revenue
Again, the above numbers are from the 2Q19 10-Q but the 2018 10-K has better descriptions of the loyalty buckets:
 “Passenger loyalty – air transportation” is mainly the revenue recognized associated with award flights.
 “Other” revenue is marketing, advertising and other travel-related benefits of the loyalty partner agreements.
The above $347 million ancillary revenue is from services like EarlyBird check-in, upgraded boarding, and transportation of pets and unaccompanied minors.
Southwest has a higher percentage of loyalty program revenue than peers:
Image Source: The Wall Street Journal
Regarding the 15.3% loyalty revenue in the graphic above, the 2Q18 10-Q shows that Southwest had $5,742 million in quarterly revenue. $588 million “Passenger loyalty – air transportation” revenue was part of the loyalty revenue and most of the $340 million “Other” revenue was as well.
The “Hidden Side Of Airline Profits” article talks about the fact that much of the loyalty revenue in the “other revenue” bucket across the industry makes its way to the bottom line.
Baggage-fee revenue has increased dramatically across the industry but not at Southwest where they want to avoid nickel-and-diming customers. It is annoying when overhead bin space runs low and I’m guessing this happens more often at other airlines where customers are trying to save money by not checking bags.
RASM And CASM
Seeing as their 2018 revenue per available seat mile [RASM] was 17% over their cost per available seat mile [CASM], Southwest was in an enviable position for the year. This percentage was 13%, 9%, 8%, 6% and 4% for Delta, United, Alaska, American and JetBlue, respectively. 2018 wasn’t a fluke for Southwest, their RASM and CASM numbers have been consistent from 2016 to 2018:
Image Source: 2018 10-K filings for Southwest, Delta, American, United, JetBlue and Alaska
The Southwest stage-length adjusted, non-fuel CASM looked good for the 12 months ended June 2018 as well coming in at just 7.71 cents:
Image Source: Slide 49 of the Alaska Airlines 2018 Investor Day presentation
Net Income And Free Cash Flow
Net income and free cash flow have been very high since the price of crude oil lessened dramatically in 2014. Note that free cash flow for 2013 to 2018 includes “Assets constructed for others” and “Reimbursement for assets constructed for others”:
Image Source: 10-K filings
* Net income was recast for 2016 and 2017. The “Other, net” line in “Net cash provided by operating activities” is shown as $194 mn in the 2011 10-K but it is shown as $165 mn in the 2012 10-K. Fuel numbers are from the table on page 5 of the 2018 10-K.
The airline business is capital intensive. Looking at the 15-year period from 2004 to 2018, we see that cumulative net income was almost $15.3 billion while cumulative free cash flow was just under $12.4 billion for a difference of almost $3 billion.
Southwest shows 2018 after-tax ROIC of 18.4% but much of the denominator for this is the $9.9 billion stockholders’ equity line from the balance sheet. We have $(8.5) billion of Treasury stock on the balance sheet from buybacks. The buybacks were probably excellent for shareholder returns but had Southwest sat on cash instead then retained earnings and stockholders’ equity would be higher. In other words, the stockholders’ equity part of the ROIC denominator could be much more than $9.9 billion if capital allocation decisions other than buybacks were made. And of course with a larger denominator the ROIC percentage would be smaller. So their economic after-tax ROIC might be thought of as being less than 18.4% depending on which lens one is using:
Image Source: 4Q19 earnings press release
Looking at the competitive landscape, some companies like American have delicate balance sheets. The American 2Q19 10-Q shows $21 billion in long-term debt which is more than their market cap. The balance sheet for Southwest is fine and their enterprise value is close to their market cap:
$28.12 bn market cap 
$2.45 bn long-term debt
$1.07 bn noncurrent operating lease liabilities
$0.35 bn current operating lease liabilities
$0.65 bn long-term debt current portion
$(2.45) bn cash
$(1.54) bn short-term investments
 The 2Q19 shows that the number of shares of Common Stock outstanding as of July 26, 2019 was 537,517,040. The share price as of 8/29/19 was $52.32.
Free cash flow for 2018 was $3.1 billion. The above valuation is very reasonable if the annual free cash flow over the next 10 years is close to this 2018 level For the trailing twelve months from 2Q19, free cash flow is solid and 2019 looks like another good year up to this point.
The actionable information is to look at the airline industry as it is today, not as it was in the past. Our thoughts on this historically tough business need to be re-evaluated regularly as the world continues to change. Airline seats have been seen as commodities in the past and the industry has been vulnerable to downturns in the cycle. Maybe loyalty programs will make the customer base a little more sticky during the next downturn. Right now, I just have a library card position in Southwest but this could change in the future.
Disclosure: I am/we are long LUV, VOO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Any material in this article should not be relied on as a formal investment recommendation. Never buy a stock without doing your own thorough research.