One of the first investing books I ever read was The Motley Fool's Rule Breakers, Rule Makers. In this entry-level book, the Motley Fool co-founders laid out the specific criteria for identifying rule-breaking and rule-making companies in any industry. While rule-breaking companies were the disrupters of an industry, co-founder Tom Gardner identified Rule Makers as the dominant consumer-facing companies that ruled a particular market space for years.
To qualify as a Rule Maker, a company needs to prove that it can provide superior returns through a sustainable competitive advantage. Let's see whether Southwest Airlines (NYSE: LUV ) , a true Rule Breaker over the past few decades, has made the leap to Rule Maker status in the airline industry.
1. The mass-market, repeat purchase of low-priced goods
A Rule Maker company delivers a good or service to a broad market and connects with customers on a regular basis. By driving down fares, airlines like Southwest have introduced air travel to the mass market in a big way over the past few decades. Business travelers might book travel multiple times a week, and even casual travelers will fly on a plane a few times a year. Southwest appeals to these varied customers by offering a no-frills flight that gets you to your destination for a reasonable fare. As such, Southwest easily meets our first Rule Maker test.
2. Gross margin
Gross margin indicates pricing power and manufacturing efficiency -- both of which have an undeniable impact on the bottom line. Per Tom's rules, the ideal gross margin for a Rule Maker is 60%, but no one in the airline industry hits that. The industry average is 26.56%, so we'll use that as a sort of revised benchmark.
Southwest comes in at 21.85% for this metric, falling slightly short of three of its rivals -- United Airlines (NYSE: UAL ) , JetBlue Airways (Nasdaq: JBLU ) , and Alaska Airlines (NYSE: ALK ) -- who come in at 26.73%, 28.55%, and 27.22% respectively. Southwest does at least edge out Delta Airlines' (NYSE: DAL ) 20.08%, but is still not impressive when it comes to this metric.
3. Net-profit margin
Net-profit margin dictates how many pennies a company gets to keep from every dollar of sales. The airline industry is extraordinarily cutthroat, as Southwest's profit margin of 1.14% over the past 12 trailing months clearly demonstrates. United, at 2.27% TTM, does a hair better, as does JetBlue at 1.91% TTM and Delta at 2.43% during that same time period.
The big winner in this category is actually Alaska Airlines, with a (relatively) whopping net profit margin of 5.66% TTM. These are all very low in absolute terms, however, with perhaps only certain retail and grocery businesses experiencing equally razor-thin margins.
4. Sales growth
Year-over-year sales growth counts even for big companies, but it will naturally slow with age. Top-tier Rule Makers grow their sales by 10% every year.
Averaging 12.41% annual revenue growth for the past three years, Southwest slightly exceeds this Rule Maker benchmark. On the flip side, industry peers United, Delta, and Alaska reported 22.49%, 15.66%, and 5.64% over this same time frame. While at first Southwest and Alaska seem like laggards in this regard, one has to pay close attention to the growth strategies embraced by these carriers. Southwest and Alaska both explore growth opportunities only when they can add to the bottom line. The other carriers tend to follow a growth-at-all-costs strategy. In the long run, the low-cost carriers have proven to possess much stronger business models.
5. Cash-to-debt ratio
Rule-making companies should be cash-heavy and debt-light, ideally having at least 1.5 times more cash than debt. Southwest has $3.14 billion in cash on hand and $3.75 billion in debt on the books, for a cash-to-debt ratio of 0.84.
With $7.76 billion in cash and $12.74 billion debt, United is a bit better off with a cash-to-debt ratio of 0.61. Delta's $3.62 billion in cash and $13.88 billion in debt leaves it with a C/D of 0.26. Alaska has $1.14 billion in cash and $1.34 billion in debt, for a better C/D of 0.85. Finally, JetBlue's $1.23 billion in cash and $3.14 billion in debt leave it at 0.39. In comparison, then, Southwest did all right on this metric, but is still not in an ideal situation.
6. The Foolish Flow Ratio
The Foolish Flow Ratio measures how well a company manages its inventory and cash. Specifically, a company should be keeping its inventory and accounts receivables low and its accounts payables high -- strong indicators of market-space dominance.
To calculate the Foolish Flow Ratio, take current assets minus cash, cash equivalents, and short-term investments and divide by current liabilities. The best companies have Foolish Flow Ratios of 1.0 or less. Southwest's is an excellent 0.26, as is United's 0.28, Delta's 0.29, Alaska's 0.24, and JetBlue's 0.28.
7. Your familiarity and interest
What's in a name? As it turns out, quite a bit. A company with a familiar name and brand is typically one that resonates with customers as well as investors. This will help you understand exactly what it does and how it makes money, thereby lowering your overall investing risk.
Southwest is a very well known and popular airline, and though its business model is no-frills, frequent flyers know it's fun to fly with. The crew is always cheerful, and they tend to provide on-time arrivals and departures compared to their peers. Overall, the company has developed an attractive approach to brand-building, customer retention, and operational excellence, all of which leads to repeat business from dedicated customers. Southwest scores well on this benchmark.
Three cheers for Rule Maker Southwest
Southwest scores well in the "repeat purchase of low-priced goods" category and does about the same as everyone else on gross margin. Net-profit margin is slim for everybody, though Alaska does significantly better than all of them. Southwest reports consistent revenue growth and has one of the better cash-to-debt ratios. Finally, the company's Foolish Flow Ratio is great, and so is the company's "familiarity and interest" level.
The airline business is a tough one, hence the seemingly endless parade of bankruptcies. Southwest Airlines rules this market space as well as it can be ruled. But remember that companies and markets are constantly in motion, so please check in with your Rule Maker investments every quarter. Of course, Southwest isn't the only easy-to-understand stock you can profitably and confidently hold on to for the long term. Learn about the stock The Motley Fool is calling its top pick for 2012 in this aptly-named special free report: "The Motley Fool's Top Stock for 2012." Get it while the stock is hot by clicking here now.