What Will the Future Bring for Southwest Airlines?

International focus will not isolate this well-run airline from the cyclical nature of the industry.

Feb 3, 2014 at 9:47PM

Investors in Southwest Airlines (NYSE:LUV) are having a solid start to 2013 despite the many cancellations as a result of the very cold winter. Strong earnings numbers released by the company and by other large carriers, combined with downwards pressure on oil prices are creating a solid environment for airlines to operate in.

New routes
In the final week of January, Southwest announced its first international routes. Aruba, Nassau, and Montego Bay -- all three Caribbean beach locations -- will be added to the daily schedule in time for summer travel plans.

The company notes that this is just the first stage of the international conversion plan; acquired subsidiary AirTran Airways already flies to selective international destinations.

A review to 2013
A week earlier, Southwest released its full-year results for 2013. The company nearly doubled annual earnings to $754 million in 2013, with earnings coming in at $1.05 per diluted share. Results were driven by a strong final quarter, in which earnings totaled $212 million, or $0.30 per share. 

Revenues inched up by 3.6% to $17.70 billion for the past year, indicating that even in this strong year, net earnings make up just 4% of total revenues, illustrating the very tight margins within the industry. The load factor fell by 20 basis points to 80.1%, despite a strong fourth quarter. Total passengers carried by Southwest fell by 1.2% to 108 million, while those onboard on average made longer trips.

Note that conditions within the airline industry remain volatile as carriers like Southwest operated in a relatively favorable environment last year with moderate oil prices and strong demand. Despite the modest uptick in revenues, the fuel bill fell by 5.8% to $5.76 billion on lower oil prices and the usage of more fuel-efficient planes. Fuel remains the most important cost category surpassing salaries and benefits, making up roughly a third of total revenues.

Consolidation as a threat?
It is not just Southwest which had a great year. Other legacy carriers which have been structurally less profitable in recent years benefited from significant restructuring efforts and favorable operating conditions as well. Note that these carriers furthermore had the benefit of having access to lucrative international hubs and routes.

Much larger competitors and legacy carriers have the potential for superior economies of scale. As such, Southwest continues to search for scale and international routes to improve its competitive position. Yet it is fair to say that in general all major airlines performed well. Southwest's shares returned 80% over the past year while shares of United Continental Holdings (NYSE:UAL) returned a similar percentage, as shares of Delta Air Lines (NYSE:DAL) more than doubled.

Both competitors generate revenues of around $38 billion per year, much more than the reported $17.7 billion in revenues by Southwest for 2013. While Delta made great achievements in boosting its operating earnings, those earnings at United Continental trail those of Southwest in actual dollar terms despite being much bigger in size.

Implications for investors
Southwest remains one of the most profitable and best run domestic airline companies in the U.S., yet the airline industry remains notoriously difficult for investors. Famous investor Warren Buffett called the industry "a death trap" to investors. Even Southwest with more than $3 billion in cash and equivalents at hand, while operating with a modest net cash position, has not been able to deliver consistent strong returns to its investors. This is despite the fact that the company proudly reported 41 years of consecutive earnings in 2013.

Even after shares have risen sharply from $8 in 2011 to levels around $20 at the moment, they are only retesting their all-time highs set around the turn of the century. Even now, the business is already valued at roughly $15 billion, the equivalent of 20 times 2013's strong earnings results. This makes the valuation way too expensive, even for this less-cyclical name within the industry.

While the long term prospects remain solid, I follow Buffett on this one, and will avoid the death trap.

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Fool contributor rhp broens has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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