FOOL ON THE HILL: An Investment Opinion
Southwest Airlines' Competitive Edge

Until my recent flight aboard Southwest I would have told you its competitive advantage is a low-cost structure. Not after flight 211Q from Hartford to Baltimore. CEO Herb Kelleher's right. His people make the difference.

By Richard McCaffery (TMF Gibson)
September 28, 2000

It's easy to look down at the airline industry with its high costs, low margins, overcapacity, and commodity services, but that doesn't mean you can't find value, or learn a lot watching a company like Southwest (NYSE: LUV) grow sales, earnings, and cash flow every year.

And if you like learning about businesses, not just trolling for ticker symbols, Southwest is a story not to be missed.

A few points about Herb Kelleher's maverick airline. In an industry notorious for losing money, Southwest thrives. It's had 27 straight years of profitability. If you bought 100 shares of Southwest in 1985 at $26.88 and held through the end of last year, your stake would have appreciated 858% to about $24,864 (with dividends reinvested). That's an average annual return of 17.5%.

Over the last five years Southwest has increased return on equity to 18.3% from 13.7%, cash flow from operations to $1 billion from $456 million, and cut its long-term-debt-to-equity ratio from 46.3 to 30.7 -- very high, of course, but much lower than rivals and trending in the right direction. Its operating and net margins are the industry's highest -- by far -- and its costs, according to an April Fortune magazine story, are 22% below the industry average.

Of course, this is old news. Investors interested in looking at Southwest have to ask where future growth lies. In October, Southwest will begin flying into Buffalo, New York, its 57th city. In its most recent annual report, Southwest said it has received requests from more than 100 cities to add service, and that with just 8% of the domestic market and a low cost structure, it's poised to grow over the long term.

Analysts expect about 14% annual EPS growth over the long term. This makes Southwest one of the industry's few growth stories. Buckingham Research analyst Helane Becker points out in a recent report that Southwest typically expands to two or three new cities per year, and with 100 cities calling there could be more room for expansion than you might think.

There's plenty of risk, too. Southwest's compound annual EPS growth rate over the last five years is 27%, so 14% is a significant drop-off. Airlines have enjoyed renewed profitability over the last few years with a booming economy, and when economic growth slows these companies -- consumer cyclicals -- are among the first to get whacked. At a forward P/E of 21.7, Southwest is priced well above its historical P/E, which averaged 17.2 over the last five years, and light-years beyond its peers, which usually sport P/Es in the 5 to 10 range. It won't be easy for Southwest to further expand its earnings multiple since its advantages are already priced into the stock.

In the Fortune article mentioned above, CEO Kelleher is asked about his company's competitive advantage. What do you think he said? Low cost structure would be a good guess. That's an advantage that's hard to copy. Consider that the year-over-year cost of jet fuel in the second quarter jumped a whopping 76%, yet Southwest's Q2 operating expenses actually decreased 70 basis points.

Clearly, Southwest has always been focused on costs. But Kelleher said his employees, not the company's cost structure, are its real advantage. Is that really an edge? Sounds pretty weak, I know, but let me tell you about my experience on Southwest flight 211Q from Hartford, Connecticut to Baltimore, Maryland last weekend. This is only anecdotal, but it's worth passing along.

I took off from Bradley International Airport at 9:25 in the morning and landed on time. (We actually arrived 10 minutes early.) I used the Web to purchase my ticket and everything ran smoothly. In fact, about 30% of Southwest's ticket revenues come from its website, generating more than $1 billion so far this year. According to Becker, it costs an airline roughly $5 to generate a ticket sale online and roughly $30 through a traditional travel agent. These cost savings obviously boost the carrier's efficiency.

(Other trends boosting airline profits, according to Becker: more efficient aircraft, stronger balance sheets, better labor relations, lower capacity than originally expected, lower distribution costs.)

But that's not the story. Southwest's employees are supposed to be goofy, tell jokes over the loudspeaker, throw gate parties, dress up for holidays, right? Here's a few snippets from the flight attendant's spiel.

"The flight attendants will be offering complimentary juice and coffee. Wine, beer, and cocktails are $4. If you're drinking this early, shame, shame, shame."

"Please pay attention to the flight attendant at the front of the cabin. She's either going to be Miss America 2000 or a very bitter runner up."

"Please make sure all carry-on items are crammed in the tiny space under the seat in front of you, leaving absolutely no room for your feet."

"In the event of a water landing, your seat cushion can be used as a flotation device. Simply remove the cushion, grab the designer red handles, and paddle like crazy for shore."

"If the cabin depressurizes during the flight, stop screaming, let go of the person's hair sitting next to you, and breathe like this (heavy breathing). No that wasn't me who called your house last night."

"Remember if you're sitting next to a child, or someone you think may act like one, first put the mask over your big ole nose and mouth then turn to your neighbor. Women can then help their husbands."

"For all you folks in the middle section of the plane this is Lauren's first month with Southwest. She's here on the work release program. You can ask her about prison."

"Whew! (As the plane touched down.) Please remember that items in the overhead racks may have shifted during the flight. They could fall out, hurt you, and that would create more paperwork."

"If you're catching another Southwest flight, the flight numbers are posted on a board near the exit ramp. If you're continuing on another carrier, we really don't care."

"Remember, no one loves you or your money more than Southwest."

"When the plane stops moving you may exit... Get ready, get set, get out."
We were dying. In fact, everybody started clapping, and that's not what you expect on a jammed, early morning flight into Baltimore. A company with a joyful, irreverent personality can indeed rely on its employees to distinguish its services, and that does more to transmit the Southwest brand in a few minutes than 100 pricey commercials.