Southwest Airlines Stock Upgraded: What You Need to Know

This airline is best of breed, and running circles around its rivals.

Rich Smith
Rich Smith
Jun 22, 2017 at 11:34AM

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Up more than 51% over the past year -- and beating the market by 35 points, by the way -- shares of Southwest Airlines (NYSE:LUV) have richly rewarded their owners. According to one analyst, though, Southwest's run is not yet done. Far from it, in fact.

This morning, stock rater Argus Research announced it is upgrading Southwest stock as a sort of best-of-breed play on the airline industry. Here are three reasons why Argus likes it.

Southwest airplane

Image source: Southwest Airlines.

1. Pricey...

Argus begins its analysis with a plain admission that Southwest stock does not look cheap on the surface. Costing 18.4 times trailing earnings, Southwest stock sells for a 56% premium to the 11.8 valuation on a share of American Airlines (NASDAQ:AAL), costs 64% more than United Continental Holdings (NASDAQ:UAL), and fetches a whopping 90% premium to industry giant Delta Air Lines (NYSE:DAL) -- both the biggest company in the industry by market cap, and the cheapest stock at just 9.7 times earnings.

2. ...but worth the price

And yet, Argus thinks Southwest stock deserves to be "priced slightly higher than the peer group." After all, Southwest Airlines is one of the "most profitable airlines in the world," as my fellow Fool Adam Levine-Weinberg pointed out earlier this year, with an operating profit margin that tops those of any of the three big legacy airlines named above.

In a report quoted on (requires subscription) this morning, Argus praises Southwest's "clean" balance sheet and "impressive record of returning capital to shareholders through dividends and share buybacks." Helping with the latter, I suspect, is the fact that Southwest's profits are of significantly higher quality than its rivals', and its balance sheet looks better as well.

3. Crunching the numbers

Consider: According to data from S&P Global Market Intelligence, every dollar of the $2.1 billion in net profit that Southwest Airlines reported earning over the past 12 months is backed up by $1.03 in actual free cash flow generated by its business. Compare that with:

  • Delta Air Lines, which reported earning $4 billion over the past year, but generated only $2.1 billion in free cash flow.
  • United, which reported profits of more than $2 billion, but whose free cash flow was less than $1.8 billion.
  • And most especially American Airlines, which reported earning $2.2 billion, but generated FCF of only $266 million -- just $0.12 on the dollar!

You can see right there that not only is Southwest Airlines is more profitable than its rivals, as Argus claims, but the profits it's earning are also more "real" than anything its competitors can match. No wonder, then, that when you turn to examine the companies' respective balance sheets, you find that Southwest's balance sheet is flush with $416 million more cash than debt -- while Delta carries $6.6 billion in net debt on its balance sheet, United is $8.5 billion in hock, and American carries a staggering $17.9 billion net debt load!

More profitable, and widening the gap

One final note before we close. Digging deep into Argus's research, (requires subscription) touches down upon the fact that Southwest has just finished investing $500 million in a new reservation system to streamline its business. Argus calculates that this investment will pay for itself in under three years, generating an additional $500 million in earnings by 2020. After that, presumably, the investment will continue earning profits, and adding to Southwest's bottom line -- widening the gap between Southwest and its rivals even further.

Mind you, at today's valuation of an enterprise value 17.4 times trailing free cash flow and a projected profits growth rate of only 14.3%, I wouldn't call Southwest Airlines stock cheap, exactly. But Argus Research is right. Within the airline industry, this company is clearly best of breed -- and worthy of its buy rating, just as soon as the price is right.