The airline industry has historically been a lousy one to invest in. It's sensitive to the economy, capital-intensive, highly regulated, and hypercompetitive. Making matters worse has been poor management decisions by some of the top airlines that have led to numerous bankruptcies over the years.
But with all the bankruptcies, wars, fuel-cost spikes, and recessions, Southwest Airlines (LUV 0.97%) has stood tall for almost half a century. An early investment in Southwest would make even Walmart millionaires jealous.
I don't expect Southwest to be a home-run investment, but I do think it can outperform the broader market. Here are the main reasons I decided to buy shares of the low-fare giant recently.
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1. Industry-leading profitability
Since its founding in the 1970s, Southwest has prided itself on delivering best-in-class service and competitive fares. The formula of flying short routes, driving up productivity by flying one type of aircraft, and stripping out extraneous operating costs like in-flight meals has made Southwest the industry's most profitable airline since the late 1970s. Even with smaller airlines like Spirit Airlines trying to copy the low-cost model, Southwest still maintains industry-leading margins and returns on invested capital.
Southwest is the only airline that has turned a profit for 46 consecutive years, and that's while its competitors, including American Airlines, Delta Air Lines, United (now United Continental Holdings, US Airways (now operated by American Airlines), and TWA filed for bankruptcy between 2000 and 2011.
2. Industry-leading financial fortitude
Southwest is the only airline with a credit rating of A- or better from the credit rating firm Moody's. The company has more cash than debt on its balance sheet and generated $2.97 billion in free cash flow over the past year.
The company's financial strength makes it a good dividend stock, too. The dividend yield is currently below average at 1.23%, but that's because Southwest pays out only 14% of its earnings as dividends. The important thing is that Southwest has increased the dividend by 236% over the past five years.
With a low payout, a history of raising the dividend, and growth initiatives underway (more on this below), Southwest should be a great dividend growth stock for years to come.
3. Valuation
I love looking for fast-growing companies that could become multibaggers, but I equally enjoy looking for industry leaders that are on sale.
Southwest stock is cheap. It trades for a trailing P/E of 12.3 and a forward P/E of 10 based on next year's earnings estimates. That's at the low end of its trading range over the past 10 years. This is for a company that analysts expect to grow earnings by 12% per year over the next five years.
4. Track record of growth
Those growth estimates seem very reasonable, given that adjusted earnings per share climbed about 300% over the past five years. Much of that increase was from a significant improvement in operating margin, as revenue has increased only by 8.8% per year since 2009.
Keep in mind that Southwest's recent growth has come while there has been much skepticism about whether the low-cost pioneer would be able to maintain its lead, given the heightened competition over the past decade. While competitors have emerged from bankruptcy with a renewed focus on profitability, Southwest continues to maintain high returns on capital by modernizing its fleet, investing in facilities, and introducing new technologies, such as a new reservation system on the customer side and a new maintenance system on the company side, all designed to increase profitability.
Of course, staying ahead of the curve with these investments is a lot easier when you generate the best margins among your peers.
5. New growth opportunities
Management has big goals for the future. Its vision is "to become the world's most loved, most flown, and most profitable airline." It has already achieved that domestically, so now it is turning its sights on international expansion. However, consistent with its strategy in the early years, Southwest is expanding in baby steps.
First, Southwest is expanding its routing to Hawaii, which is management's highest growth priority for 2019 and 2020. After a delay, Southwest initiated its Hawaii flights in March. The delay in launching the Hawaii service caused some pressure to margins during the first quarter, as the company's fleet was underutilized. But management said during the fourth-quarter conference call in February that they expect the cost pressure to ease up in the second half of the year.
The new reservation system is also adding to the company's top line. Southwest rolled out this new system in 2017, and last year, it generated $200 million in additional pretax profit. Management expects the annual benefit from the new system to reach $500 million in incremental pretax profit by 2020, which is about a quarter of the company's current annual net income.
A well-run company built for sustainable returns
In recent years, Southwest has faced increasing competition, especially from ultralow-cost carriers, but Southwest stock has still outperformed the broader market, delivering a return of 120% over the past five years. Management's relentless focus on keeping costs down while investing in new moneymaking opportunities, such as new routes and technologies, should keep Southwest generating a healthy profit and paying a rising dividend for a long time.
On top of all the under-the-hood initiatives that could improve company performance, what I'm most enthusiastic about is the potential for extra juice to the stock's return stemming from its low valuation. The combination of a well-run business and a cheap valuation is what ultimately persuaded me to pull the trigger.
