The airline industry isn't the first place an investor might think to go in search of a company that scores well on environmental, social, and governance issues. Many environmental advocates view global air travel's enormous carbon footprint as needlessly wasteful, and amid numerous bankruptcies and consumer protection failures among major airlines throughout the industry's history, employees and customers alike have often found their lives disrupted.

Yet within the industry, Southwest Airlines (NYSE:LUV) has long stood out from the crowd. The airline looks a lot different than it did back in the early 1970s, when Southwest took advantage of a gap in federal regulatory coverage to offer intrastate air travel between key cities within the state of Texas. Once airline deregulation became reality, Southwest began to broaden its scope, moving first to serve key U.S. markets outside Texas and then looking beyond the nation's borders. Currently, Southwest helps travelers visit more than 100 destinations in the U.S. along with 10 countries internationally. Key cities include Chicago, Baltimore, Las Vegas, Denver, and Southwest's home market in Dallas. Southwest now counts itself among the top airlines in the nation, and it’s No. 11 on Fortune’s list of the World’s Most Admired Companies in 2019.

A Southwest airplane.

Image Source: Southwest.

Southwest has embraced ESG principles throughout its history, even before most investors paid much attention to those concepts as being critically valuable to a company's long-term business prospects. The company's efforts to embrace its employee base date back to its origins. Southwest's more recent efforts to modernize its aircraft fleet to become more fuel-efficient have aimed at the joint goals of cutting costs and reducing environmental impact. Those types of initiatives are exactly what ESG investors like to see, because they show that investing with ESG principles in mind doesn't have to be inconsistent with traditional work to maximize profits.

The recent death of co-founder Herb Kelleher was a sad occasion for Southwest, as the airline's former CEO stood as an example for airline employees to give their best and always try to put passengers first. But the awareness of Kelleher's legacy at the airline has given current Southwest employees new inspiration to keep the spirit of what he helped to build alive and well for generations to come. Let's analyze Southwest using The Motley Fool's 10-question ESG framework.

1. Does Southwest Airlines treat its employees, customers, community, and other stakeholders well?

Yes. Southwest expresses its mission simply: putting people first. That includes not just its passengers and its workers but also the broader communities that the airline serves. Southwest's annual One Report sets out its sustainability objectives and lists some of its achievements, and although the company doesn't have a perfect record, it has done a good job of balancing the needs of its various stakeholders.

Southwest knows that its employees are the gateway to delivering high-quality customer service to its passengers, so it works hard to focus on workers' needs. Employees earned $544 million through Southwest's profit-sharing program in 2018 as partial compensation for serving a record 134 million passengers.

Yet money is only one element of Southwest's approach to working with its employees. The company's culture is designed to put a smile on everyone's face -- a necessary goal in the often-frustrating world of air travel. Southwest put on more than 4,000 "celebrations" in 2018, including "fun flights" and "gate games" to keep passengers amused. Although customers benefit from those efforts, the fun also creates a work environment that resonates well with workers.

Southwest's attention to its workers also pays off for the communities in which it operates. The company's Adopt-A-Pilot program has involved nearly 600,000 students since its inception in 1997, and employees volunteered nearly 190,000 hours to help the causes most important to them. That resulted in the donation of more than 3,400 tickets through the Tickets for Time program, which donates a round-trip ticket for every 40 hours of volunteer time that employees work with a qualifying organization. Southwest has also given travel assistance to medical patients in need, with payments totaling more than $27 million since 2007.

Employees have rewarded Southwest with a great reputation, and the airline was ranked No. 10 on Glassdoor's 2019 list of Best Places to Work and No. 2 on Forbes' 2019 list of America's Best Large Employers.

2. Is Southwest Airlines a good steward of the environment?

Yes. The airline industry is energy intensive and draws criticism from many environmental advocates. Yet Southwest has taken several steps to reduce its impact on the environment. The airline has improved its jet fuel efficiency by nearly 33% since 2005, and Southwest boasts seven straight years of improving its emissions intensity ratios. By spending more than $600 million in efforts to boost fuel efficiency since 2002, Southwest saved nearly 13 million gallons of fuel in 2018.

Beyond fuel, airlines have the potential to produce large amounts of waste. Yet Southwest has aimed to make improvements there too, looking for ways to recycle and reuse materials whenever possible. The airline recycled more than 3,750 tons of material in 2018, including 193 tons of electronic waste that's especially difficult to dispose of properly.

Southwest is also reaching out to communities to make a difference on environmental issues. The company boasts 60 environmental projects in 22 states, including partnering with the Student Conservation Association to plant thousands of trees, flowers, and shrubs. Its efforts have helped conserve 136,000 square feet of parks and public green spaces.

Going forward, Southwest has higher ambitions. It hopes to introduce more use of sustainable aviation fuel starting in 2020, and efforts to work with environmental partners on new opportunities should keep Southwest moving in the right direction.

Areas for improvement: Southwest could do more to find greener fuel alternatives, including biofuels, to further reduce its carbon footprint.

3. Does Southwest Airlines promote diversity and inclusion?

Yes. Southwest has built an inclusive environment on three pillars: team, value, and respect. The airline acknowledges that each of its 58,000 workers brings a unique perspective to work, and the company's culture relies on creating an environment in which every one of those workers feels valued and included.

Those efforts take shape in different ways. Southwest's diversity and inclusion team hosts monthly events called Power of Inclusion, which bring workers together to learn more about certain ideas. Highlights in 2018 included themes celebrating Black History, Asian American and Pacific Islander Heritage, and LGBTQ pride. That last point is consistent with Southwest's perfect 100 rating on LGBTQ equality on the Human Rights Campaign Corporate Equality Index. More broadly, individual workers at Southwest have opportunities to take their specific talents and put them to work in creative ways to help serve the common goal of treating customers better.

Areas for improvement: According to the company’s website, its board of directors has 11 members and 3 are women, giving the board a 27% gender diversity ratio. The company should aim to improve this balance by setting a goal of reaching a 50% gender diversity ratio.

4. Does Southwest Airlines have ethical corporate governance principles?

Yes. Southwest is committed to maintaining ethical business practices at the highest level. Its code of ethics stresses the need to comply with legal and regulatory requirements while acknowledging the value of honesty, integrity, and personal responsibility.

Specific ethical issues that Southwest calls out include:

  • Use of material nonpublic information for insider trading purposes is both unethical and illegal.
  • Healthy competition is essential, but unfair dealing practices are prohibited, and Southwest wants to avoid even the appearance of any impropriety.
  • Bribes and other payments to foreign officials are illegal.
  • Employees must respect confidential information, acknowledge and avoid conflicts of interest, and maintain accurate records for audit and regulatory purposes.

Southwest holds all of its team members accountable for reporting illegal or unethical behavior to a wide range of different leaders, department heads, and officers of the company.

5. Do Southwest Airlines' business model and investments promote ESG principles?

Yes. Southwest views many of its business accomplishments from the perspective of how they promote environmental, social, and governance principles. For instance, within the airline industry, the fact that Southwest has been profitable for 46 straight years is unusual, and it might seem like a win primarily for shareholders in the company. Yet through its profit-sharing program, Southwest shares its earnings with its employees, so the entire corporate community benefits from the work that employees do to maximize the airline's bottom line.

Southwest believes that it does a better job of operating its airline than its rivals do, so its expansion efforts directly serve the needs of its employees, passengers, and communities. For example, Southwest has dramatically expanded its network in recent years, serving more communities in Central America and the Caribbean. The airline just added service to Hawaii as well. Because of the structure of its network, more than three-quarters of its customers flew on nonstop flights, improving the service demanded by its passengers.

As controversial as Boeing's (NYSE:BA) 737 MAX aircraft has been, Southwest's investment in the new model sought to improve efficient operations further. Throughout its history, Southwest has focused almost exclusively on 737 models for its fleet, allowing it to concentrate its maintenance and training efforts on a single type of aircraft rather than having a wider range of aircraft for its various worker groups to master.

Operationally, Southwest has spent a lot on making sure its employees can do the best job possible. In 2018, the company opened an 800,000-square-foot facility that includes extensive training opportunities for pilots and other operational teams. Workers spent more than 2 million hours in training during the year to enhance their knowledge and serve passengers better.

6. Does Southwest Airlines have a healthy balance sheet?

Yes. Airlines are notorious for having extremely debt-laden balance sheets. That makes sense, given the capital-intensive nature of investing in costly aircraft expected to operate for decades into the future. In particular, with so many airlines spending heavily on updated aircraft, debt-to-equity ratios are soaring through the roof at many of Southwest's closest competitors.

Yet Southwest itself is in much better financial shape. The company boasted nearly $4 billion in cash and short-term investments as of June 2019. That's more than enough to cover the $1.84 billion in long-term debt and the $1.68 billion in outstanding long-term capital leases with money left over. With almost $10 billion in shareholder equity, Southwest has provided a financial model that most airlines can only aspire toward achieving over the long haul.

7. Can Southwest Airlines generate organic revenue growth supported by long-term tailwinds?

Yes. Southwest has worked hard lately to find new opportunities for organic sales growth. Although the airline has a history of working domestically to expand service gradually over long periods of time, the past several years have seen a huge shift in the direction of expansion toward international destinations. Now, Southwest passengers can fly to Belize, Costa Rica, Jamaica, Grand Cayman, Dominican Republic, Turks and Caicos, Aruba, Cuba, and several locations in Mexico. Given that the International Air Transport Association expects air travel demand worldwide to grow at a 3.5% average annual rate over the next 20 years and that much of that growth will come outside the U.S., Southwest’s move seems like a smart one.

Southwest also saw profit potential in breaking into the Hawaii air market, and it just started offering service in 2019 from the U.S. mainland to the island state. The airline is also giving passengers the ability to fly from island to island once they reach Hawaii, with flights out of Lihue on Kauai, Kahului on Maui, and Hilo and Kailua-Kona on the Big Island, in addition to Honolulu. Southwest hopes that by offering comprehensive service, it can capture more passenger traffic from the mainland and make the most of the growth available on the islands.

More broadly, Southwest's ESG mentality should be a key element of its future growth. For decades, the airline has relied on its corporate culture to help it stand apart from its peers. Even now, business practices like refusing to charge a standard baggage fee from the first bag make it far different from nearly all of its competitors. At a time when other major airlines are adopting far less passenger-friendly policies in their pursuit of profits, Southwest's no-frills approach has done a much better job of preserving the quality of service that has deteriorated so badly aboard some of its rivals' planes.

8. Can Southwest Airlines generate growing FCF and sustain high ROIC?

Yes. Even with the costly nature of the airline industry, Southwest has sustained gains in free cash flow and kept its returns on invested capital healthy. In the 12 months that ended in June 2019, Southwest posted FCF of $2.94 billion, roughly flat from 2018 levels but up dramatically from the $1.68 billion the airline saw in 2017. Total operating cash flow has tripled since 2011, showing the extent to which Southwest has fought to maintain its leadership position in the airline industry.

Southwest has kept investing in its future, but its returns from its investments remain healthy. In 2018, the company posted a 23.6% ROIC on a pretax basis, and that worked out to an 18.4% ROIC figure after tax. That's far better than the single-digit-percentage figures that prevailed throughout much of the 2000s and early 2010s, and it speaks to the work that Southwest has done to concentrate on its most promising investment opportunities in directing capital expenditures aimed at growth.

9. Is the management team at Southwest Airlines focused on driving long-term profitable growth?

Yes. It's hard to overstate the impact Kelleher had on Southwest Airlines before his death in early 2019. From its beginning in 1971, Southwest's mission was to make flying more affordable for everyday passengers, taking advantage of an intrastate exemption from air travel regulations to offer cheaper flights serving markets within Texas. Southwest never felt the need to offer the same frills that other airlines did, but it did prove to be prescient, as its rivals have largely stopped offering the additional services they once provided -- or at best have started to charge exorbitant fees to continue providing them.

Instead, Kelleher focused on the employee experience, ensuring that the brand ambassadors who passengers see on the front lines every day are delivering a positive message. As Doug Parker, CEO of American Airlines Group (NASDAQ:AAL), said after Kelleher's death: "If you take care of your people, they will take care of your customers, which will take care of your shareholders. That simple yet profound way of leading continues to inspire us, and we aspire to honor Herb's example."

At first glance, Kelleher's legacy might seem to be focused on reducing profit growth. After all, Southwest remains the only major carrier not charging a fee for those who want to change their reservations after purchase. It's also the most prominent airline not charging baggage fees on the first bag a passenger checks. Many have criticized Southwest for missing out on what for other airlines has been a gold mine from ancillary fee revenue.

Yet current CEO Gary Kelly has his vision squarely focused on continuing the work Kelleher started, which means not compromising on the mission that the airline has at its core. Even now, you won't find Southwest flights at some of the most popular online travel websites, because the airline wants to drive traffic to its own website. That costs it some business, but it also teaches passengers that they need to check Southwest.com in order to complete their research on the cheapest way to travel.

Specifically, Southwest encourages efficient operation and has allocated capital toward investments to boost efficiency. Kelly and his team are committed to the honest and transparent manner in which Kelleher began operating Southwest half a century ago. Most importantly, Southwest employees value the company that they've built, and they know that their work is essential in order to preserve its competitive advantages and continue to stand out from the airline crowd.

10. Does Southwest Airlines have a medium- or lower-risk profile?

Yes. Southwest has done a good job of avoiding the risks listed in The Motley Fool's ESG Framework. Healthy levels of debt and solid financials mark its recent experience, and leadership has been resolute in its approach toward running the company. Although the airline does have exposure to fuel prices and cyclical ups and downs in the economy, there are extremely high barriers to entry for rival airlines to challenge what Southwest has created.

If anything, long-term trends favor the company. Despite recent trade hiccups, globalization remains a powerful force around the world, and rising demand for travel should keep Southwest growing. Southwest's customer service is unparalleled, and its corporate culture is attractive to workers looking to the airline industry for employment. Kelly's success in taking over as CEO points to the strength of the succession plan that Kelleher and Southwest put in place.

The biggest threat to Southwest recently has come from calls for greater regulation of the airline industry. High-profile accidents involving the 737 MAX aircraft have raised questions about whether aircraft manufacturers have proper oversight, and changes could have implications not just for Boeing but also for the carriers that use its aircraft most extensively. Yet even with the 737 MAX's woes, few have suggested that Southwest itself faces any reputational risk just because it has traditionally concentrated its aircraft purchases on the 737 model line.

Moreover, even the 737 MAX issue is one on which Southwest has shown its true colors. The company said that it's working with Boeing on a settlement that will compensate the airline for the damages it's suffered as a result of the grounding of the aircraft, and it intends to share part of whatever Boeing pays Southwest with its own employees. As Kelly noted, "I recognize this hasn't just affected some of you; it has affected all of you."

The ESG case for Southwest

Southwest has made an effort toward achieving nearly all of the goals that an investor who follows environment, social, and governance issues wants to see. Some might reasonably disagree about whether the airline really deserves an unqualified "yes" answer to some of the questions above. For instance, it wouldn't be completely unreasonable for an ESG investor to rule out investing in the airline industry entirely because of the huge carbon footprint that air travel involves by its very nature.

We'd suggest a couple of areas for improvement. First, gender diversity could be improved, with just 3 out of 11 directors and barely a quarter of its 62 senior management committee members being women. Getting those proportions up to somewhere between one-third and one-half would be a good goal.

Second, one of the biggest expenses an airline has is fuel, and there's room for Southwest to invest more in finding eco-friendlier alternatives to conventional jet fuel. We're optimistic about its plans for 2020 to purchase 3 million gallons of sustainable fuel, and it'll be interesting to see how those purchases scale up in future years.

No company is perfect when it comes to ESG issues. But at least when you look within the airline group, it's hard to find an industry player that makes a better ESG case than Southwest Airlines. With its business success, its constant efforts to improve, and its unmatched corporate culture, Southwest has put itself in position to thrive for years to come.