Air travel is grinding to a halt in the U.S. and many other countries due to the growing COVID-19 pandemic. U.S. airlines have been sounding the alarm this month, warning investors and employees that revenue is plunging toward zero, which will lead to a period of deep losses and rapid cash burn.
As a result, airline stocks have been crushed over the past month, with the Arca Airline Index plummeting 64% over that period. Low-fare airline giant Southwest Airlines (NYSE:LUV) has fared better than most of its peers, with shares falling 47% in the past month.
However, while Southwest Airlines stock hasn't been marked down as much as most other airline stocks, it still looks like a great opportunity for investors to profit from the recent sell-off. Southwest's industry-leading balance sheet, low costs, and strong track record for generating free cash flow should enable it to survive the current crisis and potentially gain market share in the aftermath.
A rock-solid balance sheet
Southwest Airlines has long stood out within the industry for having the strongest balance sheet of any major airline. As of the end of 2019, the company had $4.1 billion of cash and short-term investments, offset by $4 billion of debt and lease liabilities. As a result, it has solid investment-grade credit ratings from all three major ratings agencies.
The COVID-19 pandemic will certainly put stress on Southwest's balance sheet, but the airline has the financial strength to weather the storm. During March, the company has drawn down the $1 billion available through its revolving credit facility and arranged an additional short-term $1 billion term loan. Thanks to this additional financing, Southwest Airlines had a massive cash stockpile of $6.2 billion as of earlier this week.
Even $6.2 billion of cash may not be enough to see Southwest through this crisis, depending on how much pressure it faces on working capital, how long the pandemic lasts, and how quickly booking activity recovers once the rate of new cases slows down. Fortunately, Southwest Airlines also owns more than 500 unencumbered aircraft, worth approximately $10 billion. Some of those planes could be sold or used as collateral for additional borrowings if necessary, giving management plenty of levers to pay the bills.
Evaluating the likely losses
With new information arriving daily, it's impossible to know exactly how much money airlines will lose due to the COVID-19 pandemic. That said, the number is likely to be quite small compared to the nearly $14 billion that has been knocked off of Southwest's market cap over the past month.
Back on March 5, Southwest Airlines slashed its first-quarter unit revenue outlook by 5 percentage points at the midpoint of the guidance range, with about 2 percentage points of that reduction likely to be offset by lower unit costs. Even with this guidance cut, Southwest's updated forecast still implied solidly positive net income in Q1.
Last week, Southwest acknowledged that booking trends had deteriorated dramatically since early March. It said that load factor averaged 67% in the first half of the month -- 85% is more typical -- and had fallen toward 50% by mid-March. As a result, the company pulled its previous guidance. Still, with two solid months in the books to start the period, Southwest Airlines isn't likely to lose much money this quarter.
By contrast, demand is likely to be severely depressed throughout the second quarter. In the same period a year ago, Southwest's operating expenses totaled $4.94 billion. Earlier this week, Southwest Airlines said it would cut at least 20% of its capacity from April 14 through June 5 to compensate for plunging demand. Based on recent reports, it appears to have accelerated the cuts to begin this weekend and deepened them to a schedule reduction of approximately 25%.
Between these capacity cuts, a more than 50% plunge in fuel prices, and discretionary expense reductions, Southwest can probably slash its quarterly spending to under $4 billion -- even without unpalatable mass furloughs. Even if revenue plunges to $1 billion next quarter, down more than 80% year over year, that would still imply a quarterly operating loss of less than $3 billion.
While it's impossible to be certain, losses are likely to slow significantly in the second half of the year. Hopefully the pandemic will be starting to recede a few months from now -- and if there's still no end in sight, Southwest's management would be more likely to take drastic steps to cut costs, like grounding most or all of the fleet and furloughing large numbers of workers.
While the short-term outlook for Southwest Airlines is very poor due to COVID-19, looking further out, the pandemic could lead to new opportunities. Southwest's competitors have much weaker balance sheets (dramatically so, in some cases), which means they are likely to exit 2020 with bloated debt loads. Meanwhile, demand isn't likely to bounce back to 2019 levels immediately. Some people may hesitate to travel until the pandemic is definitively stamped out, while businesses that have been hit hard may slash corporate travel to save money.
As a result, weaker airlines will have to devote all of their effort to maximizing near-term free cash flow in order to pay down debt. That could force them to shrink by pulling out of underperforming markets, opening up long-term growth opportunities for Southwest.
For example, American Airlines hasn't closed any hubs since its late-2013 merger with US Airways. But with an industry-worst balance sheet and weak profitability in recent years, management may need to make tough decisions going forward, such as potentially closing the airline's undersized hub in Phoenix. That would pave the way for Southwest (already the No. 2 carrier there) to dominate the market.
An excellent turnaround bet
There are no sure things in investing, and that's doubly true when it comes to investing in airline stocks. However, with Southwest Airlines stock trading at a bargain valuation of just seven times last year's earnings -- and its profitability was depressed in 2019 due to the 737 MAX grounding -- the popular low-cost carrier looks like an intriguing opportunity for patient investors.
It seems extremely likely at this point that Southwest's streak of 47 consecutive years of profitability will be broken in 2020. Nevertheless, the company's losses should be very manageable in the context of its rock-solid balance sheet.
Looking beyond 2020, Southwest's financial strength relative to its peers could enable it to recover faster and gain market share as the rest of the industry retrenches. The company has an excellent track record for cash flow, including generating over $3 billion of free cash flow last year, which bodes well for its ability to quickly pay down debt and rebuild its cash stockpile in 2021 and beyond. As a result, Southwest Airlines is worth a look for long-term investors after the airline stock sell-off of the past month.