Air travel in the U.S. continues to plummet to negligible levels, as coronavirus has forced people to cancel all non-emergency travel. As a result, airlines' revenue has plunged to near zero. For some airlines, refund claims could be higher than new ticket sales in the short term, putting even greater pressure on cash flow.
In this kind of environment, cash is king. That's why Southwest Airlines (NYSE:LUV) has been one of my top picks for investors looking to capitalize on the sharp drop in airline shares since mid-February. For many years, Southwest has had the best balance sheet in the industry by far -- as well as a big pool of unencumbered aircraft that can be used as collateral for new borrowings if necessary.
Over the past few weeks, Southwest Airlines has been showing off its financial muscle by building up an incredible cash hoard. As a result, there is little risk that it will face severe financial distress even if travel demand remains extremely low for most of 2020.
Demand has disappeared
As recently as early March, Southwest Airlines expected to earn a profit in the first quarter, despite the impact of COVID-19. In fact, before Southwest halted all share repurchases in mid-March, the company had spent $585 million on stock buybacks since the beginning of 2020, indicating management's confidence at the time.
However, over the past several weeks, it became obvious that air travel demand was drying up. Indeed, the TSA screened just 124,021 travelers on Thursday, down nearly 95% year over year. Airlines are responding by cutting capacity rapidly. For its part, Southwest Airlines began canceling about a quarter of its daily scheduled flights on March 22. A few days later, it expanded the close-in flight cancellations to nearly 40% of its schedule.
By early May, Southwest will be operating barely more than half of its previously planned schedule. Still, these cuts don't come close to matching the extent of the decline in demand. Moreover, due to their substantial fixed costs, there's no way for airlines to avoid big losses when travel demand is virtually nonexistent.
Southwest scrambles for cash
In light of this grim outlook, Southwest Airlines has been fortifying its balance sheet. The company entered 2020 with $4.1 billion of cash and short-term investments. On March 12, it arranged a new $1 billion, 364-day term loan. A few days later, it drew the full $1 billion available on its revolving credit facility. These moves gave it an unrestricted cash balance of $6.2 billion.
While some of Southwest's larger peers have even bigger cash balances, Southwest's $6.2 billion cash stockpile (as of March 16) was easily the biggest of any airline relative to its expenses. Last year, Southwest's operating expenses totaled $4.94 billion in the second quarter, with most of that going to payroll ($2.1 billion, including profit sharing) and fuel ($1.1 billion).
Fuel prices have fallen dramatically this year (although oil prices recovered a bit this week), Southwest won't have any profit sharing expense in 2020, and various volume-related expenses -- e.g. fuel, landing fees, selling expenses, and maintenance costs -- will decline due to the carrier's flight cuts. Additionally, Southwest is likely to receive payroll protection grants that cover most of its labor costs for the next six months (part of the $2 trillion stimulus bill). As a result, its actual quarterly cash costs net of payroll grants should be well below $2 billion for the next two quarters.
This would make it seem like $6.2 billion was a more-than-adequate cash balance, even if Southwest were forced to refund a significant proportion of the more than $2 billion in advance ticket sales it is holding -- which it is trying to avoid doing.
Nevertheless, Southwest Airlines bolstered its cash reserves even further last week. On Monday, the airline amended its 364-day term loan to increase it by approximately $2.33 billion. (There's also an option to borrow another $417 million, subject to the lenders' agreement.) Even after factoring in cash burn for the second half of March, Southwest Airlines likely exited the first quarter with close to $8 billion of cash.
Worth a look for risk-tolerant investors
Despite its industry-leading balance sheet, Southwest Airlines stock has lost nearly half of its value since hitting a 52-week high of $58.83 in mid-February. That has knocked nearly $15 billion off of its market cap. True, other airline stocks have fallen further, but those airlines are far more likely to run into serious trouble if travel demand takes a long time to recover, due to their weaker balance sheets.
It's difficult to envision a scenario where Southwest Airlines would risk running out of cash. It's also hard to imagine the company actually losing as much as $15 billion from the COVID-19 crisis. In a worst-case scenario, it could shut down most of its operations this fall and temporarily furlough most of its staff. That would probably cut quarterly cash burn to under $1 billion.
Looking ahead, Southwest's low cost structure and its financial strength relative to competitors will give it a leg up as demand returns. With weaker rivals forced to focus on maximizing short-term cash flow due to what will likely be crushing debt loads, Southwest Airlines will have opportunities to gain market share.
Of course, this doesn't make Southwest Airlines a safe investment. Any airline stock carries plenty of risk right now. However, for long-term investors who can afford to assume some risk, Southwest Airlines stock looks like a bargain at its marked-down price.