Five Reasons Why Southwest Airlines is a Value Play, Not a Value Trap

Foolish investors should land industry leader stocks in their portfolio. Southwest Airlines (LUV 2.60%), alone in the sector, is the only domestic air carrier to be profitable every year since 1971. With the airline industry currently out of favor with investors, Southwest Airlines is very attractive as a long-term investment, due to its being undervalued. Here are five reasons why Southwest is an appealing buy.

Positive earnings and sales trends
The earnings-per-share (EPS) and sales growth trends for Southwest are very bullish. Buying AirTran has increased the earnings in the most recent quarter at a higher rate than for the year and the previous five years. Increasing EPS  and sales are reassuring indicators that a stock is not a value trap. It is also a very positive trend that the EPS growth rate is rising for others in the airline industry, too.

Source: Motley Fool CAPS and Finviz; *most recent quarter versus one year ago

Strong cash position
There is no substitute for cash for a company, and Southwest has a very strong cash position with a very modest debt load. Its capital structure is much sounder than its rivals and the industry average. There have been over 200 airline bankruptcies since deregulation in 1978. Southwest has more than enough cash to meet its obligations, and to avoid having to file for bankruptcy --  as has every legacy carrier in the United States.

Source: Motley Fool CAPS

Compelling valuations
Benjamin Graham, founder of the value school of investing and the inspiration for Warren Buffett, would probably have loved Southwest. The price-to-book ratio for its assets, and the price-to-earnings ratio, are very attractive compared to other carriers and the industry average. In addition, it's trading at a low valuation for its sales. That allows for Foolish investors to buy shares of Southwest when it's trading at a deep discount to its earnings, asset value, and sales, as its results have not been strong for the year.

Source: Motley Fool CAPS

Superior customer service
Numbers are great, but the company that satisfies the customer the most will prevail, particularly in the travel group. Southwest was ranked tops in customer service last year by The International Business Awards. Consumer Reports honored it as being best for customer service in May 2011, too. Traditionally, Southwest Airlines does very well in customer satisfaction surveys.

Billions in potential revenue
In a recent interview in Barron's, two mutual fund managers for T. Rowe Price were bullish on Southwest, due to its potential for generating more fee income. Spirit Airlines (SAVE) and other airlines earned $36.1 billion in this "ancillary revenue" last year by charging passengers for baggage, pillows, choice seats, etc. With reduced capacity in the airline industry, Southwest will have the pricing power to start charging more fees, like Spirit and the others. Recently, it initiated the seventh round of ticket increases for 2012, revealing confidence in its ability to raise prices and not lose customers. Southwest has been moving toward joining Spirit Airlines and others with recent moves, such as charging for early check-in, changes to the Rapid Rewards program that make it less lucrative for shorter flights at a lower cost, and other similar measures.

Dividend income takes the total return even higher.
Southwest Airlines is also one of the few airlines to pay a dividend. While the dividend yield is only 0.46%, the payout ratio is low, at just 4%. That leaves plenty of cash flow to increase the dividend in the future. Southwest recently raised its dividend in May. The income feature reinforces the leadership role of Southwest Airlines in the air carrier group.

Due to high fuel costs and low economic growth, share prices for air carriers have fallen. When a sector is out of favor like that, it's best to go with the leader, when shopping for bargains. For Foolish investors, Southwest Airlines is a stock to fly away with for a long-term journey to higher gains.