Southwest Airlines

Trading at $18.50 as of May 7, 2001

Happy Mother's Day, Mom!

Dang it, this company has already shot up more than 10% since it was first brought to my attention as an appealing possibility by my friend Dale Wettlaufer, the former TMF Ralegh. Rats. That doesn't mean it's necessarily too late to buy, though -- it depends on your expectations and risk tolerance. You might at least add Southwest Airlines(NYSE: LUV) to your watch list, in case the stock price ever slumps. Or consider dollar-cost averaging into the stock, regularly investing small amounts of money.

Let me properly introduce this fascinating company. Southwest is not your typical airline. For starters, there are no seat assignments. Passengers choose their own seats, based on when they arrive at the gate. There are no airplane meals, either, and fares are kept very low. The company only buys and flies one kind of plane -- Boeing 737s. Thus, employees only have to master servicing, maintaining, flying, and serving aboard one kind of aircraft.

Southwest is also a company with a sense of fun. Fly Southwest and you'll be treated to silly jokes over the in-cabin PA system. ("If you're traveling with an infant, small child, or another person who needs a little extra help, make sure you put your mask on first, then assist your husband.")

The company notes on its website that "[In 2000,] Southwest received 216,000 resumes and hired 5,134 new employees." The fact that Southwest hires only 2% of those who apply is kind of amazing. It's arguably tougher to get onto the Southwest payroll than to get into Harvard! (There are more interesting details on the company's website.) CEO Herb Kelleher has said that he puts employees first, because if you have happy employees, that will lead to happy customers. Employees enjoy participating in the industry's first profit-sharing plan and own a full eighth of the company.

Southwest's CFO Gary Kelly explained another powerful part of the Southwest dynamic: "The impact we have on a city is enormous. What happens when we reduce fares and add flights is that traffic levels explode by two, or three, or four times. That is our business. To go in and create a market that did not exist before because the fares were too high."

Here are some thoughts from former Fool Dale Wettlaufer: "One thing I find really interesting is that Southwest is in only 56-57 markets and only needs to add one or two markets a year to grow to its plan of 8%-12% top-line growth. Some 75% of its growth comes from adding frequency of flights in markets where it already operates and then adding new city pairs from markets where it already operates. The other nice thing about it is that it generates cash from working capital as it grows. Most growth companies have to invest in working capital (the main parts of which are receivables, inventory, accounts payable, and accrued expenses) as sales increase, whereas Southwest's working capital management actually increases net cash from operations 15%-20% per year. And with its point-to-point flight operations, it needs fewer planes to generate the same dollar of revenue other airlines do."

Southwest flies its 352 airplanes between some 57 cities, with more than 2,700 flights a day. It employs more than 30,000 people. On its website, the company states that "Southwest has grown to become the fourth largest U.S. airline (in terms of domestic customers carried). Year-end results for 2000 marked Southwest Airlines' 28th consecutive year of profitability. Southwest was the only major carrier in 1990, 1991, and 1992 to make both net and operating profits."

Clearly, the company has got some smart and profitable practices in place. In 2000, Southwest's revenues of $5.6 billion were up a full 19% over 1999. Operating earnings advanced a whopping 31% in that period, and earnings per share rose 33%. Yowza.

One of Southwest's many innovative practices is the way it protects itself (by "hedging") against rising fuel prices. In many such situations, a company might simply buy futures contracts on the commodity in question, locking in certain prices early. There aren't futures contracts sold on jet fuel, though, so Southwest buys contracts on heating oil, the price of which tends to move in tandem with jet fuel. In his annual letter to shareholders, Kelleher noted that Southwest has already covered 80% of its estimated 2001 fuel expenses by hedging, locking in an average price of $22 per barrel of crude oil, when the price at the time of his writing was $32.

Here are some numbers for Southwest:

    
      
        
          
            1996  1997  1998   1999  2000

Operating rev. ($ bil.)  3.4    3.8   4.2   4.7   5.6
Net income ($ mil.)      351    524   684   782  1,021
Net margin               6.1%   8.3  10.4  10.0  11.1
Passenger load factor*  66.5%  63.7  66.1   69   70.5
Return on assets         5.9%   8.0   9.7   9.2  10.1
Return on equity        13.5%  17.4  19.7  18.1  19.9
Return on invested cap. 11.8%  15.6  16.9  15.5  16.6

*This measures the percentage of seats filled with paying passengers.
        
      
    
  

So is everything about Southwest rosy? Not quite. As with any company, there are always risks. For starters, co-founder and visionary leader Kelleher will soon be less involved in the firm's operations. Perhaps more important, though, is the simple fact that Southwest is an airline. The airline industry has historically been a poor performer for shareholders, for many good reasons. Let's review some:

• Airlines usually have to fly each flight, even if a flight is only half full. The emptier a flight is, the less revenue it generates.
• Price wars: If one airline cuts fares on certain routes, others tend to follow suit, resulting in reduced profitability.
• The price of fuel frequently puts pressure on profitability.
• Weather is a big factor. A stormy season can decrease the number of people flying and the number of flights able to take off and land.

Another consideration is the age of Southwest's fleet. The average age of its planes is currently just 8.2 years, which is fairly young for the industry. Southwest probably spends less on maintenance and repairs than its competitors. Still, this is a fleeting fleet advantage. The planes will continue to age. At some point, they'll become more costly.

Despite these concerns, I think this company has the wherewithal to pull off sustained growth for quite a while. Of course, that's just my opinion. (Analysts expect the company to grow at about 15% annually over the next five years.) Before I close, let me toss in a few more opinions from some Fools on the Southwest discussion board. Read what folks such as RaggMopp, harfang, PhxBrad, and EDDIEGU have to say.

Have a great day, Mom!

Selena Maranjian is smarter than a speeding bullet and faster than a tall building. To see her complete stock holdings, view her profile. The Motley Fool is Fools writing for Fools. Here's our disclosure policy.

Next: FTD.com »