Southwest Airlines (NYSE:LUV) has been struggling for multiple years to recover from the difficulties it encountered during the COVID-19 pandemic. In order to regain the levels of profitability it once enjoyed, Southwest is now undertaking a large strategic overhaul.
Is LUV stock an undervalued stock to buy on hopes of future business improvements, or does Southwest still look too risky to add to a portfolio today?
High Multiple But High LUV Expectations
Owing in part to weakening EPS over the last several years, LUV is currently priced at a rather high multiple of 49.3 times its trailing 12-month earnings.
The stock’s price multiples to sales and book value, however, are far more reasonable at 0.7 and 2.3, respectively. LUV’s current share price of $32.52 is also almost exactly in line with the analyst consensus price target of $32.51.
It’s worth noting, however, that this high earnings multiple reflects expectations of several years of strong double-digit EPS growth ahead. LUV’s current 5-year price-to-earnings-growth ratio is just 0.1, roughly half the industry average. While promising, this also means that LUV’s current valuation is based to a large degree on optimistic growth rates that could set the stock up for further difficulties if they fail to materialize or fall short of investor expectations.
Good News on Checked Bags From Southwest Airlines
One of the major concerns about Southwest Airlines recently has been the ending of its free checked bags, a popular feature that set it apart from other airlines for many years. Q2’s earnings report, however, revealed that the introduction of checked bag fees didn’t result in any significant operational problems and delivered more up-front financial benefit than management had initially expected.
In addition to successfully implementing a fee for checked bags, Southwest also made some other significant changes during Q2. Among these were the introduction of a basic economy fare and the modification of over 200 of its aircraft for enhanced legroom.
Southwest is gradually improving its fuel efficiency by incorporating a larger number of Boeing 737-8 aircraft into its mix, a move that is helping to keep fuel costs under control. In Q2, management reported a 2.9 percent improvement in fuel efficiency compared to what Southwest achieved in the year-ago quarter.
On the other end of its strategic turnaround plan, Southwest is focusing more heavily on long-haul flights and high-end airport lounges. Cumulatively, the changes Southwest is making are aimed at allowing the business to compete more effectively with its higher-margin peers. Historically, the airline has differentiated itself as a cost-effective budget travel option. Its new direction, however, appears to be a significant break with that longstanding brand identity.
Operating Revenues Down at LUV
Despite better-than-expected reception of bag check fees from its customers, Southwest still had a difficult second quarter in terms of both revenues and earnings.
Operating revenues came in at $7.2 billion, down about 1.5 percent from the year-ago quarter. The real problem, though, was in Southwest’s earnings of $0.39 per share. This result was far below both the $0.58 per share the business earned in Q2 of last year and the $0.51 per share analysts were expecting from it this year. The result, unsurprisingly, was a fairly pronounced selloff in the wake of the Q2 report.
On the brighter side, Southwest paid off $1.6 billion in convertible notes last quarter, a move that strengthened its balance sheet. As of the end of the quarter, Southwest was sitting on about $3.8 billion in cash, cash equivalents and short-term investments.
Southwest’s Buybacks and Dividend
Another factor that could be positive for investors is the fact that Southwest is returning cash to its shareholders with hefty share buybacks and dividend payouts. In Q2 alone, the business allocated a total of $1.6 billion to these two efforts, and management authorized an additional $2.0 billion for buybacks over the next two years.
With a dividend of 2.2 percent, LUV shares yield quite a bit more than the current S&P 500 average. This dividend, in conjunction with ongoing buybacks, could help to smooth out some of the stock’s volatility for investors.
Even so, LUV’s dividend still trails behind the kind of high dividends that can often be found from large consumer brands, energy businesses and other high-yield staples.
The Inherent Risks of Investing in Airlines
While there are some positive trends in Southwest Airlines at the moment, it’s important to keep in mind that airlines have historically been quite risky investments. The combination of very high fixed costs, heavy exposure to energy prices and the cyclical nature of consumer travel spending makes airline businesses quite volatile. Even Warren Buffett, known for his uncanny ability to spot value in businesses, has struggled to invest successfully in airlines over the years.
Is LUV an Undervalued Buy?
While Southwest has put together what could be an effective turnaround strategy, the results aren’t yet in to show that the business can catch up to its competition while effectively navigating the complexities of a brand overhaul. Until the business can start to deliver positive earnings and revenue growth as a result of its strategic overhaul, the stock could be a risky proposition.
It’s also worth noting that Southwest’s recent changes haven’t been without pushback from consumers, even if the ending of free checked bags proved to be financially favorable.
Next year, the business is planning to end another of its signature brand features, namely its open seating policy. With two of the airline’s most popular policies ending in short order, there’s still no guarantee that Southwest won’t see an erosion of brand loyalty from longtime customers.
On the whole, LUV shares are likely trading at a relatively fair value at the moment. The risks associated with the business and its industry as a whole, however, could still make the risk-reward ratio on Southwest Airlines unappealing for some value investors. As such, LUV may be a decent stock to hold for the time being, but it may not be cheap enough to buy.
The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.