A deeper dive into Southwest Airlines

Regular readers will recall that I'm not impressed with Southwest Airlines' (LUV) historical financial performance...

In Wednesday's e-mail, I broke down the company's financial history. As I concluded:

Southwest is clearly struggling.

The company is spending billions of dollars a year to grow its top line, but profits and cash flows are going in the opposite direction. It's little wonder that the stock has fallen to levels first seen 10 years ago.

However, this kind of setup doesn't deter me – in fact, it makes my bargain-loving heart beat faster!

As I discussed in last Tuesday's e-mail, Southwest today reminds me of one of my most successful investments ever – when I bought the beaten-down shares of JetBlue Airways (JBLU) in 2014 and tripled my money in less than two years.

Today, I'll review what changes that activist investor Elliott Investment Management has proposed to fix Southwest, whether they make sense, and what Elliott's chances are of "persuading" the company to implement them.

Elliott has set up a website entitled "Stronger Southwest," featuring this 51-page presentation posted on June 10. After introducing itself and the work it has done for Southwest, Elliott gave this overview of the airline in the presentation:

Elliott then argues that Southwest has gone from an "innovative leader" to being "outdated":

Elliott continues the presentation by calling for change in eight areas:

Much of the presentation lays out Southwest's terrible performance, but Elliott also offers long-suffering shareholders hope by noting that the "challenges are addressable":

But the problem, according to Elliott, is that management refuses to change and adopt obvious changes that its peers have embraced:

Therefore, Elliott argues that Southwest's "worst in class" management needs to be replaced, starting with CEO Bob Jordan and Executive Chairman Gary Kelly:

Under new leadership, Elliott believes Southwest's stock has 67% to 87% upside – here's the slide in the presentation:

Following up on its June 10 presentation, Elliott released this harshly worded 10-page letter last Monday, reiterating its critique and highlighting its proposed slate of 10 new board members. It concludes:

Southwest is a storied American company that deserves to have the best stewards that its Board can possibly provide. It is also a public company, accountable to its owners. It is not an absolute monarchy. Southwest does not belong to Mr. Jordan and Mr. Kelly, but rather to its shareholders, a designation that importantly includes many of the Company's employees.

We are seeking to engage with Southwest to create a better future for the Company, not for a fight. Fighting is a distraction from the business of creating value for shareholders, and our track record reflects that we much prefer working collaboratively with companies to drive value-enhancing change over engaging in proxy fights. If we end up having to nominate directors to the Board of Southwest and take this contest all the way to a special meeting, then it will be the first time we have had to conduct such a contest in the United States in more than seven years.

And as the letter continues:

However, when we encounter corporate executives who believe that the companies they run are their personal fiefdoms and that they are entitled to run them – and to be paid handsomely to run them – unchallenged for as long as they want, no matter what results they deliver, then we are more than happy to provide a voice for those whose interests are being poorly served.

As Southwest has already announced, we are meeting with the Company's representatives on September 9, and we look forward to hearing their views on the topics we have raised in this letter. In the interim, we expect the Company will try to distract shareholders with its own unilateral half-measures and divert from real engagement with shareholders. If so, so be it. Nevertheless, we are hopeful that we will find individuals on the Board willing to look past the personal interests of Mr. Jordan and Mr. Kelly in favor of what is best for Southwest and its many other constituents.

But in the absence of these leaders rising to the occasion, we are convinced the next step will be for you, Southwest's owners, to have a direct say in your Company's future.

For more background, the Wall Street Journal has published a number of articles about the company recently:

• Elliott Takes Big Stake in Southwest Airlines (June 10)
• Can Southwest Airlines Find Its Way Again? (June 13)
• Meet the Southwest Superfans Who Don't Want the Airline to Change (June 19)
• Southwest Airlines Is Ditching Open Seating on Flights (July 25)
• Southwest Airlines Faces Federal Scrutiny After Spate of Near Accidents (July 23)
• Elliott Investment Critiques Southwest Leadership, Overdue Changes (August 26)
• Budget Airlines Want to Go Premium. That's Easier Said Than Done (August 30)

And here are two comments from my readers:

• "Until the partial management turnover two years ago, Southwest was basically being run [by] bean counters and financial engineers rather than operations people. They bought back stock instead of making the needed investments in technology which ultimately led to the meltdown in 2021. It may take a while to fix all of that." – Robert H.
• "I've always been an aviation buff and have been an A-list frequent flier on Southwest for 20 years. But this is the last year – their pricing is no longer compelling. And they are changing their 'cattle call' no-reserved-seat policy which worked in my favor all these years. (This may be coincident with this activist influence.) They always ran a great schedule with good customer service. Over the past five years or so, they seem to have developed a case of attitude that reminded me of Pan Am and TWA before they failed. So much for airline deregulation success stories." – Rick J.

I know that's a lot to digest, so let me try to summarize my thoughts...

First, keep in mind that this is a terrible industry. As Jonathan Ornstein – the CEO of Mesa Air (MESA) told me back in 2003: "You can't own airline stocks. You can only rent them."

That said, I think Elliott is right that there is no reason, other than poor management that refuses to change, why Southwest – the largest domestic airline by number of passengers – should be underperforming its peers so badly.

As was the case with JetBlue in 2014, there are a handful of quick, obvious steps that the company can take to quickly improve profitability: assigned seating, creating a Basic Economy class, premium products (like rows with extra legroom), and fees for checked bags. Plus there are other longer-term improvements as well – such as upgrading the company's computer systems that Elliott outlines.

So I think Elliott's prediction that Southwest's stock has 67% to 87% upside is, if anything, conservative.

Lastly, I think Elliott is going to win this fight because: a) the firm is very good at this... b) it's correct with its criticisms... and c) Southwest's stock has done so poorly that few shareholders will support the current board and management.

So I think this is an excellent stock idea for a one-to-two-year holding period (but not longer) – though keep in mind that if a recession hits, all airline stocks are likely to get whacked... so appropriate position sizing is important.

As always with other stock ideas I discuss here in my free daily e-mails, my team and I here at Stansberry Research will be doing more work on Southwest and keeping an eye on the stock. If we decide it looks compelling enough for an official recommendation in our flagship Stansberry's Investment Advisory newsletter, our subscribers will be the first to know.

And if you aren't already a subscriber, you can find out how to become one – and gain access to the entire portfolio of existing open recommendations – as part of a special presentation right here.

Best regards,

Whitney

P.S. I welcome your feedback – send me an e-mail by clicking here.