Taking a 'first look' at Southwest Airlines

I've made a lot of money over the years by "piggybacking on activism"...

This refers to buying stocks of companies in which an activist investor is pushing for change. They do the hard work and I get to ride their coattails for free – what a deal!

So when one of the largest and most successful activist investors – Elliott Investment Management – took a big stake in Southwest Airlines (LUV) two months ago, I decided to take a closer look at the airline.

I'm particularly intrigued because, as I discussed in yesterday's e-mail, I tripled my money on JetBlue Airways (JBLU) a decade ago thanks to a setup that has some parallels to Southwest today.

As I usually do, I'll break my analysis into two parts – covering Southwest's financial history today... And then tomorrow, I'll take a look at the story, why the stock is down, the valuation, and what the future might hold.

It's easy to see why an activist targeted Southwest, as the stock has merely doubled over the past 20 years, while the S&P 500 Index is up by five times. The stock had a huge run for five years from the beginning of 2013 through 2017... but since then, it has been on a long-term decline. You can see the moves in the chart below:

In particular, since the day the market bottomed during the COVID-19 crash on March 23, 2020, Southwest has underperformed not only the market but its major peers as well – Delta Air Lines (DAL), United Airlines (UAL), and American Airlines (AAL). In the chart below, you can see the stock's big underperformance:

This is possibly presenting investors with an opportunity to buy a good company on the cheap, with an excellent catalyst in place... So today, let's first take a closer look at the financials.

As always, I'll start with a two-decade chart of revenue and net income. Southwest has grown its revenues steadily, recovering nicely from the COVID-impacted years of 2020 and 2021, but profits have collapsed from the 2017 peak of about $3.4 billion to almost nothing – a mere $78 million over the past year. Take a look:

In case you're thinking that Southwest's decline in profitability over the past two-and-a-half years is due to lingering weakness from the pandemic, it's not... Here's the same chart for the past decade for Delta, which shows that its profits have rebounded to around prepandemic levels:

Southwest's cash-flow statement tells a similar story...

The company's operating cash flow is down sharply and, more alarmingly, capital expenditures ("capex") have soared... resulting in free cash flow ("FCF") turning sharply negative. And FCF over the recent 12-month period was even worse than it was in 2020! Take a look:

As a result, Southwest's cash (net of debt) has fallen sharply:

Meanwhile, Southwest's situation with dividends and share repurchases both raise warning flags for me. Here's what they look like on the chart:

On the dividend front, why is the company paying any dividend right now, when cash flow is so negative? It smells like Southwest is trying to prop up the stock... but even at today's depressed price, it's only yielding about 2.5% – so it's not even doing that.

And if we compare the share repurchases with the long-term stock chart, we can see that the company's heaviest buying was when the stock was hitting multiyear highs from 2016 through 2019 – exactly the opposite of what's best for investors.

As a result, despite spending $11.1 billion on share repurchases from 2011 to 2020 (nearly two-thirds of Southwest's current market cap of $17.4 billion), the share count only declined 21%. And then, even worse, the company had to issue stock at depressed prices to raise cash to survive the pandemic, increasing the share count by 5%.

You can see it on the chart of shares outstanding:

In summary, 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.

Is the situation salvageable? Does Elliott have the right plan to fix Southwest? And will it succeed in forcing the company to implement it? I'll address these questions tomorrow with the next part of my analysis, so stay tuned!

Best regards,

Whitney

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