Overvalued Company of the Week – Southwest Airlines (LUV)

The overvalued company of the week is Southwest Airlines Co. (LUV), the discounted airline company that proved to out-run the larger airlines and beat them both price wise and in some consumers opinion’s service as well. We will analyze using Warren Buffett’s approach for the Business and Management Review as well use Benjamin Graham’s model of valuation of a company.

Business and Management Review

1) Is the business simple and understandable?

     Southwest is obviously in the airline industry, and this industry is an extremely volatile business that has several factors affecting profitability. Firstly, is the load factor, or the amount of seats filled on average, which presents industry specific problems we will not go into detail, but it can be said that is a complex portion of the business. Secondly, are the fixed costs associated with running an airline, including fuel, maintenance, and gate costs or fees. These issues create too much volatility and uncertainty, even though Southwest has proved to perform better than the pack over the years.

2) Does the business have a consistent operating history?

     Historically speaking, yes, Southwest has performed nicely over the past few years as they have proven to control their fixed costs, mainly fuel, effectively. The issues we see in the future are the rising labor costs that will begin to affect Southwest as it has other airlines. The increased union workers, and their benefit packages will drain the company of cash and but a crunch on earnings. Particularly, the increases this country is seeing in health costs and the continued uncertainty in fuel costs will all play into this equation.

3) Does the business have favorable long term prospects?

     Again, as stated prior for the same reasons, we feel that Southwest’s glorious run is going to be coming to an end. We still believe that Southwest will continue to be a powerful and profitable company, but just feel that currently their share price is overvalued for the reasons mentioned. The airline industry is in a sore position post- 9/11/01, and we feel that the industry as a whole will continue to suffer with the continued concern of global terrorism. Any airline based terrorism strike would invalidate the small recovery that Southwest has experienced.

4) Is management rational?

     We feel that management currently in place is the right group for the job. They have proven themselves in the past and have done a remarkable job in a very tough industry. The future, though, will be the testing ground as Southwest enters a more mature state of a company and begins to experience the same types of problems other airlines are currently.

5) Is management candid with its shareholders?

     Southwest has an outstanding investor relation page (investor) that really performs above and beyond that of other companies. The typical investor information is included, but what is really interesting is the addition of the ownership profile nicely available on the Southwest site itself. Further, the dividend information page is concise and easily obtained as well.

6) Does management resist the institutional imperative?

     It seems that Southwest does in fact operate in the interests of shareholders. Further, it seems to be that the company respects and invites community involvement. There seems to be no indication of not revisiting the institutional imperative.

Financial and Value Review

Upon review, we found Southwest to be moderately overpriced and unsuitable for either the defensive nor enterprising investor. Its current P/E ratio is 31.90 which is high, but not drastically, but we would like to see it lower before we would execute a buy recommendation.

We find an appropriate buy price to be $12/share.

Neither of us held a position in Southwest at time of publication. Please review our disclaimer, and our methods.


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