Southwest Airlines (NYSE: LUV)

Executive Summary

Investment Thesis and Recommendation

We recommend Southwest Airlines (LUV) as a buy and hold asset due to strong industry
outlook with the economic recovery and low fuel costs driving consumer demand and lowering
costs. Southwest’s low-cost business model and increasing share in the international market
gives it a competitive advantage that makes the company more profitable and will allow it to
gain a larger market share quicker than its competitors. LUV has a high expected growth rate
and current stock is trading at discount based on our analysis. Southwest has seen improving
financial performance such as ROE in the past three years due to its sources of value and
strong corporate governance. Southwest’s low cost business model offers attractive fare prices
to consumers with little to no additional fees allowing the company to capture market share in
the domestic airline industry as customers seek lower prices. Southwest also flies a single
aircraft type- the Boeing 737. This helps lowers its
personal training, spare part maintenance, and costs. This low cost operating model translates
into a significant competitive advantage for Southwest. Low costs allow the airline to offer lower
fares, attracting passengers from competitors. Such an operating model allows the carrier to
maintain these low fares, which have been instrumental in growing its market share over the
past several years. LUV stock offers little downside risk mainly limited to volatile oil prices,
technological substitutes for travel, and security shocks.

• Base - $44.61 Bull - $56.42, Bear - $40.81

• Hold Duration: 1.5 - 2 years

Part 1) Financial Analysis and Corporate Governance

1. Corporate Governance

Southwest Airlines, as a major player in the public airlines market, has strict rules
overlaying its corporate governance policies as an insurance to investors. Southwest has
established a nominating and corporate governance committee with the sole goal of evaluating
new members, existing member’s level of commitment, and the assurance of good business
practices. The Nominating and Corporate Governance Committee will take into consideration
the nature and time involved in a Director’s service on other boards in evaluating the suitability
of that Director. Directors should advise the chairman of the board and of the nomination
committee before even accepting an invitation to serve the board, proving as a testing period to
validate the validity and quality of input given. A non-employee board member must not sit on
more than six public company boards, nor will any employee member be allowed to sit on more
than three public company boards. Further rules state that, “members of the Audit Committee
should not serve on the Audit Committee of more than three public boards of directors. The
board also states that no board member may serve if greater than 75 years old. The board has
established a compensation committee which reviews the executive compensation and reserves

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the right to make significant adjustments as they see fit to promote and reward productivity in
the company. The Board believes that, in order to align the interests of Directors and
Shareholders, Directors should have a financial stake in the Company and that by the end of the
second year should beneficially own 1,000 share of Southwest stock. The board also reserves
the right to have access any member of management.

See Appendix 1 for breakdown of major shareholders.

We believe that Southwest Airlines has adequate corporate governance procedures in

place in order to maximize shareholder value. The board of directors and top management have
incentive based compensation structures in place that aligns their personal interests with those
of the individual shareholders. The board of directors also have extensive checks and balances
to assure that the individual board members are acting according to their listed guidelines as
well as procedures in place to oversee management. The process to join the board is extensive
and requires commitment even before being asked to join, which proves loyalty to the goals of
the company from an early stage. The establishment of the nomination and compensation are
further steps taken by the board to ensure the good business practices of the firm are executed.
If I had to add anything, the addition of a poison pill may be a good strategy to prevent hostile
takeovers. They could include a “flip in” that allows shareholders to buy more shares at a
discount or a “flip over” that allows stockholders to buy the acquirer’s shares at a discounted
price after the merger. Both strategies of a poison pill will make its stock less attractive to an
potential buyer and the acquisition more expensive.

2. Financial Statement Analysis

a. Common size balance sheet - appendix
b. Ratios especially ROE decomposition - appendix
c. Peer group and key financial ratios:

Sticking to what it knows, Southwest has expanded its low-cost, no-frills, no-reserved-
seats approach to air travel throughout the US to serve nearly 90 destinations across North
America. Now as the largest carrier of US domestic passengers, Southwest still stands as an
inspiration for new scrappy upstarts all over the world over. The most relevant peer firms
comparable to Southwest Airlines would be; Delta Air Lines, JetBlue Airways, Spirit Airlines,
American Airlines,Virgin America, and United Continental Holdings. Jetblue, Spirit Airlines, and
Virgin America would be particularly relevant as they are fellow low cost providers of airfare in
the United States and directly compete for the same customers. These other listed airlines also
compete with Southwest, each slightly different in terms of price and quality. The market
remains saturated with many options for consumers to buy so Southwest will have to continue
to be a cost leader to remain profitable.

See appendix 2, Part C for peer group ratios.

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 d. Assessment of financial performance by analysis
i. Overtime Trend:
Southwest Airline’s financial performance is evaluated by looking at the firm’s return on
equity, (ROE). Southwest has strong financial performance shown by a calculated ROE of
29.7% in 2015. ROE has also increased at an average growth rate of 69.8% from 10.32% in
2013. The DuPont identity allows us to decompose the determinants of ROE to analyze what
has been driving the increase in performance. The main driver of increased ROE has been
Southwest’s profit margin. The net margin in 2015 was 11.02% as compared to 4.28% in 2013.
This reflects that Southwest has an effective pricing strategy and the ability to control operating
costs. However, profit margin cannot be analyzed without also looking at the Asset Turnover
ratio. The asset turnover ratio has remained steady at 0.9 for the past three years because
assets have been increasing at almost exactly the same rate as sales. The combination of
increased profit margins and steady asset turnover has led to an increase in ROA from 4.13% in
2013 to 10.61% in 2015. Lastly, the equity multiplier has remained steady with a slight increase
from 2.6 in 2013 to 2.9 in 2015.
In addition to ROE decomposition, we analyzed the coverage and liquidity ratios.
Looking at liquidity, both the quick and current ratios have declined a slight amount of the past
three years. In 2015, the quick and current ratios were 0.48 and 0.54, respectively. Ratios
below 1 are disadvantageous and mean that the company may have a difficult time fulfilling its
short-term obligations. However, Southwest is in a capital intensive industry with alternative
methods of raising capital. In addition, most of the firm’s short term liabilities are categorized as
“other liabilities.” Further analysis is needed to determine the nature of these liabilities.
Coverage ratios are exceptionally well for the firm. While we still have to compare to
competitors, Southwest has strong ability to fulfill their debt obligations with a DCR of 37.9 in
2015, improved from 16.7 in 2013. Total outstanding debt is also only about 72% of of yearly
EBITDA according to our computed credit statistics.
In conclusion, Southwest Airlines has shown strong financial performance in the past 3
years and has strengthened its position in terms of ROE, ROA, and debt coverage. Liquidity
remains weak but is made up for in other areas of financial performance and may be
characteristic of the industry pending our analysis of competitors.

ii. Relative to peers

Relative to its peers, Southwest Airlines (LUV-US) is traded at roughly similar stock
prices and was most recently valued by the market at $44.61. Delta is at $41.67, United
Continental is at $45.81, and Spirit is traded at $43.93. The next important ratios to look at is the
Net Margin, Southwest has a slightly lower margin at 11.09% compared to its competitors with a
mean of 14.30%. This can be explained by analyzing Southwest’s business model of low cost-
high turnover.

Return on equity (ROE) is the next important ratio to compare to Southwest’s Peers. As
stated above, Southwest’s ROE was 29.7% in 2015 compared to the industry mean of 61.51%.
A much higher ROE is not always a good thing because a company could borrow more, hence

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leveraging itself up more which makes the company a much riskier asset. When looking at the
financial leverage of Southwest, their debt to equity comes in at 0.44 while the industry median
is 0.65 meaning Southwest is slightly less leveraged up. American Airlines stands out with this
ratio when compared to the rest of the industry coming in at 4.62.

In conclusion, Southwest has constantly come in at an on-average or better level when

comparing financial ratios to their peers. With these ratios in mind, and our calculated price from
the DCF in part 2 we have Southwest as a buy. We also like Southwest’s business models
when comparing them to its peers. The standardized practices of this company allows for
simplification and has lead them to successfully become the largest carrier of US domestic
travelers.

e. Potential Pitfalls
One of the largest potential pitfalls facing Southwest Airlines and the travel
industry in general is the increased frequency of terrorist attack in the last year combined with
political unrest that is the driver of these attacks. Recent terrorist attacks in Paris, Belgium,
Turkey, and California among others have already been estimated to have cost the travel
industry billions of dollars. Southwest is partly shielded from this effect because most of their
target destinations are within the United States with a few destinations in Central America.
Accidents can also have a similar effect on reducing consumers confidence in the airline.
Southwest has been fortunate with a very safe history with minor incidents. The last significant
incident was when a passenger sustained injury during a landing in December 2015.
Another potential pitfall for Southwest is Union negotiations. Talks with the union have
been ongoing for three years. DEpending on the outcome of the negotiations this could have
significant impact on Southwest’s profit margins due to increased costs. Another factor that
could limit Southwest’s profit margins are antitrust violations. Certain states including
Connecticut are concerned about the state of competition in the airline industry and are
conducting antitrust investigations.

Part 2) Firm Valuation

2.1 - See the attached DCF Valuation Excel File

Major Assumption:
Steady Growth

Findings:
SouthWest trading at a Discount
Calculated Stock Price - $56.42
2.2

A. Appendix C

B. i.Appendix C

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ii. Southwest Airlines Co. has higher ratios than the industry medians. The company’s high P/E
and P/B ratios show that they are expected to have high growth as investors are willing to pay
significantly more for the company than its actual book value and its current earnings value.

Southwest Airlines’ EV/Sales is only slightly larger than the industry median when compared to
other ratios. This shows what it costs to buy the company’s sales and using EV instead of
market cap is more accurate because it includes debt held by the company. The high EV/Sales
shows that investors believe the company’s sales to increase.

Because P/E does not take into account the balance sheet, we can use EV/EBIT to get a more
accurate representation of a company’s earnings yield. Their large EV/EBIT shows that per dollar of
EBIT, Southwest Airlines is valued much higher than the industry median.

Southwest’s larger EV/EBITDA indicates that the company would be hard to be taken over by
an outsider as the company would find it difficult to pay for their purchase with yearly earnings.

The market values Southwest Airlines higher than its industry peers and has expectations for
strong growth as it beats the median value in all of the above ratios. The company is well
established in its industry, and with its size and strong financials, would be very difficult to be
taken over.

iii. The financial analysis conducted in part 1 can justify the belief that the company has
expectations for future growth and why the market values the company greater than its book
value. Southwest Airlines’ ROE of 29.7% shows that company management is using investor
capital very effectively and there is high potential growth. In addition, the average increase in
ROE of 69.8% per year since 2013 shows shareholders are getting more for their money.
However, ROE does not let investors know if a company is taking on debt and raising funds
through borrowing. By looking at coverage ratios to determine if Southwest Airlines has been
taking more debt than they can handle, their DCR of 37.9 shows they can easily pay off their
debts. Southwest Airlines’ high market expectations and valuations are validated in a financial
analysis of the company, focusing on their strong ROE and debt coverage.

IV. Since 2011, Southwest Airlines has made many strategic moves and investments that have
fueled their growth and market success. Southwest has had 43 consecutive years of profitability
making them highly regarded by investors. The company consistently exceeds industry average
ratios likely due to their strong operational performance and reliability. Southwest has steadily
reduced costs while increasing their capacity. The acquisition of AirTran in 2011 was a key
investment towards their growth, improving their capacity by 43 percent. Over the last several
years they have also expanded their share in the international markets and gained valuable
gate positioning in LaGuardia. Since 2010, Shareholder value has increased more than 3 fold,
dividends per share have increased more than 16 fold, and $4.3 billion has been returned to
Shareholders in dividends and share repurchases. Southwest’s performance was further
enhanced by significantly lower jet fuel costs. Operating revenues grew while operating

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expenses fell due to a 29.1 percent drop in jet fuel costs per gallon. Southwest’s 2015 net
income was a record $2.2 billion surpassing the record set the year before. Additionally, the
increased utilization Boeing 737-800s, has helped lower fuel burn, lower maintenance, and adds
more seats per departure. Ultimately, the investments Southwest have made, such as the
acquisition of Air Trans, explains their high financial ratios, specifically EV/EBITA, because they
have efficiently used investor equity to create value from their operations.

C. The airline industry faces many challenges which has had historically volatile economic
performance. It is extremely, energy intensive, labor intensive, capital intensive, technology
intensive, highly regulated, heavily taxed, and extremely competitive. As of late, the airline
industry is experiencing increased profitability and growth. The U.S. airline industry, including
Southwest, has increased capacity through slimline seat retrofits and the use of larger aircraft.
The industry has fundamentally changed through mergers and restructuring which ultimately
improved the industry’s financial shape. Many companies have changed the way they compete
focusing on long-term profitability rather than short-term gains in market share. There is an
increased attention to making capacity, schedule planning, and capital investments towards
sustainable long-term profitability, and return on invested capital. The industry has largely
benefited from less competitors and strong passenger demand. Most recently, the airline
industry has seen a significant reduction in input costs due to the decline of oil prices. Several
years of positive performance has allowed many companies to use cash for debt pay downs,
dividends and stock buybacks, further improving the industry’s financial health. Airline stocks
have sharply outperformed the market in both 2013 and 2014, but are not considered
overvalued due to the large profit growth that the industry has seen.

Appendix

1.

Major Holders Breakdown

% of Shares Held by Institutional and Mutual 78%
Fund Owner

Number of Institutional Holding Shares 755

Major Direct Holders- Top Individual Owners

Holder Shares Reported

KELLY GARY 538,831 Feb. 21, 2016

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VAN DE VEN MICHAEL G 201,538 Feb. 21, 2016

RICKS RON 201,210 Feb. 21, 2016

LAMB JEFF 166,248 Feb. 26, 2016

JORDAN ROBERT 135,713 Feb. 21, 2016

Major Institutional Holders

Holder Shares % Value Report
Out ed

Primecap Management Company 74,088,35 11. 3,190,244,769 Dec 31,

8 60 2015

FMR, LLC 49,581,95 7.7 2,134,999,204 Dec 31,

9 6 2015

Vanguard Group, Inc. (The) 37,795,59 5.9 1,627,478,143 Dec 31,

0 2 2015

Major Mutual Fund Holders

Holder Shares % Out Value Reported

Vanguard/Primecap Fund 34,210,300 5.36 1,473,095,552 Dec 31, 2015

Fidelity Contrafund Inc 15,447,805 2.42 581,146,408 Jan 31, 2016
Vanguard Total Stock Market Index Fund 11,929,317 1.87 513,676,401 Dec 31, 2015

Common Size Balance Sheet

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Common Size Income Statement

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b.
Ratios

ROE Decomposition
ROE=Profitibility*Asset Turnover*Leverage
ROE=(Net Income/Sales)*(Sales/Total Assets)*(Total Assets/Avg Shareholder Equity)

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 C

2.2a

P/E P/B EV/Sales EV/EBITDA EV/EBIT

Industry Median
10.83 3.34 1.24 5.24 6.45
Value

2.2b

P/E P/B EV/Sales EV/EBITDA EV/EBIT

Southwest Airlines Co. 13.63 4.04 1.44 6.19 7.98

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