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Southwest's new legacy shouldn't strand shareholders

We know what's wrong with Air Canada, American Airlines and every other carrier that's toppled into bankruptcy in the past decade: They weren't more like Southwest Airlines, the legendary company whose low costs, happy employees and loyal customers have produced 39 consecutive years of profit.

So it may surprise you to learn Southwest is one of the very cheapest stocks in the S&P 500. Its forward price-to-earnings ratio hovers at around 10. Its enterprise value – net debt plus market capitalization – is 2.3 times its EBITDA (earnings before interest, taxes, depreciation and amortization); only two companies in the S&P 500 index are cheaper by that measure.

Where's the LUV?

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It seems investors fear that Southwest is becoming one of the legacy carriers it always won its business from. For years, Southwest built its business by operating one type of plane, which kept maintenance and training costs down, and concentrating on point-to-point leisure travel between second-tier airports with cheap landing fees. It eschewed complicated national and international networks that appealed to business travellers. (LUV, the airport code for Dallas's Love Field, the city's smaller airport and Southwest's home base, begat the company's ticker symbol.)

Last year's acquisition of AirTran Holdings Inc. marked a significant change for Southwest, though. The deal introduced a new type of aircraft to the company, negating some of Southwest's savings through simplicity.

It also gave Southwest entry into more expensive, more congested airports, particularly AirTran's home base of Atlanta-Hartsfield, the world's busiest. Now, Southwest is acquiring bigger planes with the idea of introducing service to Hawaii this year, with international flights possible in the future.

"We believe the AirTran purchase may signal the end to the Southwest to which most passengers are accustomed to flying," says Basili Alukos, who covers Southwest stock for Morningstar Equity Research. "While international flights are more profitable, we suspect the new Southwest will more closely resemble a legacy carrier than its traditional operating model, and we think its future returns will suffer as a result."

So Mr. Alukos has a "sell" rating slapped on Southwest? Not so fast. He estimates Southwest's "fair value" at $12 (U.S.), about 50 per cent above today's levels. He gives it four stars on Morningstar's five-star rating system, which doesn't use target prices or explicit recommendations.

Mr. Alukos says the AirTran acquisition makes sense in the context of rising fuel prices. For many years, Southwest hedged rising fuel costs better than any other large U.S. airline, saving $2-billion from 2004 to 2008 by his estimate, something that "overshadow[ed]any of its other cost-containment measures." Those contracts have gradually expired, and the current hedges are no longer a significant cost advantage, he believes.

"Since we expect expenses to rise, Southwest must increase its revenue by possibly raising fares," he says. And while leisure travellers are price-sensitive, the AirTran deal gives Southwest access to 37 new markets, the Atlanta hub, and an opportunity to bring aboard more business fliers.

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Mr. Alukos sees mid-single-digit revenue growth for Southwest in 2012, coupled with a successful integration of AirTran that could deliver as much as $700-million in synergies by 2015 (an upside case that would increase his fair value estimate by 85 per cent.)

He is not alone: James Parker of Raymond James sees Southwest's fleet modernization plan and AirTran synergies contributing heavily to his 2013 estimate of $1 in share earnings, more than double 2011's result. (He has an "outperform" rating and an $11 price target.)

Other analysts match Mr. Alukos' $12 target, and Michael Derchin of CRT Capital Group LLC uses a $17 figure because he believes Southwest will resume its growth path in 2013 with $1.50 in EPS and an enterprise value multiple that's more than double today's figures.

Will Southwest ever soar like that again? Possibly not. But for now, the shares have been grounded, and it will only take a small amount of liftoff for investors to profit.

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About the Author
Business and investing reporter and columnist

A business journalist since 1994, David Milstead began writing for The Globe and Mail in 2009. During eight years at the Rocky Mountain News in Denver, Colo., he individually or jointly won nine national awards from SABEW, the Society of American Business Editors and Writers. He has also worked at the Wall Street Journal. More

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