Southwest's Lean, Mean Flying Machine


By David Shook These days, giants like United Airlines (UAL) and Northwest Airlines (NWAC) have market values of $2 billion each -- one-sixth the value of online auctioneer eBay (EBAY). Campbell Soup Co. (CPB) has almost three times the market value of Delta Air Lines (DAL). If you add up the value of all major airlines, their combined worth of just over $37 billion doesn't even come close to the $70 billion market cap of biotech giant Amgen (AMGN). "It's ridiculous the way airlines are valued," says Goldman Sachs analyst Glenn Engel. "They're much better businesses than what you see in the market."

For air carriers, the picture is grim. Little relief is in sight from sky-high fuel costs, labor unrest, increasing airport congestion, and charges of predatory pricing. One exception stands out: Southwest Airlines (LUV), the creation of legendary CEO Herb Kelleher. According to analysts and industry watchers, it's the airline that still deserves to be called a growth stock.

SMALL IS BEAUTIFUL. Southwest has managed to steer clear of nearly all the woes that afflict its competitors. Over the past few years, the Dallas-based carrier has done a much better job of protecting itself against high fuel costs and labor disputes than industry rivals. It has avoided being associated with airport gridlock in the minds of travelers because, in many regions, it flies in and out of smaller, less congested airports, such as Providence, R.I. And it has learned to take advantage of the Internet by selling 31% of tickets online -- a higher percentage than any other airline.

As a result, at a current price of around $30 a share, the company has a pretty healthy valuation. With a market cap of nearly $15 billion, it trades at about 20 times earnings -- relatively high by industry standards. All the same, analysts are sanguine. "The Southwest business model continues to thrive," says Michael Linenberg of Merrill Lynch. "Low cost, low fare, high growth, and very profitable."

Robert Milmore of Arnhold & S. Bleichroeder says management made a brilliant move by hedging fuel costs in 2000, before oil prices soared to as much as $35 a barrel. "Southwest has hedged 80% of its 2001 fuel costs at roughly $22 a barrel," says Merrill Lynch's Michael Linenberg. The current market price is roughly $30 a barrel. That's a big part of why Southwest is on track to earn $1.47 a share this year, which is 25% above last year's earnings, according to First Call estimates. That would be in line with its 25%-a-year earnings growth the past several years, vs. an average 11% for the industry.

"HERO" MATERIAL. While Continential and Northwest are up in arms about the request by United and American Airlines (AMR) to divide the assets of U.S. Airways (U), and about American's plans to acquire the assets of bankrupt TWA, Southwest remains unruffled.

Instead, it appears to be ignoring the consolidation wave while staying on course by serving smaller regional airports where congestion has not reached epidemic proportions. "Southwest could emerge as the hero," says Philip Baggaley, bond-rating analyst for Standard & Poor's. The company, he adds, "is well positioned -- either for an economic downturn or a round of consolidation."

On Jan. 22, Southwest announced it would cease flights to and from the major hub at San Francisco International Airport on Mar. 5. In line with the smaller-market strategy, it plans to relocate most of its Northern California service to Oakland, San Jose, and Sacramento. That looks like a smart move, analysts say, and the credit goes to Kelleher, who has piloted the airline's rise to profitability. "Southwest has a superdeep management team, but it's really Herb: He is Southwest, and he has obviously surrounded himself with good people," says analyst Milmore.

The sort of "good people," for example, who are on top of labor negotiations. Southwest is hedged against a big uptick in labor costs, the single biggest expense for the industry in 2001. Its only ongoing negotiations are with fleet employees, and that contract is close to being signed. The next negotiations are with mechanics toward yearend. And its pay ranges, on average, are near the top for the industry.

NO TURBULENCE. The same can't be said for its rivals. Following the hefty pay hikes United's pilots received in 2000, the other carriers are in catch-up mode. Delta is negotiating with its pilots, United and Northwest are bargaining with mechanics, and American is pursuing a pact with flight attendants. Houston-based Continental (CAL) may be the only other carrier reporting strong profits while enjoying little exposure to labor unrest. "Most carriers have little or no fuel hedges, and selective carriers are battling labor or operational problems," notes Ray Neidl of ING Barings.

To be sure, if energy prices take an unexpected dive in 2001, the industry would benefit -- and investors would likely flow into other airline stocks. At the same time, if the new Bush Administration gets serious about dealing with air-traffic congestion, optimism about the sector could blossom. But Southwest would also benefit from those two events.

If Southwest has any uncertainty weighing down its stock, it may be whether 68-year-old CEO Kelleher, who swears he isn't ready to retire, will name a successor anytime soon. While he stays in Southwest's cockpit, the carrier is likely to remain an exception among airline stocks. Shook covers financial markets for BW Online in New York


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