Too High at JetBlue and Southwest?


By Amy Tsao The two premier names in low-cost flying, Southwest Airlines and JetBlue Airways (JBLU), are the future of the airline industry, many analysts say. Their recent stock-price gains reflect investors' belief in the carriers' ability to lure significant market share from larger "network" carriers, which can't match their point-to-point efficiency. Over the next several years, the upstart operators each plan to offer cheaper tickets while significantly expanding fleets and routes. Meanwhile, says JP Morgan analyst Jamie Baker, the traditional, hub-focused carriers are likely to "remain stable, if not shrink further, in the face of increasing competition." (JP Morgan is a market maker in JetBlue stock and has received fees from Southwest in the last 12 months.)

Unfortunately for investors, the stock of JetBlue (JBLU) and Southwest (LUV) -- both of which have remained profitable throughout the devastating downturn in air travel -- may each have reached a zenith. Shares in Dallas-based Southwest, the carrier with the industry's longest track record of rising revenues and profits, have risen 68%, to $18-and-change, over the past 12 months. JetBlue has witnessed an even more spectacular ascent, soaring nearly 250%, in the same period. Southwest's forward price-earnings ratio is 30.1, while JetBlue's is 38.7, based on 2004's consensus earnings estimate.

NOT CHEAP ENOUGH. Some profit-taking is already in the works, and lots of folks on the Street believe more selling is likely. While the low-cost airline business has certainly become more sophisticated, "They're not perfect, nor are they immune from basic principles of supply and demand," wrote Sam Buttrick, airline analyst at UBS Warburg in an Oct. 10 research report. He downgraded JetBlue to a reduce rating, figuring that the "margin growth required to justify lofty p-e ratios should become increasingly difficult for hypergrowth discounters." He also cut AirTran Holdings (AAI) to reduce. He already rated Southwest as such.

Others agree. Nicholas Owens, analyst at independent investments researcher Morningstar, says both stocks have gotten ahead of themselves. He pegs fair value for Southwest at $17, more than a dollar below the current price. As for JetBlue, it has become particularly expensive, and Owens puts its fair value at about $38 -- almost $30 below the closing price of $67.89 on Oct. 13.

"I certainly look at JetBlue as an interesting stock to watch, but it would have to be very cheap for me to buy it," he says. (Owens owns neither JetBlue nor Southwest.) Neither Owens nor Buttrick see JetBlue's plan for a 3-for-2 stock split, effective Nov. 20, doing anything to raise their fair-value estimates.

BIGGER FLEETS. Led by Southwest and JetBlue, the discount carriers -- including Frontier Airlines (FRNT), America West Holdings (AWA), and AirTran -- are expected to expand their fleets by more than a third, to a total of 1,030 aircraft, over the next several years, while traditional carriers plan to keep their domestic fleets static, at a total of around 2,500 planes, says JP Morgan's Baker. It may turn out the low-cost carriers are correct in betting that demand will grow with sufficient strength to justify adding so much more supply. But that wager on passenger trends is capital-intensive and, if the airlines are wrong, it could prove be a costly blunder.

Analysts expect JetBlue, based in Forest Hills, N.Y, to more than double its current fleet, which currently stands at 47 planes, with the addition of about 62 aircraft, starting this year and continuing through 2007. The airline, which has been public less than two years, has grown fast -- to $48.9 million in net income in 2002 on $635 million in sales, up from a $35.4 million loss in 2000 on $104.6 million in revenues. Wall Street forecasts JetBlue's earnings per share will rise to $1.73 in 2004, up 30% from $1.33 in 2003.

In the past two years, Southwest pulled back on fleet expansion, to about 5% annually. The future rate will be closer to its historical 10%, says Morgan Stanley analyst William Greene. (Morgan Stanley has received fees from both airlines in the last year and expects to receive more in the next three months.) He estimates that Southwest, which boasted $240.9 million in net profits on $5.3 billion in sales in 2002, will probably add more new planes than any other airline -- about 76 in the next two years. On average, Wall Street expects Southwest's earnings per share to rise to 62 cents in 2004, up from 38 cents in 2003.

"START TO STRAIN"? The rapid-expansion strategy could backfire, argues Buttrick, as the assumption that the major carriers will sit idle in the coming years may prove incorrect. He envisions the majors looking to increase flights on the most competitive routes. With the surge in capacity by low-cost carriers and some modest additions by the large carriers, Buttrick sees overall capacity in 2004 just 2% shy of peak levels seen in 2000.

Some, too, fret over JetBlue's relative youth and aggressive growth. "The superlatives are all there," says Mark Miller, president of aviation consultancy Miller Air Group, who notes that JetBlue is the fastest-growing airline in aviation history. He applauds that performance but worries that its goals may be too lofty. More risk-averse investors might remember that part of Southwest's spectacular success has been due to a disciplined and cautious approach to growth, adding about 10% capacity annually. "I wonder when [JetBlue's] model will start to strain," says Miller, who doesn't own airline stocks.

Of course, plenty of skeptics have already questioned JetBlue's phenomenal success. But so far, it's proving itself smartly run, with the means to achieve its growth goals. In an Oct. 8 note, debt-rating service Standard & Poor's said JetBlue's internally generated cash and equipment financings "would be sufficient to meet capital spending needs for the next several years."

Investors who are in this sector for the long term aren't likely to regret taking a stance in these upstart discount carriers. The wind is with both companies for the long term. But the large airlines have been through many a down cycle, and it's likely too early to view the industry's seasoned players as going down for the count. In the meantime, investors with their feet on the ground might want look long and hard at JetBlue's and Southwest's pricey valuations. Tsao covers financial markets for Business Week Online in New York


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