Southwest Airlines has recently been caught up in a software debacle that canceled thousands of flights during the holiday season. The stock price has been quite beat up even before the bad press, with the stock peaking around $64 in 2021, then sliding down to a low of $30 during the worst of the market downturn in 2022. Since I like finding stocks that have been beat up from bad news, I decided to do a quick earnings power valuation of Southwest.
Looking at Southwest’s top line from 2019-2022 shows figures of $22.4B, $9B, $15.8B, and 23.8B respectively. Obviously revenue was impacted during 2020 due to Covid, and still did not fully recover in 2021. Removing these outlier years, we can estimate Southwest’s go forward revenue at $23B.
Southwest’s operating margins vary, especially during outlier years 2020 and 2021. A reasonable estimate of operating margins seems to be 15%. Applying this margin to the estimated revenue produces an approximate operating earnings of $3.45B.
The income tax rate the LUV pays also varies quite a bit. For this analysis I will use a 25% tax rate. This tax rate turns our operating earnings into $2.6B of after tax earnings.
Next, I capitalize the estimated after tax earnings to produce an enterprise value. First I look at Southwest’s historical P/E ratio, which ranges between 10-16, with a few outlier years. While Southwest is known to be a quality airline, the airline industry is not known for having the qualities of a high quality business. Therefore I think Southwest should have a discount rate a tad higher than quality large cap companies. For my analysis I will use a 7% discount rate, which produces a $37B enterprise value.
In order to convert the enterprise value into an equity valuation, the long term debt is subtracted from the EV, and the cash balance is added back. LUV has about $9.5B in debt, and about $10.5B in cash. This produces an estimated fair value market capitalization of $38B.
Dividing the fair value market cap by the 593M shares outstanding, we arrive at a fair value stock price of $64. As I mentioned earlier, Southwest currently trades for around $37. This appears to be quite the discount to fair value. Just for some context, LUV traded above $60 a share pre-pandemic and for a brief time in 2021.
It appears the recent scandal has made Southwest’s shares look pretty attractive. One problem with this valuation is that it is potentially based on cyclical peak earnings. If a recession happens in 2023, Southwest’s revenue may take a beating. However, travel seems to be on a secular uptrend, so perhaps LUV would bounce back quickly. Either way, I think the company is worth doing a deeper dive on.