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Thursday, January 30, 2014 - 08:30
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Thursday, January 30, 2014 - 08:30

This Industry's Dividend Leader Is Set To Jump 25%

Thursday, January 30, 2014 8:30 AM

Although flying is one of the most attractive ways to travel, the airline industry has been one of the worst investments over the past decade.

Yet thanks to consolidation, the industry is getting more rational. With fewer airlines competing for customer dollars, the number of available seats should fall more in line with demand. This will allow the current operators the ability to maintain strong pricing and avoid having to drop prices to fill seats.

Given this newfound rationality, combined with a stabilizing of fuel prices and a potential rebounding of the economy, the airline industry could be a great investment over the next few years. The other beauty of the industry is the strong barriers to entry. Airports have a limited number of takeoff and landing slots, and the major airlines enjoy long-term leases on airport gates that help shut out the competition.

Southwest Airlines (NYSE: LUV) is one of the best picks in the industry given its stronghold on the short-haul market and renewed focus for returning capital to shareholders. The fact that it tailors to the short-haul market helps it keep fuel costs down and enjoy the lowest cost structure of the major airlines.

The fourth-largest U.S. airline, Southwest owns about 15% of the U.S. market in terms of revenue passenger miles. Southwest's key selling point is low-fare short-haul flights. Even during the economic downturn, Southwest remained profitable. Fiscal 2012 marked the 40th consecutive year of profitability for the company.

Flickr/StuSeeger
Southwest plans to boost revenue by tightening the flexibility of its special fares and revising its existing fee structure. The company will also implement a new revenue management system based on origin and destination.

Some of the company-specific initiatives that should help drive revenue growth for Southwest include a restructuring of its fleet. Last year, Southwest took delivery of 20 new aircraft, and that has kept the average fleet age at about 11.4 years.

For the fourth quarter, Southwest posted earnings of $0.33 a share, which beat expectations by $0.04. Revenue rose 5.5% year over year and beat expectations by $40 million. The carrier saw its revenue per available seat-mile increase by 6.1% -- which is doubly impressive, considering Southwest has been offering longer flights to attract more customers. Southwest also did a great job of managing its fuel costs, which came in 9.2% lower than last year.

Southwest's 2011 acquisition of low-cost carrier AirTran Airways is already contributing to earnings, with $120 million in cost savings during the third quarter. Southwest boosted its capacity by nearly 20% with the acquisition, which also gave it a boost in Atlanta, a heavily traveled business market.

Southwest is also turning to the international markets for growth. This includes gaining a presence in Mexico and other Latin American markets before 2015. Helping facilitate this move is Southwest's building of a new facility in Houston's Hobby Airport. The other big news after the airline's strong fourth-quarter results was its announcement of its first international routes, which will be to Aruba and the Jamaican city of Montego Bay.

Southwest is also focused on organic growth. The company plans to boost revenue by tightening the flexibility of its special fares and revising its existing fee structure. Southwest will also implement a new revenue management system based on origin and destination. Using the new network optimization system, the company will dispatch aircraft with better timing and additional capacity. This is expected to lift annual revenue roughly 17%, to $175 million.

Southwest also has a strong balance sheet, which should drive further share buybacks. At the end of the third quarter, Southwest boasted over $3.3 billion in cash, and its debt-to-equity ratio of 42% is well below its major peers.

The other major low-cost airlines have yet to offer their shareholders a dividend. Southwest is the first. Of the big four airlines, Delta Air Lines (NYSE: DAL) is the only other carrier to pay a dividend besides Southwest. Southwest's forward dividend yield is a modest 1.1%, but that amounts to a less than 15% payout of earnings.

Risks to Consider: There is no shortage of competition in the airline industry. With airline consolidation, the larger airlines now control more routes and have more planes in the air. A price war could have a negative effect on Southwest's revenues and profits. Furthermore, any miscalculation in fuel costs could have a serious impact on Southwest's bottom line.

Action to Take --> Buy Southwest with a $27 price target and 25% upside. Southwest's forward price-to-earnings (P/E) ratio is 16.5, which compares favorably with the industry average of 21. Applying a P/E ratio of 21 to expected 2014 earnings $1.28 a share suggests LUV could be trading close to $27 in just over a year.

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Marshall Hargrave does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.