Is Southwest Airlines a Value in the Sky?

The words value investing and airline generally do not go together. Indeed, the king of value investors, Warren Buffett, has become one of the industry’s harshest critics and biggest detractors.

“Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down,” Buffett wrote in his 2007 letter to Berkshire Hathaway (NYSE: BRK.B) investors. “The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit.”

Despite Uncle Warren’s cynicism, there is one air carrier in the United States that displays some of the attributes of a value investment. It is the well-loved discount operator Southwest Airlines (NYSE: LUV). The financial numbers indicate that Southwest seems to be the exception to the no airlines rule in the world of value investment.

An Exception to the Rule

Southwest reported some very impressive financial numbers for the second quarter of 2015 on June 30. To me, these numbers give an impression of a value investment; they include:

• A TTM revenue of $18.95 billion.
• A quarterly year to year revenue growth rate of 2%.
• A diluted earnings per share of 2.317.
• A net income of $1.58 billion.
• A quarterly profit margin of 11.9%.
• A forward dividend yield of .79%.
• A dividend yield of .67%.
• A payout ratio of 10.95%.
• A free cash flow of $199 million.
• A return on equity of 22.08%.

Surprisingly, this looks like a very good stock. Southwest also looks like a company that makes money. Nor was it the only airline that displayed such characteristics. We see something similar at another iconic American carrier: Delta Air Lines (NYSE: DAL).

Delta also reported some very impressive financial numbers on June 30, 2015. These numbers included:

• A TTM revenue of $40.92 billion.
• A revenue growth rate of .81%.
• A diluted earnings per share figure of 2.286.
• A net income of $1.876 billion.
• A profit margin of 13.87%.
• A forward dividend yield of 1.17%.
• A dividend yield of .78%.
• A payout ratio of 15.83%.
• A free cash flow of $1.826 billion.
• A return on equity of 18.07%.

These are also very good numbers that indicate a potential value. So what is going on here? Have airlines—or at least U.S. airlines—become a value investment?

The Value Case for Airlines (at least in the USA)

There is a sort of value case that can be made for North American airlines right now. It goes like this: Airlines have a sort of monopoly on intercity passenger travel in the United States and Canada, and it is growing.

If you want to travel between North American cities in a reasonable timeframe, you have to fly. Outside the Northeast Corridor in the United States, train travel is a joke, and bus service is largely nonexistent. Heavily congested highways, lack of road maintenance, and rising levels of truck traffic make long-distance driving an increasingly unpleasant experience.

Unless Congress gets serious about highway construction and high speed rail (which is unlikely given today’s political climate) or Elon Musk’s Hyperloop gets built, those conditions are not going to change anytime soon. Airlines’ share of the travel market is likely to increase as their customer base grows.

At the same time, falling fuel prices are likely to lead to higher profits. Airlines might be on track to enjoy a transportation monopoly similar to what railroads currently enjoy.

Congestion Threatens Airlines’ Future

There are, of course, a few clouds in the friendly skies, including airport congestion. Southwest is already having problems departing on time at Chicago’s Midway Airport, The Chicago Business Journal reported. Only around 37.9% of Southwest flights left Midway on time in July.

That situation is likely to get worse because no major airport has been built in North America since Denver International (DIA) opened in 1995. The existing airport infrastructure in the United States is not capable of supporting all the flights in the air.

Airport congestion is both a problem and an opportunity because it could lead to higher ticket prices and greater revenues at carriers. It could also lead to more regulation and government scrutiny of the industry and public demands for transportation alternatives, such as rail.

Technology to the Rescue

New advances in autopilot technology could greatly reduce costs and increase capacity in the airline industry, making it even more of a potential value investment.

Modern airliners are little more than drones that could be operated by just one pilot or even a remote controller on the ground, Duke University and MIT researcher and former military pilot Missy Cummings told Motherboard. Cummings surveyed flight crews and discovered that during the average flight on a Boeing airliner, pilots only spend seven minutes actually flying the plane.

She also discovered that a flight crew spends just three minutes flying a modern Airbus airliner. Given those findings, Cummings believes that modern airliners could be safely flown by one pilot backed up by autopilot and remote control from the ground. That would greatly reduce personnel costs because the average commercial pilot in the United States draws a salary of $98,410 a year, according to the Bureau of Labor Statistics.

NASA estimated that air traffic density could be increased by 20% by employing more autonomous airliners, The New York Times reported. That could mean more flights in the air and more potential revenue for airlines.

The technology to heavily automate the airline industry already exists, Cummings noted. She pointed out that some current generation Airbus airliners are so heavily automated that they can be flown by remote control.

Airlines as Widows and Orphans Stocks

It looks as if industry trends and technological development favors the value case for airlines. If present trends continue, these companies could become widows and orphans stocks that are relatively risk free money makers that even widows and orphans can safely invest in. One has to wonder what Uncle Warren would think of that.