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A Valuation Perspective on Southwest Airlines

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Southwest Airlines trades at considerable discount to S&P 500

In the previous part of this series, we saw that hedge funds with significant exposure to Southwest Airlines (LUV) primarily increased their stakes in 2Q15. This part will focus on valuation metrics and the possible motivation behind hedge funds increasing their position in LUV.

Airlines like Delta Air Lines (DAL), JetBlue Airways (JBLU), Alaska Air Group (ALK), Southwest Airlines (LUV), and United Continental Holdings (UAL) are cyclical stocks. Demand for air travel is heavily linked to the state of domestic and global economies. Profitability of airline companies also tends to be influenced to a large extent by fuel costs, as fuel is their major cost component. Their revenues and earnings tend to fluctuate depending on these two variables.

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DAL is the largest airline company in the United States in terms of market capitalization of $37.4 billion. It comes in ahead of American Airlines (AAL) and Southwest Airlines (LUV). Over the last three years, Southwest has been able to grow both its revenues and earnings meaningfully, facilitated by the low fuel price environment and prudent capacity management.

DAL has outperformed the market in recent years, gaining 63.90% on a compounded annual growth rate basis for the last three years compared to the SPDR S&P 500 ETF (SPY), which has gained 12.40%.

As you can see in the above graph, LUV trades at a PE (price-to-earnings) multiple of 13.1x. That’s in line with its peer average but is at an approximate discount of 36.2% compared to the S&P 500 multiple.

Looking back historically, LUV has, for the most part, traded at a premium to its peers and the S&P 500 over the last five-year period. However, given its below-industry average debt-to-equity leverage of 0.3x and its long track record for being financially stable, it’s an interesting pick among airline operators.

Assessing the timing of hedge funds with significant stakes in LUV

As we saw earlier, PAR Capital Management and AQR Capital Management increased their stakes in LUV. Both these hedge funds have held long-term positions in Southwest Airlines dating back to 2010 when Southwest was trading at a premium to both its peer group and the market.

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