In an industry like the airline industry, which requires huge capital investment, companies usually end up taking a large amount of debt. High debt tends to make a stock volatile and thus riskier. Thus, investors should keep a close eye on airlines’ leverage ratios.
The good news for Southwest Airlines (LUV) investors is that the company has the lowest leverage among industry peers. In fact, it is the only airline to be net debt negative (more cash than debt) at the end of 1Q17. Its debt has remained at an average $2.6 billion since 2014. In 2016, it increased debt slightly to $2.8 billion as compared to $2.5 billion at the end of 2015. At the end of 2017, debt remained at $2.8 billion.
The company’s net-debt-to-EBITDA ratio has risen from 0.01x at the end of 2015 to 0.08x at the end of 2016. However, good cash flow has helped bring the ratio down to -0.14x.
At the end of 1Q17, American Airlines’ (AAL) net debt-to-EBITDA ratio stands at 11.4x, United Continental’s (UAL) at 9.3x, Alaska’s (ALK) at 4.3x, Delta Air Lines’ (DAL) at 3.2x, Spirit Airlines’ (SAVE) at 0.96x, and JetBlue’s (JBLU) at 0.83x. Other airlines are yet to report their 1Q17 earnings results.
Cash flows help reduce leverage
Southwest has been successful in reducing its debt over the years because of its ability to generate strong cash flows, which have consistently outpaced its peers.
In 1Q17, LUV generated $1.6 billion in cash flow from operations and $1.2 billion in free cash flow. The company ended the quarter with ~$3.5 billion in cash on its balance sheet.
Industry fundamentals have improved tremendously in the last three years and seem to have little scope for further improvements. Reducing leverage at such a time would not only reduce interest costs but also make LUV a safer bet compared to peers with high leverage.
Investors can gain exposure to Southwest Airlines by investing in the PowerShares DWA Consumer Cyclicals Momentum Portfolio (PEZ), which holds 3% of its portfolio in the stock.