5 Reasons Not to LUV the Southwest-AirTran Merger Right Now

Consolidation is great, but short-term challenges are likely

Southwest Airlines LUV“If the Wright brothers were alive today,” Southwest Airlines’ (NYSE:LUV) co-founder Herb Kelleher said, “Wilbur would have to fire Orville to reduce costs.” While the airline’s chairman emeritus spoke those words 17 years ago, those words are perhaps even truer today — and the quest for lower costs is one of the biggest reasons LUV acquired budget competitor AirTran earlier this year.

But while few observers doubt the longer-term benefits of industry consolidation, like most previous airline marriages, Southwest-AirTran probably will have to wait a while for the honeymoon. Here’s why: The merger of two airlines is a lot easier on paper than it is in practice.

Recent major mergers between United (NYSE:UAL) and Continental (2010), Delta Air Lines (NYSE:DAL) and Northwest (2008), and US Airways (NYSE:LCC) and America West (2005) have proven that airline marriages are tough on all parties at the beginning. Issues ranging from culture wars and labor challenges, to blending flight schedules and reservations systems, have sent most newly combined carriers to couples’ therapy.

And the devil’s even in the smallest details. United Continental’s routine attempt to merge its future flight schedules in May accidentally reinstated flight numbers 93 and 175 — two of the flights that were hijacked and crashed by terrorists on 9/11. It went unnoticed by UAL until employees and customers stumbled across the future schedules online, creating a PR fracas.

With so much risk and so little immediate reward, why are airlines getting hitched? Because they’re struggling in nearly every way possible as a still-sluggish economy, expensive jet fuel and painfully thin margins eat the sector’s collective lunch. Even though planes will be packed to the gills with holiday travelers this week, that’s only because airlines are substituting smaller planes for higher capacity gas-guzzlers — actual passenger counts are expected to fall by 2%, which is 12% below the peak rates the industry enjoyed in 2006.

But Southwest has long defied the rules that have broken other airlines. Its low-cost strategy eschewed the traditional “hub-and-spoke network,” operating point-to-point service with mini-hubs for connecting passengers in some focus cities.

That business model hammered legacy carriers, and its “Bags Fly Free” policies trump other airlines’ ancillary fee explosions. Southwest has managed to keep costs low by very rapid aircraft turnarounds. It also has gleaned big efficiencies by flying only one aircraft type — the Boeing (NYSE:BA) 737.

LUV has given investors many good reasons to love it in the past — the stock has performed at a high level for a long time, though it (and the rest of the sector) has fallen on hard times as of late. At just below $8, LUV is trading more than 46% below its 52-week high of $13.77 this time last year. With a market cap of $6 billion, it has a price/earnings-to-growth (PEG) ratio of nearly 3.3, indicating the stock is overvalued. It has a current dividend yield of 0.23%.

But the AirTran acquisition effectively changes LUV’s business model — and that’s likely to impact performance for the near future. Here are five reasons not to love LUV right now:

  1. Operational Complexity. It will take a year or two for Southwest and AirTran to fully integrate operations, and the task won’t be easy. For example, AirTran had its major hub in Atlanta — LUV is cutting some Atlanta flights in favor of expanding Southwest’s Atlanta flights next year. Upgrading and integrating reservations systems will be a challenge, too.
  2. Maintaining a Mixed Fleet. Southwest’s all-737 fleet in a single-class configuration has been a big part of the airline’s cost-control and efficiency successes. That’s changing as the airline begins to integrate AirTran’s dual-class 717s and 737-700s.
  3. Fuel Price Volatility. The entire industry has been struggling with fuel price volatility, but LUV has been able to mitigate risk with its fuel hedges — until now. In the third quarter, bad bets on fuel hedges were the biggest reason Southwest lost $140 million compared with its $240 million profit for the same quarter last year.
  4. Labor Challenges. Southwest has a long-standing reputation for engaging its employees focusing on training. That’s given the airline a lot of happy employees over the years. But now it has two groups — from vastly different cultures — to satisfy, and that’s easier said than done. There’s one big piece of good news: Southwest and AirTran pilots approved a single pilot seniority list earlier this month.
  5. A Different Model. Southwest’s business model is changing from low-cost carrier to traditional legacy airline operation. It’s introducing Caribbean flights — which along with its Hawaii routes will require new over-water certification for its twin-engine 737s, their pilots and engineers. LUV also has expanded its domestic flights dramatically, which will increase complexity.

Bottom Line: While LUV’s fundamentals are stronger than many of its peers, a little of Warren Buffett’s wariness of the airline sector can’t hurt in the short run. Lamenting his 1989 investment in US Airways, Buffett joked that he had an 800 number to call if he ever craves an airline stock. “I call at two in the morning, and I say, ‘My name is Warren and I’m an aeroholic,'” Buffett said. “And they talk me down.”

As of this writing, Susan J. Aluise did not hold a position in any of the aforementioned stocks.

Article printed from InvestorPlace Media, https://investorplace.com/2011/11/southwest-airtran-merger-luv-airline-stocks/.

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