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

Consolidation is great, but short-term challenges are likely

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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,

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