Alongside the rest of the airline industry, shares of major airline operator Southwest (NYSE:LUV) have been under tremendous pressure since early 2018, driving Southwest stock lower.
First, rising oil prices negatively impacted Southwest’s margins in early 2018. Then, recession concerns dampened demand in late 2018. Now, in 2019, the Boeing (NYSE:BA) 737 MAX crisis has created operational disruption across the whole industry.
Net net, since early 2018, it’s been a consistently ugly operating environment for the airline industry. Against that ugly backdrop, LUV stock has dropped 25% since January 2018.
But, going forward, the fundamentals should improve for Southwest, and those improvements could spark a healthy 20%-plus rally in LUV stock.
The Fundamentals Will Improve
The first part of the bull thesis on LUV stock, and pretty much all other airline stocks, is that the fundamentals underlying the airline industry are about to improve in a meaningful way.
Specifically, there are three big things at play here. First, oil prices are set to move lower. That will benefit Southwest’s margins. Second, airline demand is set to move higher. That will benefit Southwest’s unit and overall revenue trends. Third, Boeing’s 737 MAX planes will start flying again soon. That will improve Southwest’s overall flying capacity.
On the first point, oil prices are very important to airlines. High oil prices equal low margins. Low oil prices equal high margins. Going forward, oil prices will stay low. That’s because we project to have a high supply (oil supply outstripped oil demand by 900,000 barrels per day in the first half of 2019, according to IEA) and low demand (the global economy is heading into what many see as a manufacturing recession) market for the foreseeable future.
On the second point, airline demand should remain healthy for two reasons. First, consumers are shifting their spend from products to experiences. Travel is at the forefront of the experience value chain. As such, this shift naturally means strong consumer appetite for air travel.
Second, that strong appetite is supported by healthy labor conditions (globally, unemployment rates are very low and wages are mostly moving higher), which means consumers are both willing to and capable of supporting strong airline demand for the foreseeable future.
Third, Boeing’s planes won’t be grounded forever. These planes will get back in the air by early 2020. When they do, present capacity issues will be resolved, and volume and traffic growth metrics across the industry will markedly improve.
Southwest Stock Isn’t Priced for Better
The second part of the bull thesis on Southwest stock is that this stock is not priced for things to get better, so when they do get better, the stock could fly higher.
Ostensibly, Southwest stock isn’t super cheap. It trades at 11.8 times forward earnings, versus an airline average 8.2-times forward earnings multiple. But, that multiple comes against the backdrop of what analysts see as 10%-plus profit growth over the next several years.
Right now, investors are discounting that 10%-plus profit growth potential amid 737 MAX capacity issues. That’s why Southwest trades at $50, with a consensus twelve-month forward price target of nearly $60, according to YCharts.
But as those 737 issues move into the rear-view mirror and as the underlying fundamentals here improve, investors will start to give more credence to that 10%-plus profit growth outlook from analysts. As they do, LUV stock will fly higher.
How much higher? Assuming mid-single-digit revenue growth from continued strong air travel demand, gradual margin expansion at the hands of increased capacity and lower fuel costs, and continued big buybacks, Southwest could very reasonably net around $5.80 in EPS by fiscal 2021.
Based on a historically average 12-times forward multiple, that implies a 2020 price target for LUV stock of nearly $70. Discounted back by 10%, that equates to a 2019 price target of over $60.
Thus, as the fundamentals improve over the next several months, LUV stock has fundamentally supported runway to fly above $60.
Bottom Line on Southwest Stock
It’s been a rough few quarters for Southwest Airlines, and the whole airline industry. But with oil prices set to move lower, demand tailwinds set to remain healthy, and 737 MAX grounding issues set to phase out soon, the fundamentals across the entire airline industry could meaningfully improve over the next few quarters.
As they do, beaten up airline stocks should bounce back — LUV stock included.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities, but may initiate a long position in LUV within the next 72 hours.