Three months ago, in the height of the summer travel season, I wrote on that stabilizing oil prices, firming global air travel demand, and renewed optimism about Boeing 737 MAX planes returning to service in 2020, would propel Southwest Airlines (NYSE:LUV) stock to $60 in no time.
At the time, LUV stock was trading hands around $48. Three months later, LUV stock has rallied an impressive 16% to year-high levels just shy of $60. The SPDR S&P Transportation ETF (NYSEArca:XTN), by comparison, is up 9.4% in that same time.
Why? Oil prices have been stuck in neutral, so the outlook for Southwest’s margins has improved. At the same time, the upstart (still) airline reported strong third quarter numbers which supported the idea that global air travel demand remains vigorous. It has also become increasingly clear that Boeing (NYSE:BA) 737 planes will return to service in 2020, and this optimism about a 737 boost in 2020 has investors buying LUV stock ahead of that catalyst.
Net net, the fundamentals have improved over the past few months. As they have, Southwest stock has rallied. The big question now is will the rally continue?
I think so. The fundamentals supporting LUV stock project to keep improving for the next few quarters. At the same time, the valuation underlying Southwest stock implies that shares have more room to run. Ultimately, then, the red-hot rally in the air carrier’s shares, which has propelled them to near $60 over the past three months, will persist and push the stock above $60 soon.
Southwest’s Fundamentals Will Keep Improving
Back in mid-August, the bull thesis on LUV stock was surprisingly simple.
Thanks to various headwinds (surging oil prices, sluggish demand, and 737 noise), LUV stock had plunged into dirt-cheap territory. But, surging oil prices were set to stabilize going forward. Sluggish demand was set to rebound with increasing global economic momentum. And the 737 noise was set to pass as those planes came back into service in 2020. As such, much like its headwinds, the dirt-cheap valuation in LUV stock wasn’t going to last.
Today, the bull thesis remains simple.
Oil prices are still set to remain stable over the next few years. Yes, demand will come back into the picture in a big way as easing U.S.-China trade tensions spark a rebound in global manufacturing activity. But, there’s a ton of supply out there right now, and emerging markets appear to be in the early stages of their supply ramps. Consequently, oil prices will likely remain stuck in the $50-$60 range, a material positive for LUV stock.
Meanwhile, global labor markets remain healthy, global consumer confidence is at all-time highs, and the world’s manufacturing activity should start rebounding. These three dynamics together paint a favorable backdrop for global air travel demand. Further adding to that favorable backdrop, Boeing’s once-ubiquitous planes are set to come back into service in 2020. When they do, Southwest — a huge 737 customer — will get a big boost.
Net net, the fundamentals here will keep improving. As they do, LUV stock will keep moving higher.
Southwest Stock Remains Cheap
Supporting the bull thesis on Southwest stock is a reasonable valuation which leaves room for further upside over the next few months.
According to market research numbers, global air travel demand has been moving higher at a steady 5-8% clip over the past several years. The drivers of this growth — a consumer pivot to spending on experiences over products, and urbanization in emerging economies — will persist. As they do, this market will remain a 5%-8% volume growth industry. Given high barriers to entry and Southwest’s large competitive footprint, it seems highly likely that the airline grows in-step with the market, implying 5%-8% revenue growth over the next several years.
During that stretch, margins should rebound as capacity expansion from renewed 737 service drives positive operating leverage, and as oil prices stop grinding higher.
Net net, Southwest projects as a mid-single-digit revenue grower over the next few years, with upside margin drivers, the sum of which should drive double-digit profit growth. Factoring in share repurchases, I reasonably think earnings per share can run toward $5.80 by fiscal 2021 from the current trailing 12 months figure of $4.45.
Based on a historically average 12x forward earnings multiple, that equates to a 2020 price target for LUV stock of $70. Discounted back by 10%, that implies a 2019 price target of $63.
Bottom Line on Southwest Stock
Southwest stock has been on fire over the past three months because the fundamental picture here has improved and the stock was too cheap for its own good. The best part of this rally is over. But, going forward, the fundamentals should continue to improve, and the stock is still too cheap.
The implication? LUV stock isn’t going to gain another 20% over the next three months. But, it’s going to fly above $60 soon.
As of this writing, Luke Lango did not hold a position in any of the aforementioned securities.