Even though the terrible prospects for the airline industry justify the sector’s steep drop, value investors cannot ignore the discount. Southwest Airlines (NYSE:LUV) stock has traded in a narrow range between $50-$60 since January 2017. Then, LUV stock fell to levels not seen since 2016 as a result of the novel coronavirus.
The steep drop in passengers will continue as long as countries are in lockdown. Yet Southwest Airlines is positioned to rebound in the coming months. When air travel rebounds, its losses will narrow. Plus, government relief worth billions will cushion the downturn in the industry.
The U.S. government will give $25 billion in grants exclusively for workers in the airline industry. While this will benefit its workers more than the company, Southwest will have one less thing to worry about. Shrinking its business to the minimum to sharply reduce costs will ensure its survival.
Cutting Costs to Boost LUV Stock
Southwest Airlines’ CEO will take a 10% pay cut due to the drop in bookings. The company forecast a loss between $200 million and $300 million for March. The drop in passenger business revenue will cost the industry between $63 billion and $113 billion. Still, the collapse in oil prices will give Southwest the benefit of lower costs. It will save $1 billion this year due to lower fuel prices.
In its U.S. Securities and Exchange Commission 8-K filing, the company shored up its cash by arranging a $1 billion loan credit facility. It said that steep declines in passenger bookings in March will continue in the second quarter.
More specifically, it said that “as the impact of the COVID-19 pandemic grows, and based on current booking and cancellation trends, we expect revenue trends for the remainder of March and second quarter 2020 to deteriorate further.”
Unsurprisingly, the net negative bookings (where trip cancellations outpaced new passenger bookings) in March and April 2020 will hurt near-term revenues. Since the market is pricing LUV stock on its prospects, the increasingly worsening revenue trends are hurting the stock price.
The company voluntarily asked for employee leave, issued a hiring freeze and will cut capital costs where possible.
Southwest Suspends Stock Buybacks
Southwest had $765 million left in its $2 billion stock buyback but will suspend the program. For LUV investors, the program would have increased shareholder value. The company could have bought the stock at a sharp discount.
Unfortunately, getting government support and needing to preserve cash prevent it from buying back stock. Besides, other firms like Intel (NASDAQ:INTC) that have plenty of cash are also canceling buyback programs.
Southwest will need to show the market that it is increasing its liquidity and improving its working capital position. To avoid a complete breakdown in its business, it must first win investors’ confidence.
Price Targets on Southwest Airlines
The average analyst price target on LUV stock is $47.45. The company has a debt-equity ratio of 0.4 times and a proven history of strong operating cash flow. This suggests that even if it cuts or reduces its dividend, investors will not flee the stock. Before the Covid-19 pandemic, Southwest Airlines had a history of increasing its dividends annually:
In an earnings before interest, taxes, depreciation and amortization (EBITDA) multiple model, LUV stock is worth at least $38 at a conservative forward EBITDA multiple of 5.6 times.
And as travel restrictions are lifted in the coming months, look for that multiple to expand and for LUV stock resume its rebound.
Chris Lau is a contributing author for InvestorPlace.com and numerous other financial sites. Chris has over 20 years of investing experience in the stock market and runs the Do-It-Yourself Value Investing Marketplace on Seeking Alpha. He shares his stock picks so readers get original insight that helps improve investment returns. As of this writing, Chris did not hold a position in any of the aforementioned securities.
