In mid-August, S&P Global Ratings stated that only three airlines had investment-grade bonds: Southwest Airlines (NYSE:LUV), Ryanair Holdings (NASDAQ:RYAAY), and easyJet (OTCMKTS:ESYJY). Before the novel coronavirus, just one-third of the world’s airlines weren’t investment grade. If LUV stock wants to continue its recovery from May lows, it’s got to hang on to that rating.
At the moment, Southwest is the only U.S. airline with investment grade bonds and it shows in the year-to-date performance of the big four. Southwest has a total return of -26% through Sep. 8, followed by -45% for Delta Air Lines (NYSE:DAL), -53% for American Airlines (NASDAQ:AAL) and United Airlines (NASDAQ:UAL), lagging the pack at -58.5%.
The only thing surprising about these results is that American is ahead of United. As far as I know, American’s debt situation is the worst of the bunch. I guess the markets aren’t efficient, after all.
As we sit here with a little less than four months left in 2020, a forgetful one for the airlines, LUV stock is getting crushed a little less than the other three. To stay that way, its balance sheet has got to remain sound. The investment-grade rating is but one part of the package.
Nonetheless, keeping this status is critical to Southwest’s share price recovery. So too, is the return of passengers.
Will Southwest retain its special place in the debt markets? Here’s a quick look at both sides of the argument.
Southwest Continues to Be the Best Run Airline
In April, Southwest received $3.3 billion in payroll support from the federal government through the $2 trillion CARES Act.
A significant portion ($2.3 billion) was for payroll support through the end of September. That isn’t repayable. The remaining funds ($948 million) were in the form of a 10-year, low-interest loan of 1% for the first five years and the secured overnight financing rate plus 2% for the remaining five years. The government also got 2.6 million warrants to buy Southwest shares at $36.47. They have a five-year term through April 2025.
At the time, it also signed a non-binding agreement to borrow an additional $2.8 billion from the Treasury Department. However, on Aug. 19, Southwest turned down the loan stating that the deal included the issuance of additional warrants to the Treasury. In doing so, Southwest’s shareholders would have been diluted, putting its investment-grade rating on its debt at risk.
Furthermore, it stated in its Aug. 19 filing with the Securities and Exchange Commission that it can secure better terms from commercial lenders. But only if it retains the investment-grade rating on its debt.
In the filing, it updated its business situation, suggesting that passenger numbers improved in May and June, they fell back in July, getting slightly better in August, but still well down from a year ago. It estimates that August revenues will be down 70% to 75% with a 27% reduction in capacity.
In July, Southwest burned $17 million per day, a million less than its original estimate. In third-quarter 2002, it should burn approximately $20 million per day, $3 million less than its initial estimate.
As of Aug. 18, it had cash and short-term investments of $15.2 billion, adjusted debt to invested capital of 53%, and $12 billion in unencumbered assets.
If you own Southwest stock, this is evidence that chief executive officer Gary Kelly and the rest of his management team are working hard to keep the company moving in the right direction.
The Fall Could Send LUV Stock in Reverse
There’s no doubt in my mind that if you had to buy an airline stock, Southwest should be the one. However, you don’t have to buy an airline stock. You don’t have to buy any stock. You have options. Staying in cash is an option. It’s not a great one in this low-interest environment, but a choice nonetheless.
As we move into the fall, the odds of a Covid-19/flu combination seem very high at this point. Whether Mr. Trump likes it or not, the stock market is not the same thing as the economy. In 2021, the U.S. national debt is expected to exceed the entire U.S. economy for the first time since 1946. The Congressional Budget Office estimates that the 2020 federal deficit will be $3.3 billion, three times what it was a year ago.
Stocks of all kinds got battered on Sep. 3 as investors turned the old saw, “sell in May and go away,” into “sell in September and forget about the markets until Nov. 4.”
Ok, so I don’t have a shot at being a world-class songwriter.
The markets have become detached from reality. We know this to be true. The Nasdaq’s nearly 5% decline was overdue. Apple (NASDAQ:AAPL), the world’s biggest public company, lost 8% of its value. Even poor Jeff Bezos has to make do with $9 billion less after the selloff.
The problem is this could be the beginning of a perfect storm. Allianz chief economist, Mohamed El-Erian, who used to be Pimco CEO and knows a thing or two about the markets, appeared on CNBC Sep. 3. He suggested that a significant correction could be at hand.
“That is the tug of war that’s going to play out, and it’s going to show the DNA of investors,” El-Erian said on CNBC’s Closing Bell.
“We could have another 10% fall, easily … if people start thinking fundamentals,” El-Erian stated.
“If the mindset changes from technicals to fundamentals then this market has further to go, but it remains to be seen whether it will change.”
If investors start thinking about fundamentals, even Southwest, at a daily burn rate of $17 million, is too much for prices to remain this high. Bankruptcies among the airlines could happen. Once investors come down from their unrealistic perches, all bets are off how far things could fall.
Day after day, watching the news, I’ve become sickened by the constant droning on about how the indexes are at record highs — much of it from the Trump family. By the time Trump realizes the stock market isn’t the economy, it will be too late.
The Bottom Line
I can’t tell you whether Southwest can hang on to its investment-grade rating. Not even the ratings’ agencies can do that. However, if any airline can buck the trend, my money will always be on Southwest.
It’s a long-term winner. In the near-term, if investors pay attention to fundamentals, as El-Erian suggests, I could see LUV stock dropping back into the $20s.
I hope I’m wrong.
On the date of publication, Will Ashworth did not have (either directly or indirectly) any positions in the securities mentioned in this article.
Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia. At the time of this writing Will Ashworth did not hold a position in any of the aforementioned securities.
