Southwest Airlines vs. American Airlines

Southwest Airlines (NYSE: LUV) was founded in 1971 by Rollin King and Herb Kelleher as a small Texas airline. By 1973 they had turned their first profit, beginning a streak which is unprecedented in the airline industry. They grew slowly in the early years, adding a handful of Texas cities. In 1977 Southwest was listed on the NYSE. With the addition of New Orleans in 1979, the airline began a path of expansion beyond the Texas market, and soon cities across the southwest were being added. They launched they’re first loyalty program in 1987, the Company Club, which would later morph into Rapid Rewards. Online booking was added in 2000. Since then, both expansion and profitability have been maintained, even after the terrorist attacks of 9/11.

Southwest finished third in the 18Th Annual Airline Quality Rankings. The rankings are based on four criteria: on-time arrival, denied boarding, mishandled baggage, and consumer complain statistics. The airline industry had a terrible year in 2007, finishing with its worst ranking ever. Southwest climbed from sixth place a year previous, but registered a decline in its score, due to problems with mishandled baggage and denied boarding.

Southwest has had issues in its maintenance department over the past year. In March, they pulled 38 jets, resulting in 126 cancelled flights. The issue was a type of maintenance check that had not been performed. Southwest is already facing regulatory and congressional investigations of its decision in 2006 to continue flying planes that should have been grounded. Furthermore, an FAA audit of Southwest’s maintenance practices resulted in a $10.2 million fine to the airline this March.

4) Southwest’s has strong profitability ratios relative to AMR, the parent corporation of American Airlines. Southwest has a gross margin of 26.14%, ahead of AMR’s 21.83%. The difference was more dramatic in terms of operating profit margin and net profit margin.

5) Southwest recorded stronger asset utilization ratios than did AMR. LUV had a return on assets of 4.27%, and a return on invested capital of 0.26%. The airline business is so capital-intensive and with such slim profit margins that these numbers are never strong. For AMR the return on assets was a mere 1.75%.

6) Southwest is more liquid than is American Airlines. Both airlines have fairly strong current, quick and cash ratios, but Southwest has a slight edge in all three.

7). Southwest has a strong interest coverage ratio, whereas AMR lost money and is thus not able to cover their debt obligations. In the airline business, debt is only one fixed obligation – airplane leases and landing fees are fixed obligations that are essential to the conduct of business, which makes the fixed charge coverage ratio more valuable. For Southwest, this is.594, not unusual for the industry but significantly weaker than their interest coverage.

8) the Dupont number for Southwest is 0.16. AMR lost money and has no equity. The Dupont number is 0.113 inasmuch as this has any meaning without profit or equity. For Southwest, the number reflects that they did not make much money for the amount of shareholder’s equity.

9) Southwest has a more healthy degree of financial leverage than does AMR. AMR’s lack of equity indicates a position where they have more debt than assets, which is not healthy. Southwest’s interest coverage is comfortable, at 3.909. Southwest’s operating leverage is high, as they are in a low margin business. They had a negative change in EBIT over the period, as did AMR, despite both having higher sales. Southwest’s combined leverage is 1.505, much stronger than AMR, which suffered a huge decline in earnings per share despite having higher sales.

10) the weighted-average cost of capital for Southwest is 0.56%. This is based on a risk free rate of 1.2% (three-month T-Bill) and a historic return on the Dow Jones of 3.2%. For AMR, the WACC is 3.53%. This reflects that AMR’s equity has a negative value, and that they do not pay dividends. Their cost of capital is the cost of their debt.

11) LUV’s chart is very stable, whereas AMR’s is not. AMR has been highly volatile in the past couple of years, showing strong gains and then a consistent decline. Over the same period, LUV has been virtually flat, with a slight dip at the end.

12) the growth rate for the last five years of LUV’s earnings has been an average of 7.8%. This gives the present value of their next five years’ earnings respectively to be $691.43, $741.21, $794.54, $851.76, and $913.12 for a total of $3,992.09. The P/E ratios for the past four quarters, based on trailing 12-month EPS are 14.35 for the latest quarter, 19.22, 24.47, and 21.94. The P/E had risen in the second quarter after a strong earnings figure but as those earnings began to decline, the price of the stock started to slip as well. Investors no longer believed in strong growth prospects for LUV.

13) Right now I would hold LUV. It is fairly valued, in my opinion. The recent FAA troubles seem to have not affected the stock so much as weaker earnings. The high P/E we’d seen in six months to a year ago was probably too much, given the growth prospects for LUV. Therefore I feel it has settled down into better price range.

Exhibit a:

LUV AMR

Gross Margin: 26.14-21.83

Operating Profit Margin: 8.02 4.21

Net Profit Margin: 6.54 2.2

ROA: 4.27% 1.75%

ROIC: 0.26% -0.01%

ROE: 9.63% 49.15%

Current Ratio:.92.85

Quick Ratio:.86.78

Cash Ratio:.574.554

Debt/Equity: 1.416 -48.6

Interest Coverage: 31.64 1.73

Exhibit B:

Dupont Number

Net Income/Equity 111/6941 = 0.16 (69)/(606) = 0.113

Exhibit C:

Financial Leverage:

Debt/Equity 1.416 -48.6

Debt/Value.586 1.021

Interest Coverage 31.64 1.73

Operating Leverage:

change in EBIT change in sales -27.6/9.5 = -2.905 -5.05/5.3 = -.095

Combined Leverage:

change in EPS change in sales 14.3/9.5 = 1.505 -450/5.3 = -84.9

Exhibit D:

WACC = Wd (1-t) Rd + WeRe 586(1-.393).015 +.414(.0014) 1.0207(1)(3.46) + 0 total WACC.0056% 3.53%

Bibliography

Ratios except ROIC from Reuters. Retrieved April 10, 2008 at http://stocks.us.reuters.com/stocks/ratios.asp?symbol=LUV&WTmodLOC=R2-Ratios-1-More

ROIC, leverage and Dupont calculated from data from the latest quarterly and annual reports. Retrieved from Southwest.com and American Airlines.com on April 9, 10, 11, 2008.

On the WACC, betas, risk free and market return from MSN MoneyCentral. Retrieved April 11, 2008 http://moneycentral.msn.com/detail/stock_quote?Symbol=luv

Southwest corporate history from Southwest.com, retrieved April 8, 2008 at http://www.southwest.com/about_swa/airborne.html (April7, 2008) Southwest Airlines Travel Quality Ranked No 3. Business First of Columbus Retrieved April 8, 2008 at http://www.bizjournals.com/columbus/stories/2008/04/07/daily9.html

Michaels, Dave & Maxon, Terry. (March 13, 2008). Southwest Airlines Grounds Dozens of Jets After Safety Probe. Dallas Morning News. Retrieved April 8, 2008 at http://www.dallasnews.com/sharedcontent/dws/bus/industries/airlines/stories/031308dnbussouthwestjets.492e3dea.html