LUV Stock Forecast: Cleared to Takeoff But Not Yet to Soar

This Southwest Airlines (NYSE: LUV) stock forecast article is written by Hao Liu, Financial Analyst at I Know First.

(Source: Getty Images)

Summary

  • The worst seems to have passed for the airline industry, but it may take at least 3 years before it fully recovers.
  • Meanwhile the industry will face potential challenges such as price war and heavy debt burdens.
  • Southwest is likely to lose less than other airlines in this Covid-19 crisis due to its low-cost strategy, domestic service feature and strong fundamentals (especially high solvency).
  • Both fundamental and technical analysis indicate a moderate BUY/HOLD recommendation for LUV, but investors should be particularly cautious when it comes to airline companies in the following years.

The Worst Has Passed But Recovery Takes Time

The airline stocks are definitely the biggest winner in last week’s market. As airlines boost flights and travel restrictions get eased, the airline stocks just took off and surged. American Airlines soared 90%, United Airlines jumped over 60%, Delta Air Lines increased more than 40%, and Southwest Airlines was up 25%.

Considering the devastating blow by the Coronavirus, the industry recovery actually comes sooner than expected. This can be greatly attributed to consumers’ “real confidence” and dire expectations to make trips in July, according to Raja, who recently made some comments on American Air’s big jump. However, analysts don’t seem to have the same confidence as consumers. While Moody’s analyst predicts no substantial recovery until 2023, Wall Street Journal analyst only said it would take a few years. 

Even though it remains uncertain how long it will take before the airlines to catch up with the broader market recovery, it seems positive that May has already hit the bottom and the worst has passed for the sector. One strong indicator to look at is the Global Available Seat Miles (ASMs), which measures an airplane’s carrying capacity available to generate revenues. The rebound of this indicator shows the profitability of airline industry is recovering.

Price War and Debt Burdens Are New Challenges for Airlines

As the industry showed encouraging signs to recover, airline companies also quickly became aware that potential challenges may follow. One of the biggest challenges would be the intense competition within the industry. Gary Kelly, the CEO of Southwest Airlines, warned about “a brutal low-fare environment” of the industry in the aftermath of Coronavirus. He indicated a potential price war as he told the Southwest employees the available seats will greatly outnumber customers in the short term.

(Photographer: Jake Dean)

Well acknowledged of the potential price war, however, Kelly is confident the company will be prepared for the future pricing pressure with a low-cost strategy. This confidence is further boosted by the recent restart of Max production. Since Southwest is the biggest operator of the Max when it was grounded last year, this is undoubtedly a good news for the company. In light of these positive factors, the CCO of Southwest Andrew Watterson thinks “the capacity outlook is more optimistic than other U.S. airlines” and expects the company to operate the pre-Coronavirus capacity by the end of 2020.

Apart from the potential price war, the huge amounts of debt faced by the airline companies will be another challenge. During the pandemic, a majority of the airlines have been burning cash and trying to improve their liquidity at the cost of raising debt. Although the Fed has put $25 billion to stimulate the industry, it later proved that this money was only capable of keeping the companies afloat, not enough to prevent the industry from shrinking. The problem now is demand will be years before it rebound to pre-pandemic level (according to analyst prediction mentioned above). As a result of that, airlines will have to carry heavy debt burdens before revenues become sufficient to cover the costs. And the anticipation, according to American’s Chief Executive Doug Parker, is that airline don’t expect to have 2019 revenues in 2021. Questions have been raised whether the airlines will default or go bankrupt.

To make the situation worse, the likely low-fare environment in the near future will cause more financial burden as demand goes up, the cost goes up. Also, adapting to new air travel incurs costs. 

Shrinking Industry Brings Advantages to LUV

I very much agree with WSJ reporter Jon Sindreu’s opinion that low-cost airlines may suffer less loss than others from the COVID-19 crisis. While he mainly discussed how a shrinking industry could bring advantages to the European budget carrier leader Ryanair (RYAAY), Southwest Airlines is the budget leader in the US who also benefits.

There are two major reasons why Southwest will have advantages over other airlines. One is that legacy airlines rely heavily on revenue, which may not be satisfying under a low-fare future industry environment. In fact a low revenue for those full-service airlines with less profit margin (more employees, more expensive planes and facilities) may not even cover their expense to break even. However, a budget carrier like Southwest may achieve moderate profitability for its consistent low cost strategy. According to most recent figures, American Airlines is burning through $70 million cash per day while it’s $30 million at Southwest. Based on the assumption of similar sizes of customer base, Southwest is more likely to survive through the environment. 

(Source: FT)

The other reason is that domestic and short-haul travel will recover faster than international and long-haul travel, especially considering current border restrictions. Southwest has been focusing on domestic flights over the past decades. And in its recent published flight schedule through Jan 4th, 2021, the company announced its reach into new markets such as Long Beach. This move is interpreted by analysts from Deutsche Bank that Southwest is planning for a quicker recovery in demand than other airlines and at the same time seeing an opportunity to gain market share. Indeed, Southwest’s biggest markets are states that eased lockdown early (Florida, Texas and Georgia) and 80% of its customers are leisure travelers. Additionally, it’s continuation of build-up at that airport will cause a threaten to its competitor JetBlue.

Technical Analysis Indicates a Moderate BUY/HOLD

(Source: BarChart) 

As we can see in the chart, following a strong uptrend starting in mid-May, LUV stock price has retraced since this week. However, it is still within the range of pivot levels, meaning there’s no reverse in the momentum. Based on current stock performance, the recommendation is a moderate BUY/HOLD for short term holdings.

As shown in the table below, LUV is not as “hot” as other airlines. It has a lowest standard deviation of 2.14 from 50-DMA, indicating LUV is not overbought as other stocks. Thus the stock performance is reflecting the true momentum.

(Source: Seeking Alpha)

Recently US Global Jets ETF (JETS) has been widely used by technicians to predict the market trend as well as individual US airline stock, which show similar trends. At start of this week, based on US Global Jets ETF (JETS)’s relative strength to S&P 500, market technician Craig Johnson gave an even stronger BUY recommendation, betting on another 25% rally.

(Source: CNBC)

For the longer term, if the stock oscillates between the pivot levels (as long as primary trend is not broken) or initiates a new rise breaking the resistance levels, the recommendation will remain a BUY/HOLD. On the other hand, if the stock continues to decrease as earlier this week and dropped below the support levels, then this would be a SELL signal.

Fundamental Analysis Also Recommends BUY/HOLD

(Source: the Screener)

Above charts shows the key financial ratios for the past 5 years, using the most recent available data as of March 31, 2020. The historical average ROE is 28%, which is above the industry average of 19%, indicating an efficient use of shareholder capital. Recent ROE of 23% is located near the long-term average of 28%. The average historical operating margin (EBIT) is 16% (close to industry average of 14%) and the most recent data is 14%, also near the historical average of 16%. With an equity ratio of 38%, the company’s finances are more conservative than industry (24%). This status remains the same for the past quarter. Asset value obtained relative to the market price has been 6% higher than industry average in the past, but the current value falls behind.

(Source: the Screener)

The estimated dividend represents 3.9% of the estimated earnings, thus it’s largely covered, and its payment looks very sustainable. 

Since May, Southwest’s operations has begun to see “modest recovery” as bookings continue to outpace cancellations. In a recent filing, Southwest is reported to have achieved much better results in May than in April, and projected June will even outperformed May. The seat filling percentage in May reached more than 25%, which nearly tripled the 10% prediction based on the April figure 8%. With this massive out-performance, Southwest predicted in June the percentage of seats filled per plane to further increase to between 35% and 45%. The expense was also below previous estimate, with on average $10 million less per day this quarter.

As the biggest concern I hold for the airline industry is companies’ ability to payback their debt, Southwest demonstrates very good credit health as shown in the table below.

(Source: Capital IQ)

In terms of valuation, following the company’s recently published flights schedule and strategy, assumptions are made based on past 5 years historical data (2015-2019) to derive estimations through 2022. Considering the expansion costs to new cities as well as the slow recovery demand speed, we expect the company performance hits the lowest at the end of 2020 and then starts to rebound in the following years. The main assumptions are decrease percentage of revenue and CapEx. Other assumptions are based on current industry consensus, which is likely to be changed as this industry has been very volatile recently. In these assumptions, we tended to consider the simpler cases. For example, we assumed no additional financing, no change in 2020 tax rate, and all variable operating expenses change proportionally with revenues.

The current market capitalization is $21889.8, total enterprise value is $22760.8, and total capital mounts to $15495.0. Then multiples are derived based on current capitalization.

The estimations fall into analysts’ estimate ranges on Yahoo. This leads to a recommendation similar to the consensus among analysts: a BUY/HOLD position for LUV.

Bullish Investors Beware of Airline Industry

Although we see Southwest is likely to emerge from this crisis better than other airlines, we need to be cautious about the potential risks can be caused by other airlines or the industry. For example, If too many airline companies default, the government could put forward restrictive regulations on the whole industry. Even if Southwest paid off its debt, its business could be affected by the regulation.

Airline industry itself is a highly risky industry, featuring high debt, high cash flow volatility and high infrastructure costs. With such features, this industry as a whole will not hold a very promising prospects from this pandemic. Especially during this time, this industry is very volatile. While people are still emerged in the market surge, JPMorgan already downgraded some airlines with a pessimistic view on long-term rally.

Therefore, I suggest bullish investors to be particularly cautious when it comes to airline companies, including LUV.

Conclusion

(Source: Justin Sullivan, Getty Images)

As the economies continue to reopen and travel halts start to ease, the demand for airline travel is returning. However, it is estimated to take as much as 3 years before the airline industry fully recovers. In the meantime, airline companies will face big challenges such as price war and debt burdens. Southwest Airlines is estimated to receive advantages over other airlines because it’s low-cost and serves domestically, which features will help the company survive this crisis. Both technical and fundamental analyses indicate a BUY/HOLD signal, but bullish investors should be careful about airlines due to the nature of this industry.

Current I Know First Algorithm Forecast for LUV

I Know First Algorithm forecast dated on June 14th, 2020 also predicts a bullish outlook for Southwest Airlines. As shown in the diagram below, LUV shows a moderate bullish signal in the short term. This is in line with my analysis above. In the long term, I Know First gives a rather strong BUY recommendation with a 160.75 BUY signal and a 0.56 predictability indicator. According to the management’s strategy discussed above, the company should have accomplished its expansion and profitability should have started to recover. Even though profitability is unlikely to go back to previous level one year from now, the trend should be bullish.

Go here to read how to interpret this diagram.

Past I Know First Forecast Success with LUV

As stated in last week’s newsletter, the signs of ascent recovery in airline industry has been detected by I Know First Predictive Algorithm 2 weeks ahead. Last week I Know First recorded another success as UAL surged 64% and LUV rose by 29% in agreement with the AI forecast.

On May 22nd 2020, I Know First has made a 2-week forecast on LUV with a bullish signal of 2.21, which proves to be successful as we saw LUV jumped 28.99% last week, together with a surge of the whole airline industry. Actually, this is not our only successful forecast with LUV. For the past two weeks, I Know First has been following up the performance of LUV. On May 27th 2020 and June 2nd 2020, I Know First respectively offered a 7-day and 3-day forecast, and both successfully predict the performances.

In addition, I Know First also looks at other companies within the same industry. You can also find United Airlines (UAL) in the above forecasts and see it’s performances are also successfully predicted.

These past success shows I Know First’s AI can provide valuable forecasts in both short term and long term, and for both individual company and the whole industry.

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Please note-for trading decisions use the most recent forecast.