Difficult Quarter for Southwest as Air Traffic Grounded

We are reducing our fair value for Southwest Airlines LUV by 8.5% to $42 per share as we incorporate a somewhat more bearish 2020 into our forecast and account for the firm’s capital raise. Management indicated that more difficult days remain, and the firm intends to dramatically reduce capacity by at least 60% in the second quarter. The firm disclosed that they generated a cash burn (including capital expenditures but excluding sales refunds) of roughly $900 million in April, which is just shy of 15% of 2019’s operating profit. As these losses are not sustainable, the firm is raising roughly $1.6 billion of equity and $1 billion of debt to fund operations. While we respect the need for the firm to raise capital to survive in an unprecedentedly challenging operating environment, we think these capital raises would be value destructive if they are used to fund unprofitable operations, as they would dilute ownership and introduce liabilities without increasing the long-term value of the firm.

Southwest disclosed that operating revenue is down roughly 90% to 95% in April due to substantially reduced demand. As a substantial portion of the firm’s cost base is fixed, a dramatic reduction in revenue leads to operating losses. While it’s difficult to say with any certainty when air traffic will return, we are confident that demand will eventually bounce back. We’re modeling demand beginning to normalize in 2021 and that the firm will reach 2019 capacity levels once again in 2022. We think the primary risks to airline investors are increased leverage and equity dilution as airlines look to bolster solvency while demand is in the doldrums. We think the best-positioned airlines are firms like Southwest, which came into this crisis with relatively little debt and an efficient cost base. We still think that Southwest looks cheap for investors with a strong stomach and a willingness to accept a wide dispersion of outcomes.

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