Southwest Airlines Earnings: Cutting Valuation to $19 From $36 on Yields, Expenditure, and Risk

Southwest Airlines LUV turned in record third-quarter revenue and fairly thin operating margins below 2%. More importantly, the no-moat carrier provided a preview of its capacity plans for 2024 and an updated order book for hundreds of new Boeing 737 MAX jets. We incorporated Southwest’s announced plans into our industry model, which lowered our forecasts for the company’s profitability for the near and medium term compared with our prior estimates. We also adjusted the discount rate we use to value Southwest’s cash flows to place it in line with the best U.S. industry peers. These changes result in a 47% reduction in our fair value estimate to $19 from $36.

We don’t doubt that Southwest will eventually take market share from its smaller low-cost competitors, but we believe these gains will be hard won. We expect eventual price competition, even with a near-term pullback in Southwest’s capacity expansion, will reduce yields and thwart Southwest’s ambition to raise margins in the near and medium term. We also increased our forecast of capital expenses for more new planes, offset slightly by their greater efficiency. These changes reduced our fair value estimate by $12.

Southwest occupies a somewhat precarious position in the North American airline market. As the largest airline in the country by passengers, Southwest operates nationwide with its no-frills business model, competing directly with numerous low-cost operators like Frontier, Spirit, and startup Breeze Air. It also increasingly vies for customers against the full-service airlines Delta, United, and American. As a result, we think Southwest deserves a cost of equity on par with its best U.S.-based airline peers, and a lower cost of debt given its conservative balance sheet. Southwest funds its business much more with equity than debt, resulting in a 9.3% weighted average cost of capital. Adjusting Southwest’s cost of equity in our forecast reduced our previous fair value estimate by a further $5.