Southwest: Still Room to Grow, but Competition Will Restrain Profitability; Fair Value to $42.90

We’ve taken a fresh look at North American airlines and instituted an industry-based demand model for air travel, capacity, and airline revenue yields. As a result, we’ve lowered no-moat Southwest Airlines’ LUV fair value estimate to $42.90 from $54.

We’ve tempered our view of the medium-term operating environment for U.S. airlines, including Southwest. We model a return to normalized competitive dynamics after current supply constraints moderate, likely in a year or two. Our 2023-27 forecast resembles the 2015-19 period before the pandemic—we forecast declining fuel costs, a mostly consolidated industry, and robust demand for air travel. However, three key differences temper our outlook for airline profitability and risk: the industry piled on billions of dollars of debt to withstand the pandemic, current high profitability will erase tax shields the airlines previously enjoyed, and postpandemic labor agreements add structural costs to airlines’ income statements.

Therefore, our 2027 midcycle forecast for Southwest includes a 16 cent per revenue passenger mile passenger revenue yield, 15% share of revenue passenger miles, and load factors in the low 80s. It also incorporates higher depreciation as Southwest takes delivery of new planes. More importantly, our forecast locks in almost 1.5 cents per available seat mile of structural unit costs that materialized at the end of the prepandemic period. Southwest only booked about 3.5 cents per available seat mile of spread between its passenger revenue and non-fuel recurring costs before the pandemic, so this change accounts for the bulk of our lower forecast operating margins.

Even with a rosy near-term outlook for airlines, we still think the industry enjoys no durable competitive advantages. Therefore, long-term investors should seek air travel exposure elsewhere, such as with wide-moat suppliers of airframes and jet engines. Airlines compete with one another to buy these products years in advance.