The airline is 'getting on with the times,' one fund manager says
A Southwest Airlines jet departing Portland International Airport in Oregon. Southwest shed its one-size-fits-all approach under pressure from activist investors, and the changes are starting to bear results.
Southwest Airlines is in the middle of major makeover that has angered some of its most loyal fans. On Wall Street, however, the changes are landing much better.
For years, Southwest $(LUV)$ stuck with a one-size-fits-all approach, including an open-seating policy that lasted for decades. The strategy put the carrier out of sync with other U.S. airlines, which went deeper into tiered fares and into charging for different services and products as a way to wring more profits.
Under pressure from activist investors, Southwest has announced major changes recently. It started charging baggage fees last year, and extra legroom and assigned-seating options went live in January.
"Customers might miss the old Southwest, but investors love the new Southwest," said Keith Buchanan, a fund manager with Globalt Investments.
The simplicity of Southwest's previous model is probably something of the past, Buchanan said. The airline might not have wanted to change, but had to in order to protect its margins. Stronger margins protect airlines in tough times like the current moment, as jet-fuel spikes are pressuring the companies' bottom lines, he noted.
"Southwest is just getting on with the times," Buchanan said, as demand for perks and premium seats for full-service airlines such as Delta Air Lines $(DAL)$ and United Airlines $(UAL)$ shows no sign of abating. "From Southwest's perspective, if you can't beat them, join them."
A Southwest spokesperson directed MarketWatch's request for comment about the evolution of the company's turnaround plan to materials made public when the airline reported second-quarter earnings on July 22.
At that time, Southwest reported second-quarter earnings well above Wall Street expectations, and updated its full-year guidance for earnings between $3.25 a share to $4.25 a share, compared with a previous outlook of at least $4 a share.
That its original guidance is "still in play" despite volatile jet-fuel prices speaks of the company's strong revenue performance, the Southwest spokesperson said.
Jet fuel has been a sore point for U.S. airlines in recent months, as the U.S. and Israel's war with Iran has jolted energy markets and impacted prices for crude oil and fuels. Jet-fuel prices moderated in June, but have been on the rise again in recent days.
Jet fuel is the industry's No. 2 expense after labor, accounting for about 25% to 30% of total airline operating costs, according to the International Air Transport Association.
Changing perspective
Analysts have become more optimistic about Southwest in recent months, with those assigning the company's stock "buy" or "hold" ratings slowly becoming the majority.
Of the 28 Wall Street analysts surveyed by FactSet, buy and hold ratings are now evenly divided at roughly 40% each. The remaining 20% of the analysts are holding a sell rating on the shares. A year ago, about half of the analysts had hold ratings, with the remainder split between buy or sell ratings.
Southwest "is reclaiming its place among U.S. airline profit leaders," Raymond James analyst Savanthi Syth said in a recent note. It had the second-highest profit margin in the latest quarter among five large U.S. air carriers, behind only Delta.
Despite the near-term "noise" such as jet-fuel prices and tougher year-on-year comparisons, "we expect Southwest to be a long-term winner of a much more rational industry with the balance sheet and asset base to withstand near-term shocks," Syth said.
Syth has the equivalent of a buy rating on the shares, in part thanks to "still mostly skeptical investor sentiment."
To be sure, the changes are not without hiccups.
The company is still working to improve its passenger experience and booking options, said Nicolas Owens, an analyst with Morningstar.
Crew and passengers are "essentially relearning" the boarding process and becoming acquainted with different fare levels, new bundles and new names - all of which impacts what it's like to book a fare on the Southwest app or through an aggregator, Owens said.
The stock is also looking overvalued at the moment, he added. Morningstar assigns a fair-value estimate of $35.20 for Southwest shares; they currently trading at roughly 30% above that.
The stock is underperforming the broader industry, however, so far this year. It has gained about 10%, which compares with an advance of about 12% for the U.S. Global Jets ETF JETS in the same period. On a 12-month basis, however, Southwest shares are ahead of the ETF with gains of nearly 50%, compared with about 30% for the fund.
-Claudia Assis
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