From Thomson Reuters I/B/E/S Estimates:
Forward Earnings: 3.34
Forward PE: 10.87
Earnings Growth Rate (EGR): 22.5%
PEG Ratio: .48S&P Forward PE: 17.82
S&P EGR: 7.12%
LUV reported its quarterly earnings Thursday, July 23. The reported revenues and earnings for the previous quarter were slightly above analysts estimates. LUV is achieving significant growth in its earnings due to drastically lowered fuel costs and through its AirTran acquisition, which occurred in May 2011. The 43% year-over-year (y-o-y) earnings growth was accomplished with only 2% y-o-y revenue growth.
In addition to the earnings and revenue numbers, two other noteworthy topics were presented in the earnings call. One was a re-signed agreement with Chase bank for the Rapid Rewards Chase credit card. The amended agreement will contribute $500 million in yearly revenue, or $125 million a quarter. This amounts to nearly 2.5% of the revenue reported for the second quarter, which is significant considering revenue grew only 2% y-o-y. This agreement should continue to support a modest y-o-y revenue growth for Southwest.
Another noteworthy topic is Southwest's share repurchase plan. LUV has completed $380 million of its current $1.5 billion share repurchase authorization. The $1.5 billion value amounts to approximately 6.2% of LUV's market capitalization. This effectively means, if all of the $1.5 billion repurchase allotment is used, LUV will increase its EPS by 6.2% without earning a single dollar more of profit (same profit but less shares to divide into the profit). In addition, LUV increased its dividend distribution recently and now sports a .84% yield. Pretty pathetic, but still an indicator of the substantial cash flow LUV is generating.
As far of LUV's current valuation (PE) goes, it seems like LUV is greatly undervalued relative to the S&P index. Considering the growth rate of 22.5%, LUV also seems to be undervalued using a PEG analysis. However, while LUV is achieving tremendous growth this year, analysts expect the future consecutive years to grow at low single digits. For this reason, a lower PE for LUV is likely warranted, as the majority of its growth over the next 5 years will be obtained this year. Therefore, we need to come up with a more realistic valuation.
Using the 2% revenue growth number reported this quarter, the 22.5% margin reported this quarter, and the 6.2% EPS growth assuming a consistent share repurchase plan, LUV's growth rate can be estimated at 6.65%. The calculation goes as follows: 2% revenue growth x .225 margin on the revenue growth = .45% (only 22.5% of the revenue growth will turn into profit). Add in the 6.2% growth from buybacks to the .45% and we get 6.65%. We can see from the above numbers that the PEG ratio for the S&P is above 2, so we can conservatively choose a fair PEG ratio of 2 for LUV. This gives us a fair PE of 13.3 (2 x 6.65), or a share price of $44.40 (3.34 future EPS x 13.3 fair PE). This value obtained through our very rough estimates seems reasonable considering the strong management execution and balance sheet of LUV.
Several other factors could help to support earnings performance relative to estimates. The persistence of low oil prices may not be assumed by analysts in their current estimates. Prolonged low oil prices may cause analysts to revise their estimates upwards, which would increase LUV's stock price. Also, LUV is low-balling a few markets where it is trying to grow rapidly. Ticket prices will increase once the markets are more established, which will raise revenue and earnings. In summary, Common Cents maintains that LUV is an attractive buy and would be fairly valued at a share price of $44.
Common Cents Take: The growth prospects for LUV are unclear after this year. However, LUV generates a great deal of cash and returns much of it to investors through share buybacks and dividends. Any persistence of low oil prices will only enhance the growth prospects and return of cash to shareholders.
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