LUV: Hold; PT $53.7; Q315 Update

LUV reported its earnings for the third quarter on October 19.

LUV: 11/9/15; $46.37

From Thomson Reuters I/B/E/S Estimates:

Forward Earnings: 4.04

Forward PE: 11.48

5-yr Estimated Earnings Growth Rate (EGR): 28.9%

PEG Ratio: .40

S&P Forward PE: 17.65
S&P EGR: 5.90%

LUV reported its earnings for the third quarter on October 19.  The reported revenues and earnings for the previous quarter exceeded analyst's estimates.  LUV is benefitting from sustained lower fuel costs, as profits for the quarter increased 71% year-over-year (y-o-y) on a 10.6% increase in revenue. The increase in revenues occurred in part due to a 7.6% increase in capacity.

LUV is increasing its profitability through increased capacity, increased loading of flights, and lower costs.  This has resulted in LUV converting $0.07 more of each revenue dollar into profit.  The lower fuel costs is providing a cushion for Southwest to invest in cost-saving measures; however, the increase in y-o-y profit is substantially attributable to lower fuel costs.  As such, Common Cents feels it necessary to temper our enthusiasm on this position.

According to Thomson Reuters I/B/E/S estimates, the y-o-y growth rate in profits is estimated at 75.6%, 14.3%, and 6.1% for 2015, 2016, and 2017, respectively.  While the growth rates, particularly for the near future, are impressive, it is likely that investors will sour on Southwest when oil prices start to creep up.  The 5-year estimated earnings growth rate is heavily weighted to the early years.  As such, the PEG ratio of .4 will increase dramatically once 2015 has past due to its significantly higher y-o-y growth rate.  Therefore, the current PEG ratio is not a reliable value to estimate LUV's fair valuation.

LUV is generating substantial cash to fund share repurchases, dividend payouts, and repayment of debt.  The $1.5 billion of planned share repurchases in 2015 amounts to roughly 6% of LUV's shares outstanding; however, this level of share buybacks may not be sustainable in a rising oil price environment.

All of the previous factors make establishing a fair valuation for LUV difficult.  In the previous quarterly update for Southwest, Common Cents conservatively estimated a 5-yr growth rate of 6.65% for LUV.  While the calculation was a very crude, back-of-the-envelope estimate, Common Cents estimates that LUV would be fairly valued at a PE ratio of 13.3.  This value was reached by multiplying the growth rate by an assumed PEG ratio of 2.  Based on the forward earnings estimate of 4.04, LUV would be fairly valued at $53.7.  However, due to the arbitrary assumptions used to calculate this value, Common Cents feels that caution is warranted with this position and that LUV is not an attractive buy at these levels.  Going forward, Common Cents will look to trim its position at a 5% - 10% increase in share price and add to its position at a 5% - 10% decrease.

Common Cents Take: LUV is performing very well operationally; however, the majority of its drastic earnings improvement is related to the persistence of low oil prices.  In the low oil price environment, Common Cents expects LUV to generate significant levels of cash to return to investors through dividends and share buybacks, in addition to reducing debt.  While LUV is performing well operationally, the future performance of its stock price is heavily related to the future of oil prices.  A conservative, defensive mindset for this position is warranted until further clarity is obtained on the future of oil prices and LUV's growth after 2015.