Southwest Airlines: Best of the Worst

Soaring oil prices have forced the usually irrational airline industry into acting, well, rationally. Major airlines, such as Continental and United, have raised ticket prices and plan to shed staff, unprofitable routes and aircraft to cope with profit-draining fuel costs.

While this is bad news for travelers, the industry moves have some investors taking a closer look at airline stocks. Why? Because the bloodletting improves the financial strength of airlines, and because the stocks are trading near historic lows.

But one stock has held up remarkably well despite all the adversity: Shares of Southwest Airlines (symbol LUV), which closed June 11 at $13.43, are up 10% year to date and are off their 52-week high by a relatively modest 20%.

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By contrast, shares of UAL (UAUA), parent of United Air Lines, are 85% below their 52-week high and those of AMR (AMR), parent of American Airlines, are down 79% from their high. The Amex Airline Index, a benchmark of airline stocks, hit a new low of 17.37 on June 11. Before 2008, the index, which was created in 1992, hit its all-time low, at 25.95, in March 2003.

Airlines have a long track record of financial failure. Since 1947, the industry as a whole has racked up some $9 billion in net losses, according to the Air Transport Association, a trade group.

Airline stocks have disappointed investors for decades, too. That's partly because earnings are notoriously difficult to predict. Analysts have to account for business-travel spending, fuel-price spikes, labor disruptions, bankruptcies, accidents and the threat of terrorism.

Airlines are largely a commodity business with limited pricing power. As energy costs rise, they must generate more revenue to offset higher prices for jet fuel. "The primary path to higher revenue is fewer seats," says Raymond James analyst Duane Pfennigwerth. By cutting capacity, airlines can more easily boost ticket prices.

Most airlines are following Pfennigwerth's prescription. Cuts announced by American Airlines, Continental Airlines (CAL), Delta Air Lines (DAL) and United should reduce U.S. airline capacity by about 11% in the fourth quarter, he says. Southwest is only major airline planning to expand capacity this year, by a modest 1%.

Rising jet fuel costs have weighed heavily on airlines' expenses. Over the past year through June 6, jet fuel prices have risen 67%, according to the Air Transport Association. Every dollar increase per barrel of crude oil boosts U.S. airline fuel expenses by an additional $465 million, according to the trade group. Historically, fuel costs have ranged from 10% to 15% of U.S. passenger airline operating costs but are currently running at between 30% and 50%. Southwest's fuel costs run on the low end, accounting for about 30% of costs.

Southwest is the standout among the U.S. airlines because it knows how to hedge its bets. The Dallas-based airline has used derivatives to hedge the cost of more than 70% of its estimated fuel consumption for 2008 and 55% of its estimated costs for 2009 and is paying a price equivalent to $51 per barrel of crude oil. By contrast, other major airlines have hedged 30% or less of their estimated fuel needs this year. But Southwest's fuel advantage is not permanent. Once its hedges expire, it may lose some of its fuel-cost lead over competitors.

The pioneering low-cost carrier has some other points in its favor. Southwest has a stronger balance sheet than most of its competitors. And a highly productive workforce enables Southwest to fly more aircraft at a lower cost than its peers.

Analysts expect Southwest to earn 27 cents a share this year. The company, which has been profitable for 68 quarters in a row, is one of the few airlines that are expected to make money in 2008.

It's unquestionably difficult to make money in airline stocks. But if there's one that's worth taking a flier on, it's Southwest.