Southwest Airlines: Experiencing Turbulence

Every budget traveler has been there. Queued up at the gate, waiting for the flight attendant to call your letter. Passengers asking you if they are in the right line, others trying to cut in. If you're lucky enough to have an "A" on your ticket, you get the run of the whole plane. Take a window seat or plop down in a chair with some extra leg room by the aisle. If you are among the poor unfortunates in the "C" group, expect to be wedged in a middle seat between two obese passengers or left with a spot in the stinky row of seats next to the lavatory in the rear of the plane. Cruel, efficient and profitable -- we all know the cattle call at Southwest Airlines.

Complain about the no-frills service if you must, but Southwest is the best-run airline in the business. The ruthless boarding procedures allow Southwest employees to turn planes around faster, which translates into more flights per day than their competitors. While its rivals wallow in red ink, battle with bankruptcy court or issue a "passenger bill of rights," Dallas-based Southwest squeezes out profits year after year, even during the industry's turbulent patch after the September 11 terrorist attacks.

But for the past seven months, Southwest shares have lagged as the stocks of its financially inferior competitors have rallied. These so-called legacy airlines are saddled with hefty pension costs, overlapping routes and Byzantine bureaucracies. Yet the market has rewarded their investors while more or less ignoring Southwest's. Shares of AMR Corp. (symbol AMR), parent of American Airlines, Continental Airlines (CAL) and UAL (UAUA), parent of United Airlines, have soared 75% to 80% from their August lows. Meanwhile, Southwest (LUV) has fallen 7% in that period. Speculation about industry consolidation and lower fuel prices may have contributed to an outbreak of irrational airline optimism.

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Market sentiment has beaten down Southwest shares to bargain prices, says Prudential analyst Bob McAdoo. He upgraded the stock to "overweight" from "neutral" on March 1. McAdoo points out that the stock, which closed at $15.20 on March 2, has historically traded at about 20 times earnings but is now selling at about 15 times his 2007 earnings estimate of $1.01 per share.

Greater market share in Florida bodes well for the airline, McAdoo predicts. As a result, he says, Southwest will report earnings in the second quarter better than what most analysts expect. He estimates that the airline will earn 41 cents in the quarter, versus the average analyst estimate of 34 cents.

McAdoo's arguments are reasonable, but the airline industry does not have a history of rational behavior. Since 1947, the industry as a whole has racked up an estimated $14 billion in net losses, according to the Air Transport Association, a trade group.

Plus, airline stocks have disappointed investors for decades. Even Warren Buffett has sworn off airline stocks, after making an ill-fated investment in US Air in the 1990s. Earnings of airline stocks are notoriously difficult to predict because analysts have to forecast business-travel spending, fuel-price volatility, labor disruptions, bankruptcies and terrorism risk. A foiled terrorism plot by British authorities sparked a sell-off of airline stocks in August. Next week, a spike in fuel prices could cause a similar result. It's hard for investors to know with a great degree of confidence.

Traders can profit from sharp moves in airline stocks, but buy-and-hold investors are better off putting their money elsewhere. McAdoo may be right about Southwest shares, but it's a trip you don't want to take over the long haul.