Southwest Airlines Co. (NYSE: LUV) has not been doing well as a stock.  Over the last two years its stock has lost nearly one-third of its value.  Even over the last 5-year period, its stock has recently put in new lows.  In the past we noted how many of the issues in the sector were out of context relative to other airlines.  But in today’s environment the situation looks like it has reversed.  If passengers think they are unhappy with major airlines now, wait until they get to deal with all the problems when two majors merge into one structure.

If you believe that oil is the largest wild card for airlines, you’ll scratch your head when you consider that Southwest had the best fuel cost structure of any large airline operator out there.  The company decided to enter major counterparty fuel hedge transactions back when oil prices were so low that oil was cheaper than water.  That strategy worked as the uncertainty was making the entire sector look at risk of failure and when all of the others had to get a government handout.

If you look at the hedging strategy below you might determine that fuel hedging acts a de-leveraging mechanism that investors don’t prefer.  If you compare the hedging structure from this year to last year, you will see some slight differences.  Here is the hedge structure noted in their annual report:

• 2008 over 70% at $51 per barrel;
• 2009 55% at $51 per barrel;
• 2010 30% at $63 per barrel;
• 2011 over 15% at $64 per barrel;
• 2012 over 15% at $63 per barrel.

If you will take note, this is slightly different than the fuel hedges we noted from the same period last year.  If you wanted to draw a parallel it would probably be assumed that as the fuel gets used and as the capacity rises slightly the cost basis ends up being higher because of the current oil/barrel prices.  Here were the prices noted in early 2007 for the forward years:

• 2007 was 95% hedged at $50/barrel;
• 2008 was 65% hedged at $49/barrel;
• 2009 was over 50% hedged at $51/barrel;
• 2010 was over 25% hedged at $63/barrel;
• 2011 was over is 15% hedged at $64/barrel;
• 2012 was 15% hedged at $63/barrel.

This is more than surprising when you consider the cost structure of the other airlines. Over the last 5-years Southwest as a stock has underperformed the major airlines that didn’t file for credit protection.  It looks like Continental (NYSE: CAL) is up some 200% and AMR (NYSE: AMR) is up much more than that.  On the discount side, Airtran (NYSE: AAI) has outperformed as a stock, but JetBlue (NASDAQ: JBLU) lost its way and is down sharply. It is also the belief of Wall Street that as the top 5 or 6 airlines merge into perhaps the top 2 or 3, Southwest will remain an independent carrier in the mix.  We had noted how the discount airline wasn’t such a discount to other carriers anymore, yet that may actually be a good thing in today’s airline environment.

Can we determine that Wall Street is discounting the results two years out as the fuel hedges dwindle?  That is nonsense.  If you have watched housing or financial stocks over the last six months you will know that Wall Street has lost its ability to price in any forward events and that traders are only reacting to each new round of news headlines.  It’s almost amazing how the airline with the best cost structure, the smartest in foreseeing fuel price escalation,  perhaps the best employee relations in the sector, the safest track record, and one of the best brand loyalties hasn’t translated into a win for investors compared to other airlines.  It seems that no good deed goes unpunished.

Jon C. Ogg
February 5, 2008

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