Why This Analyst Thinks Southwest Offers Great Upside and Value

Argus maintained its Buy rating for Southwest but lowered its price target to $45 from $56. The reasoning behind this is that Southwest is taking steps to increase revenue and lower costs. However, management recently said that it expects revenues for the second quarter to be down 4% to 5% compared to last year due to a decline in revenue passenger yield and a difficult year-over-year comparison, among other factors.

In 2014, Southwest added to its fleet of 737-800s and preowned Boeing-700 aircraft. At the same time it retired older 737s and AirTran 717-200s. The company is also offering satellite-based Wi-Fi, live television and on-demand movies on both its 737-800s and 737-700s.

Southwest has taken a number of actions to increase available flights. The company recently acquired 12 gate slots at New York’s LaGuardia airport and became the permanent owner of 10 previously operated slots. The company was also the winning bidder for 27 pairs of slots at Washington’s Reagan airport and, beginning in December 2014, had 44 flights departing daily.

To increase ancillary revenue, Southwest plans to sell select boarding positions, raise existing fees and avoid fare wars. Based on current booking and revenue trends, management expects passenger revenue per available seat mile (PRASM) to increase throughout 2015.

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In terms of returning cash to shareholders: Southwest is the first low-cost carrier to pay a dividend. In 2014, it paid $139 million in dividends and repurchased $955 million of its common stock. In a nod to shareholders, management recently boosted its dividend 25% to an annual payout of $0.30 per share.

Argus gave its valuation for Southwest as:

We believe that LUV shares are attractively valued at current prices near $35. The shares are trading slightly below the midpoint of their 52-week range of $25.47-$47.17. From a technical perspective, the shares had been in a bullish pattern of higher highs and higher lows since October 2012. However, they have been in a bearish pattern recently due to a selloff in the airline sector.

The independent research firm concluded:

To value the stock on a fundamental basis, we use a peer and multiple comparison model. LUV shares are trading at 9.9-times our FY15 estimate, below the low end of the historical range of 10-75 and the peer average of 16.3. However, on a price/ sales basis, they are trading at a multiple of 1.3, above the midpoint of the five-year range of 0.6-1.7 and the peer average of 1.1.

The forward yield of 0.8% is above the high end of the five-year range of 0.13%-0.7%, but below the peer average. Low-fare carriers such as Southwest tend to trade at higher multiples than legacy carriers, reflecting their rapid growth and higher margins. As such, we believe that Southwest shares are attractively valued at current prices near $35. We are lowering our target price to $45 from $56.

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Shares of Southwest closed trading at $35.00 on Friday. The stock has a consensus analyst price target of $49.82 and a 52-week trading range of $25.68 to $47.17.

Over the past quarter, shares have underperformed, declining 23% while the S&P has gained 2%. Over the past year, the shares have outperformed, rising 34% versus a 9% gain for the index.