Southwest Shares Are Tempting But Airline Stocks Usually Don’t Fly

Most of us sane adults have gotten the idea of investing in airline stocks out of our systems. It’s an industry that provides a fabulous service to its customers, but one that destroys gobs of capital and in some years has seemed to pay out most of its cash to bankruptcy lawyers.

Then along comes a wonderful acquisition – Southwest’s (LUV) agreement to buy AirTran (AAI) for about $1.4 billion in stock and cash – and one is tempted to think about owning some Southwest shares. On top of the purchase price, Southwest estimates one-time costs from combining the two companies at $300 million-to-$500 million. Let’s call it $400 million. So, owning AirTran costs Southwest $1.8 billion (aside from $2 billion in AirTran debt and airplane leases in assumes).

By 2013, however, Southwest expects synergies – a nice word for cost cuts and for extracting more money from customers – to reach $400 million a year. So, in this very crude calculation, AirTran pays for the acquisition price in 4.5 years, excluding financing costs.

And look: Southwest may not be trading at the cheapest-ever price, but it’s trading far below its highs. And earnings are on the upswing, thanks to an improving economy.

LUV Stock Chart

There are other reasons to like Southwest. It’s universally regarded as well-managed, in an industry known for basket cases. It hasn’t had to chisel its workers on wages and pensions, so they’re a relatively happy and productive lot. And though it’s almost 40 years old, Southwest was built to take advantage of the inefficiencies of American (AMR), United (UAUA) and Delta (DAL), and still does. Southwest remained profitable even when fuel prices spiked, thanks to brilliant hedging, and has launched a series of moves to raise revenue without charging to check a bag, which really irks people.

All that said, Southwest is a great company in a crummy industry. And while being smarter than the rest of the class ought to mean that one sets the curve, in airlines and some other industries, it’s hard to rise above the dullards. Southwest, for instance, essentially had to stop growing, even though it could take market share easily, because competitors respond with fare wars that trash profits. And with the bankruptcy laws and labor agreements that cover airlines, failed companies don’t go away, they just keep coming back.

McDonald’s (MCD), another well-run company surrounded by sloppy sandwich makers, also slowed its growth to improve returns. But its customers are freer to choose than Southwest’s – many airline routes are dominated by one or two carriers; a wide range of fast food is available ubiquitously in all its glory – and McDonald’s returns improved dramatically.

LUV, MCD Chart

Southwest ain’t cheap.

LUV Stock Chart

And its margins are thin. One would expect greater rewards in a business so hard to manage and with such huge risks, such as fuel prices. In all of 2009, on revenue of $10.4 billion, Southwest had net income of just $99 million, or 13 cents a diluted share. The first six months of 2010 were better — $112 million in net, or 15 cents a share. But it doesn’t seem like much for flying all those planes around.

LUV Stock Chart

Southwest will probably do a great job of absorbing AirTran. It will expand low-cost routes available through Atlanta, home to AirTran (and Delta). It will manage fuel-price risk with hedging better than the competition. But don’t count on it being a great investment. Over the long run, airlines just aren’t.

Disclosure: No Positions

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