Welcome to part two of our little Southwest Airline adventure. If you missed the first part, you’ll want to go back and start there. Today we’re going to go through a Next Level Valuation for Southwest Airlines.
Here’s what we’ll learn today:
Can I understand this business (Meaning)
What’s Southwest’s competitive advantage? (Moat)
Do we like the current management?
And in Part 3
What our Next Level Margin of safety price for LUV
What price did Pabrai pay to buy into Southwest?
Conclusion: is Southwest a great company
Do I understand Southwest’s business?
As always, this is the first question we need to ask ourselves before we do anything else. Am I capable of understanding this business? This is Warren Buffett’s first step when he’s looking to invest in any business, and it’s our first step as well.
We already went through a lot of what Southwest does as a company in the last post.
But here’s a few other tidbits for you keeners. Southwest’s business model could be summed up like this:
Low Fares, Lower Costs, High Volumes, Lots of Fun.
Their goal has been to focus on local short haul travelers, and to make flights cheap enough to attract people who would have otherwise driven to their destinations. This has been their basic business model almost since their inception. They come into a new market, undercut competitors prices (sometimes substantially) and create an excellent customer experience, so that people keep coming back.
Here’s what Herb has to say on the subject:
“If you get your passengers to their destinations when they want to get there, on time, at the lowest possible fares, and make darn sure they have a good time doing it, people will fly your airline.”
Amen to that Mr. Kelleher. I went down the rabbit hole of watching youtube videos of flight attendants for Southwest, and they sure do seem to be having fun. People are laughing, clapping, and seem to be enjoying themselves quite a bit. Keep in mind, this is all taking place on a cramped flight with complete strangers. That’s pretty special. People tend to remember when you go the extra mile. I think Southwest really tries to do that.
One of Herb Kelleher's main goals for Southwest is to reach the untapped market of individuals who don't fly due to two main reasons:
They couldn't afford to
No convenient short flights available
This is exactly the market LUV is looking to enter. The zero in on a good potential market place, lower fares, and attract those people who normally wouldn’t have flown. Then they continue to add more and more flights so that everyone has a convenient time to fly ticking off most people's original problems with flying. This also has the effect of forcing other airlines to lower their fees in order to compete.
Because of these factors, some cities see increases in traffic growth of an incredible 300%-500%. This has quite literally been coined as the ‘Southwest Effect’. Pretty neat right?
This strategy also inevitably leads to Southwest grabbing a large chunk of the market share. They are usually either the largest or second largest in the markets they enter in terms of customers served. Serving such a large number of customers allows them to spread the fixed costs of operations, leading to decreased costs per customer. This affords them the opportunity to lower prices and still remain profitable. These lower prices, convenient flight times, and emphasis on fun, creates customer loyalty.
Southwest also has developed a ‘Point-to-Point’ flight strategy, rather than the traditional ‘Point-to-Hub’ strategy that most other airlines use. This decreases the amount of connecting flights, and increases direct flights which decreases the amount of delays and total trip times for it’s passengers. It also decentralizes any potential problems that could occur when you have to rely on a specific Hub to route your flights through which again, decreases the number problems that Southwest has to deal with.
Their focus on costs also carries over into other aspects of their business. Specifically the type of planes they buy. They only buy one type of plane; a Boeing 737. Doing this has multiple cost and safety benefits. It simplifies:
Scheduling
Maintenance
Operations and,
Training
The safety benefits can be seen in the experience each pilot and staff member accrues by only having to familiarize themselves with one plane.
The last business strategy that I’ll mention here is there 25 minute plane turnaround philosophy. This plan dictates that any plane that is in-service can only be stationary for a 25 minute period. This again allows them to service more customers and lower costs per customer. They in fact still maintain a healthy cost per customer. In the Airline industry, this is represented by the unit cost per available seat mile, or ASM (Which is basically the passenger capacity calculated by seats available x the miles flown).
Here’s what they look like compared to their main competitors:
As you can see, they enjoy much lower costs than the direct competition. That’s what we like to see.
I think we are really beginning to understand this business. What we’d want to do from here is continue to learn as much as we can about this company by reading the companies annual reports and quarterly reports (10K’s and 10Q’s).
Side note: If You’re having a difficult time staying motivated on the research side of things, you can always put a little ‘skin in the game’ to keep you motivated. This always helps me dig deeper in the business. Having your own money at stake is a real kick in the butt to keep you moving. Just don’t dive in head first (Don’t invest your total allocation). Also, make sure everything you’re preliminary analysis on a company comes back positive, and the business appears to be on sale based on your Next Level Analysis.
Southwest’s competitive advantage
The first thing I think about when I ask myself ‘does Southwest Airlines have a Moat?’ (An always important question) is its culture. Southwest has always had the philosophy of Employee first, Passenger second, and Shareholders third. I’m of the opinion that as long as they do an amazing job on the first two, The stock price will take care of itself. This is exactly what has happened since the company went public, compounding their business growth by an amazing 16% per year. That gives us a big hint that they probably have some sort of competitive advantage helping protect them from attacks. And attacked they certainly have been.
Back in the early days of Southwest (1973) a competitor decided to drop their flights below that of Southwest to try and destroy them as a company. Southwest had a novel idea, instead of lowering their price to that of their competitors, instead they offered a bottle of whiskey for every passenger that paid the full price airfare ticket. What happened you ask? Well, for two months, Southwest became the largest distributor of whiskey in all of Texas!
Brand Moat
I believe that one of the biggest moats that Southwest has managed to create, centers around them as a brand. When you think about Southwest Airlines, what first comes to mind? For me it’s Fun, and cheap. It has taken them years to develop this brand. And even longer to develop the loyalty that surround it. For something that is very much like a commodity, I think Southwest has managed to stand out from the crowd with their;
Fun, Helpful, & do anything to help attitude that makes them something special.
There's a story from Herb Kelleher talking about how Southwest Airlines has developed its culture over time. He specifically mentions a new employee that took customer Service to the Next level. I have it cued up, take a quick listen:
Pretty awesome right? If you listen to that entire five minute video, you begin to understand the brand that is Southwest Airlines. As long as they can keep going the same direction, I think this is a pretty powerful competitive advantage.
Low-cost producer
Southwest also has a very strong focus on keeping their costs down and their profitability up. Herb kelleher said to his employees that ‘if anyone mentioned market share to him, he’ll punch them in the nose’ he said this because he noticed all the other airlines focus was on market share. What he said they had to focus on was profitability, not market share. He said ‘I would rather have a 5% market share and be profitable, rather than have a 90% market share and be unprofitable’. They do this by focusing on ‘good costs’ vs ‘bad costs’, and eliminating as many ‘bad costs’ as possible. This has helped them to maintain profitability for the last 44 years.
In fact, by focusing on remaining profitable, Southwest have never had to furlough an employee during their existence in an industry that has to do so, all the time. Here’s what Herb Kelleher had to say on the subject:
“We may be flamboyant from a marketing standpoint, but we’re going to be very conservative from the fiscal standpoint”
This is definitely one of the most important factors that protects Southwest from losing it’s edge. They have remained extremely disciplined in their expansion strategy, only entering markets where they believe they can implement their fundamental strategies.
“We’d like to have some cushion because there will be bad times and our strong balance sheet has served us very well,” he said. “The balance sheet strength is one of those shock absorbers that has really helped us in bad times.”
Gary Kelly
Kelly, who is the current CEO of Southwest continues by saying:
“The plan is to manage Southwest under the assumption that there will be very difficult times again.” “I’ve heard comments about things are different now,” he said. “Maybe. But we’re going to make sure that Southwest is very well-positioned to weather the storm.”
I Like the talk from the current management so far, and as long as they don’t over-reach, I believe Southwest still has plenty of room to grow and remain profitable. Speaking of which, let’s move onto that next topic...
Management
This is perhaps the most difficult area to investigate because it can be so subjective. What we can do is read and watch as much as we can on the individual running the business and get as good of a picture of who they are as a person as is possible. I’ve been burnt badly by management in the past. I now tread much more carefully before making any concrete decision
Side Note: You often won’t be able to know if the management team has ‘true integrity’ until their backs are against a wall. One way avoid this is by disciplining yourself to only invest in companies that have low amounts of debt (less than 3 years of earnings). This way, you don’t have to find out how they will act if they get put into an extremely difficult position. Remember, Debt kills.
We already know that Herb Kelleher is a legendary leader, and has acted extremely favorable when his back was against the wall, but what of his successor…
As you may already know, Herb retired in 2001. James Parker filled the role until 2004, and that’s when the current CEO, Gary Kelly took over. Gary was promoted from within the company, (Which is something I always like to see) first joining Southwest in 1986 as a controller. In 1989, Gary was promoted to Chief Financial Officer and Vice President of Finance. Next, in 2001, Gary was promoted to Executive Vice President, where he stayed for three years until succeeding Parker as CEO.
By all metrics it appears that we may have found another great leader in Gary Kelly. He was named one of the best CEO’s in America in 2008, 2009, and 2010. In 2016 he was the recipient of the Tony Jannus Award for distinguished achievement in commercial air transportation. Here’s Gary Kelly talking about Leadership. (If this business is starting to interest you, this will be required watching)
That’s all I have for you all today,
What do you think so far? looking promising right?
well the next part we’ll have to find out if it’s a good time to invest in this potentially Next Level Business. Until then, have a great week.
We’ll talk again soon,
~Ryan~
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