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One Wall Street analyst reveals why Southwest could be the best airline play for investors looking to buy the dip (LUV)

FILE PHOTO: Air travelers wear face masks waiting to board a Southwest Airlines flight as the spread of coronavirus disease (COVID-19) continues, at Oakland International airport in Oakland, California, U.S., April 9, 2020.  REUTERS/Shannon Stapleton

  • Stifel upgraded Southwest Airlines to "Buy" from "Hold" this week, citing an opportunity as the airline begins to recover from the coronavirus crisis.
  • In a report, Stifel analyst Joseph DeNardi cited the airline's conservative balance sheet and strong liquidity, and the fact that the carrier still has plenty of unencumbered assets available.
  • The airline is "building a liquidity war chest to play offense, at some point," which will lead its stock to outperform competitors, the report predicts.
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Stifel, the investment bank and financial services firm, upgraded Southwest Airlines to "Buy" from "Hold" last week, following the airline's report that it lost $94 million in the first quarter.

Airlines around the world have already shed billions of dollars, and the International Air Transport Association has warned that carriers could lose $314 billion in passenger revenues globally this year.

As airline stocks tumble from their pre-crisis highs, investors have a potential opportunity to "ride the dip," or buy airline shares at lower prices for longer-term holdings.

It would be wise to proceed with caution, however. Airlines are taking on debt and issuing new shares to bolster their balance sheets for what is expected to be a prolonged downturn. This is happening as the specter of bankruptcies and consolidation looms large.

Southwest Airlines, however, is a safer option, according to analyst Joseph DeNardi in a research note.

The airline maintains a strong balance sheet, relatively speaking, but the stock has underperformed recently compared to airlines in similar positions, DeNardi said.

This "presents an attractive entry point as Southwest will, undoubtedly, emerge from this crisis in a stronger position than it entered," he wrote in the report, even if that recovery takes time. DeNardi noted that despite the difficulty of predicting the pace of demand recovery, historical evidence suggests that the overall air travel sector is one of the more resilient areas of the economy.

DeNardi also argued that each airline that survives the crisis — "undoubtedly" including Southwest — will emerge with stronger earnings power afterward, as other airlines consolidate and barriers to entry for newcomers increase.

Ultimately, there are a few reasons that DeNardi and Stifel suggest Southwest is a good buy right now.

Capital raises and a liquidity war chest

As it has sought liquidity to weather the COVID-19 pandemic and the corresponding drop in demand, Southwest has been aggressive while managing its balance sheet conservatively.

"Southwest is building a liquidity war chest to play offense, at some point, when certain of its peers will be
unable to do so," DeNardi wrote.

The airline has issued new shares and convertible bonds to raise cash, putting it in a position to take on less debt. While this dilution is a short-term drag, DeNardi wrote, "we believe the market is underappreciating the returns it can generate from that capital."

When the $4 billion sale is complete, Southwest expects to have about $13.5 billion in liquidity available, factoring in recent loans and support through the federal CARES Act. The airline will still have between $9 billion and $10 billion in unencumbered assets, including up to $8 billion worth of aircraft.

"That is, by far, the strongest liquidity position in the industry for a company which also has the strongest underlying balance sheet and the best leverage with its aircraft OEM when it comes to managing capex over the next few years," the Stifel report says.

"For an airline with an expected 2Q daily cash burn rate of $30-$35 million," it added, "Southwest has the liquidity and access to additional capital to outlast any of its peers."

"In what we see as a more likely scenario where demand begins to improve later this summer and Southwest ends up not needing all the capital it has raised, it's going to be able to start playing offense - aggressively - far sooner than its peers," DeNardi wrote. "If we know one thing about downturns in the airline industry, it's that opportunities are created - and Southwest will be one of a select few, and perhaps the only airline, with the financial wherewithal to execute."

The airline also stands to benefit from future earnings through its credit card partnership with JPMorgan Chase. The bank purchases frequent-flyer miles from Southwest, which it then distributes to its cardholders as spending rewards.

One potential source of liquidity for airlines is pre-selling those miles to banks. While it earns much-needed short-term cash, pre-sales typically happen at a large discount. DeNardi and Stifel believe that, since Southwest will be able to raise sufficient cash to survive, it will not need to tap this resource, which could lead to higher earning through mileage sales in the future, once the economic recovery begins to materialize.

Stifel upgraded the stock to "Buy" with a target price of $50 per share. Southwest closed at $29.23 on Friday.

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