Southwest Airlines (NYSE: LUV) continues to defy expectations. Driven by operational excellence and better-than-expected results, the company's stock has rocketed nearly 90% in the past year, trumping the stocks of other publicly traded airlines and absolutely crushing the S&P 500's 11% rise. After such a significant gain, it's a good time to set aside any noise and look at Southwest's business performance in relation to its market capitalization to see whether it's time for investors to take their gains or if the stock is still worth holding on to.
A growing company
Upon examining Southwest's underlying business, it's no wonder shares have climbed higher in recent years. Measured by almost any key metric, Southwest's business is trending upward, too. Consider Southwest's three-, five-, and 10-year compound average growth rates, or CAGR, for these key metrics:
Southwest Metric | 3-Year CAGR | 5-Year CAGR | 10-Year CAGR |
|---|---|---|---|
Revenue | 5.9% | 12.4% | 11% |
Operating Income | 47.5% | 53.4% | 14.9% |
Net Income | 85.5% | 62.9% | 13.8% |
EPS | 92.5% | 66% | 15.8% |
While Southwest's three- and five-year CAGRs are particularly impressive, it's worth noting that -- since airline operating results are negatively affected by recessions -- Southwest's 10-year CAGR is probably the most useful time frame of the three mentioned in judging past performance since it includes the 2008 and 2009 recession.
It's clear that Southwest's business is growing. But what can investors expect going forward? Sensibly, the average analyst estimate forecasts Southwest's EPS growth in the next five years to slow from recent three- and five-year CAGRs but to exceed 10-year growth. The consensus analyst estimate for CAGR earnings per share over the five years is an impressive 29%.
Significant free cash flow
Further evidence of Southwest management's effectiveness: The company's free cash flow, or the cash from operations minus capital expenditures, is typically meaningful -- especially in recent years. In fact, for two years in a row, Southwest's free cash flow was higher than net income. Furthermore, as a percentage of sales, Southwest's free cash flow was 6.2% in 2014 -- not bad for a company in such a competitive industry.
What about valuation? Looking at Southwest's stock price relative to its free cash flow, and considering the company's historical ability to grow its business, the valuation is still reasonable. The company's recent growth and sustained operational excellence easily justify its price-to-free cash flow ratio of 25.9. Relative to earnings, the company looks a bit pricier: Southwest trades at a price-to-earnings ratio of 27. But even this isn't bad for a proven industry leader with continued growth prospects.
What growth, exactly, is assumed by the market at Southwest's valuation today? For investors to realize a reasonable 10% annualized return over the long haul, Southwest will need to grow free cash flow by about 12% annually for the next 10 years and by 3% (in line with historical rates of inflation) beyond year 10 and into perpetuity. While free cash flow is bound to be volatile on a year-to-year basis given the cyclicality of airlines, such expectations seem realistic as an average expected growth rate in the long-term.
Southwest certainly doesn't look like the no-brainer buy it may have appeared to be a year ago, but management's consistent ability to execute paired with a reasonable valuation justify holding the stock.
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Daniel Sparks has no position in any stocks mentioned.
Source: southwest - Google News http://ift.tt/1EFdZSq
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