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What Boeing Exclusivity Means for Southwest These Days

Adam Levine-Weinberg, The Motley Fool

When half a duopoly has its most popular product nixed, the ripples reach far. In this episode of Industry Focus: Energy, host Nick Sciple and Fool.com contributor Adam Levine-Weinberg explore how the 737 Max 8 grounding is affecting Southwest (NYSE: LUV), which gets the vast majority of its planes from Boeing (NYSE: BA). Just how much will this hurt Southwest? How long until these headwinds clear? Why would Southwest only have Boeing planes in the first place?

It's not all bad news for Southwest these days, though. The pair also break down Southwest's push into Hawaii -- an exciting, if competitive, new marketplace for the discount carrier.

A full transcript follows the video.

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This video was recorded on April 4, 2019.

Nick Sciple: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today's Thursday, April 4th, and we're talking Southwest Airlines. I'm your host, Nick Sciple, and today, I'm joined by Motley Fool contributor Adam Levine-Weinberg via Skype. How are you doing, Adam?

Adam Levine-Weinberg: Good! How are you?

Sciple: I'm doing great, Adam! This is my first show that I've done with you. We're going to be talking about Southwest Airlines. I know you love talking about airlines stocks. Great to have you on today!

As much we're going to be talking about Southwest Airlines, as most of our listeners know, the air travel industry has been all over the news particularly over the past month in the aftermath of the second Boeing 737 crash back in March. As the largest 737 operator in the world, with dozens of 737 Max airplanes in its fleet, Southwest has been particularly affected by the shutdown of the 737 Max.

Before we dive into Southwest, though, Adam, what's the current status of the 737 Max investigation and aftermath, just a little over a month after this first crash? What do we know about the follow-up to the crash today? 

Levine-Weinberg: Obviously, it's still a very fluid situation. What we know so far is, Boeing when it was trying to [...] make it as close to the previous generations of this 737 as possible. It did that by trying to make as few changes as possible. But one change that it had to make was put new engines on the plane, because that's where it's getting a lot of the fuel efficiency benefits on the 737 Max. Now, the new engines are quite a bit larger, which meant that you had to change the placement of them. As a result, Boeing found that the new version of the 737 Max was more prone to a stall, which is basically when the plane is not going fast enough relative to the angle that it's facing. A stall is very dangerous and can lead to a crash because it's hard to pull out of that situation. So Boeing put software on the plane that was supposed to avoid this problem by aggressively tilting the nose down on airplanes when there was a sensor that was showing that the nose was pointed too far up. If you just imagine how much power a plane needs to climb, it's more than if it's in level flight or if it's in a descent. The idea was, you'd get the plane going faster pointing the nose down. 

The problem has been that the sensor doesn't always give a correct reading for one reason or another. That caused a Lion Air plane to crash in late October. After that happened, Boeing provided some updates to pilots, reminding them of how the system is supposed to work and what they would need to do to disable this automatic system if necessary. They thought that the problem was basically fixed at that point. Then, in March, we had this second crash by Ethiopian Airlines. A very similar situation with a 737 Max 8 crashing just a few minutes after takeoff. That's brought a lot of scrutiny on Boeing, and it ultimately caused a bunch of aviation authorities around the world to ground the 737 Max until a definitive solution's been found, which is going to involve some software changes, as well as additional sensors on the plane to help pilots understand whether their sensors are functioning properly. 

Sciple: Sure. Adam, as you mentioned, Boeing had introduced after the first crash some procedures that pilots should follow if you had an issue with this anti-stall device. What we're seeing from the early reports out of the investigation of this Ethiopian Airlines crash is that those pilots actually had followed those procedures. So that, again, is additionally concerning. Boeing needs to go revisit how to handle the software. Do we have any idea, or is it just developing, how long this uncertainty around the Max may play out? Or is it just wait-and-see at this point?

Levine-Weinberg: Boeing actually did a test flight just this week, with the new software changes that it's proposed. It's definitely going to be a somewhat slow process. Boeing still needs to verify all the data, make sure that the fixes that it's planning are going to work. Once it's done that, then it gets handed off to the FAA and to other aviation safety regulating organizations around the world. Given the scrutiny that both Boeing and the aviation safety community is under right now, I think it's fair to expect at least a month, maybe two months of testing. And then, if all goes well, at that point, you could see the FAA and other countries start to lift the grounding of the Boeing 737 Max. 

Sciple: Sure. So, obviously, with the grounding of the Max looking to be prolonging at least for the coming weeks, maybe a couple of months, airlines that operate this aircraft are going to be in a state of flux moving forward. Southwest, as we mentioned off the top of the show, is one of the airlines that is most particularly exposed to the 737 Max grounding. In relation to that, just last week, the company cut its first-quarter guidance partially related to those issues. Adam, can you give us any of the details, what was behind that guidance cut, and what Southwest management is telling us about what's going on with the company right now? 

Levine-Weinberg: Southwest is the biggest 737 operator in the world. It's got more than 750 Boeing 737s in its fleet. Right now, most of those are the older generation of Boeing 737, which was built between 1997 up until this year. But Southwest does have a 34 737 Max 8s in its fleet. It's between 4% and 5% of its total aircraft fleet, which is definitely significant. The airline has some flexibility to get by with having a few aircrafts out of service. But with 34 aircrafts out of service for that long, there's no way for the airline to run the full schedule that it had intended to be flying during the spring. 

When you have a big grounding like that, you have less capacity, but the costs are somewhat fixed, so that definitely puts pressure on profitability. On top of that, Southwest has had to put these aircraft into storage to make sure that nothing happens to them to impact their airworthiness. So, while not very expensive, that does costs something to keep those aircraft parked in the desert for several months at least. 

If you look at the guidance, Southwest lowered its unit revenue guidance because of the grounding. The main reason here is that it's had to cancel so many flights over the past month or so. The problem for Southwest was that it was already facing a pretty big spike in cancellations, both because of some bad winter weather in February and into March, as well as a dispute with its maintenance workers that spilled out into the open in February. It led to a lot of cancellations, as maintenance workers seemed to be writing up more tickets for items that needed to be addressed than usual, which meant they had to pull more planes out of service. Between those three items -- the bad weather, the maintenance cancellations, and now the 737 Max groundings -- Southwest Airlines canceled 9,400 flights between mid-February and the end of March. That's compared to about 4,000 flights a day. It's like losing more than two days of service over the course of a month and a half. 

So that's caused a pretty big revenue impact. I think the company said it was going to be about $150 million for the first quarter. It's also caused some cost increases. As a result, the estimates of Southwest's profitability for the first quarter had to come down quite a bit. 

Sciple: Sure, Adam. As we see the first-quarter profitability coming down, you mentioned the costs are going to remain fixed for keeping these airplanes as part of your fleet, even though they can't fly. These profits are going to be lost for Southwest. Obviously, you can't fly these flights that have been canceled. But outside of this near-term impact, that they're not going to be able to fly these flights, they're going to take some near-term expenses, does this affect Southwest's long-term plans for how they're putting together their fleet moving forward when it comes to the 737, or when it comes to continued investment in its business? Is this going to be a single-quarter problem? Or are we going to see the impacts of this grounding play out over several quarters into Southwest's business? 

Levine-Weinberg: That's a great question. It's hard to know at this point. What we can say is that Southwest Airlines definitely relies on the Boeing 737. That's the only plane that Southwest has ever flown in nearly 50 years of service. It's a type of plane that Southwest is very comfortable with. It's very much committed to it. Southwest has more than 200 orders for the 737 Max, 41 coming actually just this year, and hundreds coming over the next seven years or so. It's likely to order even more beyond that. For Southwest Airlines, the cost savings of operating a single fleet type are really quite substantial. The CEO, Gary Kelly, has made it pretty clear that while he's in charge, he doesn't see any chance of Southwest even trying a different type of plane in its fleet. 

So the question then is, how long does the 737 Max stay grounded? It probably is a two, maybe three-quarter event. It's really hard to know for sure because safety comes first. The planes aren't getting back in the air until the regulators are very satisfied that it's going to be safe to fly. I think it's reasonable to expect that most likely around the summertime is when the 737 Max fleet would likely be back in service. I would think that any financial headwinds at Southwest are likely to calm down pretty quickly starting at that point. 

Sciple: Sure. It's something that's going to be touch-and-go for management as we see how regulators handle this latest crash and the developments moving forward. As you mentioned, to date, operating off of one aircraft has really been a huge advantage to Southwest. All their pilots know how to fly every aircraft craft in the fleet. That gives them lots of flexibility. But as you mentioned, when something like this happens that's particular to one model of aircraft, it also gives them outsized exposure there. 

I tell you, for me as an investor, I'll take those upsides in the good times for the rare occurrences like this. How often do you see a plane crash these days? It's really such a safe way to travel. I think Southwest's 737 strategy is going to continue to be advantageous for them moving forward, despite this near-term headwind. What do you think about that, Adam? 

Levine-Weinberg: Yeah, I definitely agree. It's certainly a calculated risk to rely on a single fleet type. But it's definitely a strategy that Southwest was the pioneer of. It wasn't so common back in the '70s, when Southwest started doing this. Now it's really common, and it's been quite successful. Obviously, airlines that have a single fleet type and only use Airbus A320s are in great shape because they have no impact whatsoever. There's obviously going to be some risk no matter what you choose to do. Operating with a single fleet type tends to be the better solution for airlines that have a simple network. Obviously, for an airline like American Airlines, which is flying all around the world, one single plane is not going to be the right type to both fly from New York to London and also to fly from Chicago to Ithaca, or something like that. For airlines like Southwest, that have a simple business model, it's really powerful to have just the single type of plane. 

The bigger question maybe in the future is, is it worth it to be the launch operator for a new aircraft type as Southwest was with the 737 Max? The answer is probably still yes. New planes have more of a tendency for things to go wrong. But there's a reason why large, highly profitable, stable airlines like Southwest are typically chosen to be the first to get the planes. They can absorb the financial hit. They get compensated for that by getting very big discounts on getting the new planes compared to your typical smaller airline that might be getting the plane a little later on. 

Sciple: Sure, yeah. The 737 Max story and its effects on Southwest for any shareholder in Southwest or someone thinking about investing, definitely going to be a story to continue to follow. Thanks so much, Adam, for laying it out!

OK, Adam, we spent the first half of the show breaking down the 737 Max and its effects on Southwest. But believe it or not, there's other things going on with airlines right now, specifically with Southwest. Southwest announced that it's going to expand its routes by adding flights to Hawaii. What do these new routes mean for the company? What do we know about what Southwest is doing with these routes today? 

Levine-Weinberg: There's been a lot of speculation about Southwest Airlines flying to Hawaii for many, many years. Southwest first confirmed the speculation in October of 2017. At that point, it said that it was planning to start flights to Hawaii from California. It didn't provide much further detail beyond that. 

Now, in order to fly to Hawaii, it's about a 2,500-mile flight from the West Coast. Southwest doesn't have routes that are that far from other airports right now. That requires an additional certification for its planes, certify them to be able to fly more than an hour and a half from a diversion airport. Southwest had to work through that process, which typically takes at least a year. 

It finally got toward the end of the ETOPS certification process in late 2018, then the government shutdown hit. Southwest thought it was about to be able to begin ticket sales, and then it had a five-week delay in being able to complete its testing process. Once the government reopened in late January, and the FAA got back to work, Southwest Airlines finished the process, got its certifications, launched some test flights, then had a big sale in early March to start filling up its first flights to Hawaii. 

The first flight went from Oakland to Honolulu on March 17th. Over the next several months or so, Southwest Airlines is going to be adding additional routes from Oakland to Maui, from San Jose to Honolulu and Maui, and then also some inter-island routes within Hawaii. At some point in the future that hasn't been set yet, Southwest also plans to add some additional routes in the mainland, particularly from San Diego and Sacramento into Hawaii. 

Sciple: Adam, we're really talking in two buckets when we're talking about Hawaii. I want to break this apart, how the economics work and how Southwest is thinking about them. You have this long-leg flight from California to Hawaii. There are several competitors in that market today. Hawaiian Airlines is the biggest one. Then, you have these inter-island flights, hopping from island to island. To date, Hawaiian Airlines has basically had a monopoly on those flights. The Southwest will be one of the first competitors to go in. When we look at the opportunity for Southwest in these flights to Hawaii, both the long-haul route from the mainland as well as these inter-island flights, how should we think about that opportunity for Southwest? How big can that opportunity be for them over time, and how much might it affect their business? 

Levine-Weinberg: If we start with the overseas flights from the West Coast to Hawaii, there's definitely a few big advantages for Southwest in flying to Hawaii. The first is that Southwest has a huge built-in customer base throughout the United States, particularly on the West Coast. It's the top airline in California, has more flights within the state of California than any other carrier. There are already a lot of customers that fly Southwest frequently in California. Many of these people are already going to Hawaii. Up until now, they've had to go with a different airline. That's a clear opportunity to win that business and to better serve those travelers. 

A second related issue is that a lot of people will sign up for Southwest Airlines' credit card, which is quite lucrative to the company, if they know they can use the rewards points for an experience that they are looking for -- like being able to fly to a really trendy destination like Hawaii. That could certainly help Southwest Airlines by getting more people to sign up for that rewards credit card, using it to accumulate points, and then eventually use the points for a Southwest Airlines flight to Hawaii. 

It's also, frankly, a very big market, the West Coast-Hawaii travel market. There are dozens and dozens and dozens of flights a day from many different cities on the West Coast on many different airlines to Hawaii. Southwest Airlines is definitely looking to grow, so this is a really great opportunity to put a lot of additional airplanes to work. 

Looking now into the inter-island market, as you mentioned, it's really a Hawaiian Airlines monopoly right now. That hasn't always been the case. There have been competitors in the past. But Hawaiian Airlines has essentially chased them out of the market. So, the other question is, whether Southwest Airlines, being a national carrier, having a low cost structure, and then offering them these goodies like free checked bags, open seating policy, also having no change fees, is the combination of those features and low prices enough to get customers to switch their loyalty and start flying Southwest rather than Hawaiian Airlines within the state of Hawaii? We'll just have to see whether that works. It's certainly been a type of business that's been successful for Southwest. The airline actually started with very short-haul flights within the state of Texas between Austin, Dallas, and Houston. So it's pretty similar, actually, to be flying between the different islands in Hawaii. They're short distances, but there's a lot of people traveling. So it's an area where Southwest Airlines could have success. 

But if you look at Hawaiian Airlines' position in Hawaii, the carrier has between 180 and 200 daily flights between the islands. It's really a very substantial presence. On some of these routes, Hawaiian Airlines is flying 20 or even more than 25 times a day. That could be a flight every half hour. Whereas Southwest Airlines can't get started with quite so many flights. That'll just be a question of whether the additional schedule flexibility that Hawaiian Airlines has, is that a competitive advantage that Southwest Airlines can overcome? Or, are people willing to be more flexible on what time they travel in order to get a lower fare or get free checked bags or something of that sort?

If you look at the West Coast-to-Hawaii market, the risks are a little bit different. In that market, it's much more competitive than flying within Hawaii. There are already five airlines that fly frequently between the West Coast and Hawaii. So, the fares really aren't that high even before Southwest has come to the market. While consumers certainly expect lower prices with Southwest Airlines being a factor, it may not actually have as much room to undercut other airlines as it has had in some other markets it's entered, where the prices were higher to start out with. 

Southwest also doesn't have the same amenities as other airlines. It doesn't have extra-legroom seats. It doesn't even serve meals on its flights, which could be a disadvantage for people when they're flying five or six hours. Hawaiian Airlines, for example, actually still offers free meals and coach, which is really quite a rarity in the airline industry today. 

Sciple: Yeah. Really good job, Adam, laying out the competitive dynamics there as we look. In Hawaii, the advantage that Southwest is going to be looking for is on price, vs. Hawaiian Airlines is going to have the advantage when it comes to convenience, more flights more often. Again, likewise on that long-haul route, Southwest is going to be competing on price again. But if you're a traveler who wants to have the five-star vacation, fly first class both ways, and get the luxury treatment, Southwest is probably not going to win that customer. But as Southwest moves into this more vacation-oriented traveler, it's going to be interesting to see how they fit into the competitive landscape. 

Adam, zooming out, we've talked about some things going on with Southwest's business -- both their new routes to Hawaii, as well as what's going on with the 737 Max plane. As we look at Southwest's stock today, is it a buy today? It just came off one of its best years ever when it came to many of its operating metrics, but there is some near-term uncertainty, as we laid out in the front half of the show with the 737 Max. As you look at this stock today, do you think it's a buy? Or should investors wait and see?

Levine-Weinberg: I would say that Southwest Airlines does look like a good buy right now. For one thing, the stock is extremely cheap. Southwest Airlines stock trades for about 10 times its 2018 free cash flow, which is really quite low considering how strong its balance sheet is, how significant its growth opportunities are, and how high its profit margin is. It's really a strong, stable, and growing company. Businesses like that usually trade for a premium. Whereas Southwest Airlines is really trading at quite a big discount relative to the rest of the market. 

There obviously have been some headwinds, but there's also a good amount of reason to be hopeful that those headwinds are going to fade even within just a few months. For one thing, the maintenance-related cancellations, which I mentioned earlier, related to a dispute with the maintenance personnel. Southwest Airlines actually recently reached a tentative agreement for new contract with its mechanics union. That's really good news. Obviously, it hasn't been ratified in the membership yet. But there's a pretty good reason to hope that it will be. That should settle one of the biggest labor disputes that's been going on at Southwest Airlines in recent years. Hopefully get the carrier back to what's been more typical over the years of having pretty good labor relations. 

The second thing, obviously, is the 737 Max. Boeing has proposed its software fix. It's done a test flight now. It's still refining the exact changes, but it's probably going to be submitting that fix to the FAA within the next few weeks. That gives a pretty good chance that by June or July, perhaps the 737 Max will be back in the air. Once those headwinds are gone, Southwest Airlines does have a good chance to return to a pretty significant profit growth. 

I should mention that part of Southwest's guidance update that came out in late March said that while the first quarter was going worse than expected, it still was seeing very strong bookings and was expecting high unit revenue growth in the second quarter. So it certainly seems like customers haven't been chased away by fear about the 737 Max at Southwest Airlines. 

Sciple: Sure. When we're talking about whether Southwest is a buy, I would hate not to mention the rumors that Warren Buffett and Berkshire may be exploring buying an airline. Southwest has been part of those rumors. In late February, the shares got a little bit of a pop on rumors that Berkshire and Mr. Buffett were exploring buying the airline. Again, the business is coming off one of its greatest years. There's some near-term uncertainty. We have the Oracle of Omaha taking a close look at buying the business. I think it's something that belongs on folks' radar. 

When you look at this Berkshire speculation, Adam, what are your thoughts on it? Do you have any thoughts about the rumors circling around with regard to Southwest and Berkshire? 

Levine-Weinberg: Yeah, it's definitely an interesting rumor. It's definitely an interesting possibility because, obviously, Berkshire Hathaway has gotten involved in the transportation sector before. Buffett, of course, for many, many years hated the airlines. He had a bad investment in U.S. Air back in the 1990s. After that, he swore off investing in airlines for decades. But in the last couple of years, he's changed his mind again. The main reason is that there's a lot less competition. It's more of a rational industry structure for the airlines now. There's really four big airlines and then a few smaller ones competing in the United States. There were at least a dozen major airlines all in a very cutthroat competitive situation if you look back about 20 years. For that reason, I do think there's reason for Buffett to be interested in Southwest Airlines. He's been very clear in the past year or two that he would like to make a big acquisition at Berkshire Hathaway, and it's just a matter of first finding the right fit, and second finding a business that's not horribly overpriced. A lot of the stocks he's looking at are quite expensive just because the market has done so well over the last few years. 

Southwest Airlines, as I mentioned, it's trading for only 10 times free cash flow. It's really quite inexpensive. And it's a very solid business. While Buffett has invested in several different airlines in recent years, Southwest stands out as the highest margins by a pretty significant margin, [laughs] as it were. It has an operating margin of about 15% in the last two years, which is very good. It also already has a strong balance sheet. Buffett wouldn't have to take on a lot of debt to buy the company. And it's got a strong and entrenched management team that has been there for more than a decade. They know how to run the business. They've shown an ability to respond through events like the Great Recession, some of the oil price spikes we've had in the last 10, 15 years. There's obviously no guarantee that Buffett will go ahead and buy the company for Berkshire Hathaway, but it's not a bad fit. 

Sciple: Yeah, definitely a story we're going to continue watching for Southwest, along with the other stories we mentioned today. Adam, thanks so much for coming on the show! Really enjoyed having you on! Thanks for sharing all your deep knowledge of the airlines with our listeners!

Levine-Weinberg: Thanks for having me on!

Sciple: Awesome! As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for his work behind the glass! For Adam Levine-Weinberg, I'm Nick Sciple. Thanks for listening and Fool on!

Adam Levine-Weinberg owns shares of Hawaiian Holdings and Southwest Airlines and has the following options: long January 2020 $20 calls on AAL. Nick Sciple has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Southwest Airlines and BRK-B. The Motley Fool recommends HA. The Motley Fool has a disclosure policy.