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Should Southwest buy Sun Country? Stifel Nicolaus analyst Hunter Keay thinks so

22-Sep-2010
Southwest CEO, Gary Kelly
Southwest CEO, Gary Kelly

Stifel Nicolaus analyst Hunter Keay had the news wires burning over the weekend after he suggested that the next logical merger would be the acquisition of Sun Country Airlines by Southwest Airlines.

Reading between the lines of the report Mr Keay issued last week, it seems he is worried about the lack of growth for the Dallas-based carrier next year, indicating a Sun Country acquisition could not only provide growth but could better manage CASM. In addition, he said that such a move would smooth out the quarterly earnings swings by giving Southwest strong performance in the first quarter – Sun Country’s strongest quarter – which is usually the weakest quarter for Southwest.

While quick to add he knows of no such activity, Keay laid out his arguments, suggesting the combination provides a “shift in the domestic competitive landscape”. He noted that Minneapolis-based Sun Country – now in Chapter 11 – would be a good fit for Southwest since Minneapolis has grown into a successful market for the Dallas-based carrier.

Smoothing out seasonal financial results

Most important of these would be boosting Southwest’s normally weak first quarter, the strongest period for Sun Country’s snow bird services. Only six of the carrier’s 37 routes have year-round service. “Though financial data for Sun Country is sparse due to the carrier’s bankruptcy and lack of reliable Form 41 DoT financial data,” said Mr Keay, “Sun Country’s significant seasonal emphasis during 1Q imply far better profitability during that time period. Airlines generally deploy the most capacity during periods where margins are strongest and Sun Country reported a robust 15.3% operating margin in 1Q09. We believe the addition of Sun Country to LUV’s network would help smooth out quarter-to-quarter changes in earnings.”

Mr Keay added a combination would add increased service to the West Coast, Mexico and the Caribbean. “Using OAG data to compare Sun Country’s Jun-10 and Jan-11 schedules, for example, we found Sun Country has 14 more routes in service in January and 17% more seats compared to June. These service patterns are not typical for most U.S. airlines, who typically report more profitable periods during summer months. If acquired, we believe Sun Country’s seasonal route structure would benefit LUV by strengthening LUV’s 1Q operating margin and facilitate instantly profitable growth opportunities into Mexico and the Caribbean (among others).

“Sun Country tends to overweight its capacity the first quarter relative to the rest of the year while LUV has kept its first quarter capacity slightly lower due to generally lighter operating margins relative to other quarters,” Keay continued. “LUV had ~13% more ASMs in 2Q10 than in 1Q10, for example, in order to manage the decrease in demand during what are generally considered ‘off-peak’ months.”

Acquisition costs modest

Keay called an acquisition an effective use of cash, saying it would yield margin-accretive growth although no incremental capacity would be added to the domestic network. He noted the lack of debt for Sun Country which, he said, generated USD207 million in LTM revenues through 1Q10.

Keay pointed to Southwest’s reserves, adding the bankrupt airline would be very affordable. “We believe an all-cash acquisition is easily affordable for a relatively unleveraged LUV (which holds USD3.7 billion in unrestricted cash, equating to a robust 28% of TTM revenues) and presents a unique cash deployment option,” said Keay in his latest report. “Organic growth options for LUV in 2011 are limited, in our opinion, and we believe investors would react positively to an earnings accretive acquisition that presents immediate growth opportunities.

“An acquisition price would likely be modest relative to LUV’s substantial liquidity flexibility,” Keay continued. “LUV’s debt to cap of 46% (even after capitalizing operating leases) is by far the lowest among US major airlines, and management’s appetite for share buybacks in recent years has been modest (no buybacks since USD54 million of stock was repurchased in 1Q-2008).”

Saying that Southwest shares have underperformed the rest of the industry this year, increasing only 1% versus 22% for the XAL airline index, Keay noted this was despite impressive unit revenue improvement.

“We believe an acquisition of Sun Country could spark additional investor interest in LUV, which would have immediate growth opportunities to attractive markets,” said Keay. “It is difficult to justify LUV’s premium multiple to the group (14x 2011 EPS compared to a group average of 9x) given the lack of meaningful growth opportunities. To be clear, we strongly advocate and commend LUV’s continuing capacity discipline given the current economic backdrop, but airlines that have historically traded at a premium multiple have been high growth, so continuing lack of new growth could potentially result in multiple compression for LUV. Currently, it appears organic growth opportunities for LUV in 2011 are expected to be limited to two cities in South Carolina (Charleston and Greenville-Spartanburg), and as a result, meaningful multiple expansion from current levels is unlikely, in our view.”

Stefel Nicolaus has Southwest shares unchanged, at Hold. “Shares of LUV are trading at 14.1x our 2011E EPS estimates versus a group average of 9.0x,” Keay concluded “Organic growth opportunities are likely to be limited through next year, and with only modest organic capacity growth LUV could face continuing challenges managing non-fuel CASM. We admire management’s continuing capacity discipline in the face of an improving revenue environment, but meaningful yield growth for LUV relative to network carriers could be difficult in 2011, in our opinion.”

Network advantages: only one city pair overlaps

“Sun Country serves 29 cities out of MSP compared to only four for LUV,” he said, adding it would significantly boost Southwest’s now limited market share at the Delta hub. “We believe LUV has had good initial success with its service to MSP based on the increasing destinations offered over the past 18 months. More importantly, a higher share of local traffic, which is usually far more profitable than connecting traffic. Sun Country and LUV both tend to fare well in customer satisfaction surveys, so we would expect minimal consumer defection post-acquisition.”

The two carriers have 13 destinations in common although served from different points. Only one of Sun Country’s 37 city pairs overlaps with Southwest’s (MSP-PHX) which would give Southwest flexibility to change to more advantageous schedules. In addition, Sun Country has service to JFK.

“More specifically at MSP, LUV would gain a strong local product with a geographically diverse footprint, enabling market share gains in a city LUV appears to be targeting for modest growth,” said Keay. “Examining market share data at MSP, Delta clearly dominates. However, DAL’s market share at MSP is skewed because roughly half of passengers at MSP are connecting to other flights. Assuming half of DAL’s traffic at MSP is connecting, LUV would stand to gain 5.2% share of the local MSP market, still well behind DAL but meaningful enough to have a pricing impact on the 32 cities served by a combined LUV/Sun Country airline. We note of these 32 cities out of MSP, DAL offers service to 24.”

He called both the fleet and the networks highly complementary. While Southwest has been playing it close to its chest with respect to international service, it is the next logical step for low-cost carriers once they have finished penetrating the business market in their latest evolution which started a few years ago.

Sun Country would not only give Southwest access to 11 new destinations in Mexico and the Caribbean but also London Stansted. The complementary networks, suggested Mr Keay, could mean that government approval would be almost auromatic. Cost synergies, said Mr Keay, could come from the 13 destinations the two have in common.

Fleet compatibility, with B737s

The Stifel Nicolaus analyst sees opportunities for providing low CASM with the fleets. Both fly the B737, with Sun Country operating nine leased B737NG aircraft, three B737-700 and six B737-800, with an average age of nine years.

“Though LUV currently operates three different B737 variants (-300, -500, -700), the company recently announced its intention to explore the operation of the larger -800 version,” he noted, “In fact, just last week (9/15/10), LUV issued a press release saying it was “one step closer” to adding the -800 aircraft into service following the unanimous tentative approval of its flight attendants union.

The Sun Country fleet would need reconfiguring should Southwest take over the leases since its 737-800 boasts 162 seats in a two-class configuration. “However, LUV could reject these operating leases fairly easily as Sun Country is currently in Chapter 11 bankruptcy,” he said noting that the bankruptcy judge recently approved the company's exit plan. “For comparison purposes, we note Ryanair flies B737-800 aircraft configured to seat 189 passengers, though seats on Ryanair only have a 30” pitch, 2”-3” less than LUV's B737 aircraft. Still, a B737-800 configured to LUV’s standards could likely seat at least 30 more passengers than one of LUV’s B737-700s, which seat only 137 passengers.

“Given the solid load factor growth reported by LUV so far in 2010, it comes as little surprise that the company is contemplating the addition of the larger B737-800 aircraft,” he continued. “LUV’s schedule optimisation effort is ongoing, and the larger B737-800 aircraft could help to lower challenging non-fuel CASM growth with minimal dilution to pricing, assuming effective deployment.”

Mr Keay anticipates there would be stiff opposition from Sun Country’s 160 pilots in an acquisition, but Southwest pilots would favour the combination, despite the recent failed bid at Frontier, as long as Sun Country pilots ended up at the bottom of the Southwest seniority list. “LUV management has said push back from an acquiree’s labour group would not prevent the pursuit of an acquisition,” Mr Keay noted.

Southwest has clearly demonstrated a willingness to expand through acquisition and this does offer a window of opportunity with Sun Country still to emerge from Chapter 11. Sooner or later too Southwest needs to stake a claim in international markets. There is plenty of blue ocean out there for cost effective operations, but it won't remain that way for ever.


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