@djthomas would be interesting to post your GM% improvement for LUV against oil prices to see how much correlation there is. Bet it’s a lot.
— Peter Harris (@2peterharris) March 20, 2017
For the background to this post feel free to visit:
- As Warren Buffett Dumps Retailers And Loads Up On Airline
Let’s cut straight to the chase:
For the data that really matter here’s a closer look:
Southwest Airlines gross margin data from morningstar.com and oil prices are (WTI) – Cushing, Oklahoma from the St Louis Federal Reserve
Even without plotting a graph (which I don’t know how to do in Google Sheets so if anyone knows how then feel free to let me know) a discernible negative correlation is present.
In plain English: when oil prices rose in a given year over the last nine years the gross margins of Southwest (NYSE: LUV) declined or were anaemic.
Does the negative correlation between gross margin and oil prices put into doubt the impact of tech on profitability at Southwest Airlines?
Not really because the massive expenditures in new tech that Southwest (NYSE: LUV) have been doing have greatly strengthened the balance sheet/increase book value and the more that Southwest can use it’s assets to drive earnings the better.
Because book value is a much slower and harder metric to manipulate – unlike earnings – metrics like ROIC (return on invested capital) and ROA (return on assets) gives a much better evaluation of how management allocates capital towards projects that drive value both on the balance sheet and income statement.
Let’s remind ourselves of the ROIC numbers for Southwest Airlines:
Perhaps Buffett or his lieutenants recognised this but the fact remains that the new reservation system in place has allowed Southwest’s earnings to grow and will likely continue to grow in the future:
By 2015 Southwest recorded record net income, operating income, profit sharing, higher ROIC whilst taking advantage of lower fuel costs and by this stage the investments in technology had allowed Southwest to expand internationally and fly more passengers at a lower cost than in previous years.
@djthomas Well, weve seen how that story ends… but regardless it seems like theres a new era of low oil prices b/c of US supply, no?
— financial decisions (@financialrevamp) March 20, 2017
Newswires are filled with stories about the current level of US oil inventories reaching their highest recorded level ever in February 2017.
Strong oil imports, higher exploration and production company spending, and a slowdown in demand have been the main contributors and oil analysts have also cited an ineffectual OPEC agreement to cut production with Saudi Arabia the only oil producing nation within the group to cut meaningfully.
If anything analysts are predicting increased output both in the US and from OPEC.
Again these factors could have contributed to Buffett’s conviction that now was the time to take a position in airline stocks.
It certainly adds up to a large margin of safety when you consider book value growth, record earnings from tech investments, a seemingly protracted period of low oil prices and a sensible CEO who is not afraid to shake things up.
Disclosure: I do not own stock in Southwest Airlines (NYSE: LUV).