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146% Profit Potential As Wall Street Misses the Big Picture on Southwest

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Despite the rollercoaster we’ve seen in nearly every industry from tech to consumer staples, one is having a relatively boring year and a half.

You might not think it, considering airlines have had to contend with fluctuating oil prices and the grounding of the Boeing 737 Max, but they are pretty much flat over the last 12 months and more.

From a speculator’s standpoint, this makes no sense. You’d think with such a drastic set of events, especially the grounding of the Max jets, that we’d see wild volatility in the industry… specifically for Southwest Airlines (LUV), which has the largest fleet of Boeing’s unusable planes. But that’s not the case.

As you can see from its one-year price chart, Southwest has had some price movement. But you can draw a straight line across this chart and end up where you began:

Screen Shot 2019-06-14 at 7.19.55 AM.png

While speculators might be having a problem figuring out what’s going on, a look at the company’s financials tell a different tale.

Revenue, as reported in its most recent quarter in April, set record highs. Yet income remains flat. One reason for this was certainly the grounding of the Max. But others, including fuel prices and global economic uncertainty, have played just as big of roles.

In fact, despite Southwest controlling the largest U.S. fleet of Max jets, they make up only 9% of its total number of planes. And according to the company just today in relation to the extension of its Max groundings until September 2, it only affects 100 daily flights out of more than 4,000.

The more important concern for Southwest and all other airlines is economic uncertainty and fuel costs. With trade tensions between the U.S. and just about everywhere else, airlines are worried about less travel. The issue here is that not all airlines are created equal.

Southwest only recently began international flights a few years ago. The vast majority of its routes remain domestic. So, slowdowns in China or Europe have next to no actual impact on this particular airline.

The second issue that has caused LUV and its competitors some concern is fuel costs. Even though oil has been falling (save for today), the U.S. Energy Information Administration just announced that jet fuel costs should rise around 10 cents per gallon. That doesn’t sound like a whole lot. But when you churn through as much as these airlines, it makes a big dent.

American Airlines CEO told investors last quarter that his company had to reevaluate this extra cost, noting that it now sees rising fuel costs to negatively impact American by an extra $650 million for the year. But here again, not all airlines are created equal.

Southwest has the largest fuel hedging program in the country. Meaning, it locks in prices when oil is cheap and suffers far less than competitors – some of which don’t even hedge their costs – when prices rise.

Oil might not be rocketing higher, but any increase to jet fuel prices will have only a negligible effect on Southwest. But even if these rising price estimates are too low… and oil and fuel costs spike later this year (after, say, a interest rate cut or a trade deal with China)… Southwest has already locked in these low rates.

That makes the company two-for-two in its competitive advantages. The final reason why investors have missed the mark on Southwest is a more recent development.

Just today, JP Morgan is reporting that American Airlines is raising domestic ticket prices. Southwest, as the analyst noted, already did this weeks ago. No one on Wall Street seemed to notice.

While the rest of the industry needs to raise these rates to combat their squeeze to margins, Southwest’s price hike will flow straight into its bottom line.

But of course, we can’t discuss Southwest without coming back around to the grounding of the Boeing Max jets. We noted that 9% of the company’s fleet is made up of these new troubled planes. Only about 2.5% of its flights are made by these plans. But, still, those planes will be grounded throughout the busy summer season.

While this certainly means the company isn’t going to have a “blowout” year as its management recently noted, this Max grounding does present an opportunity.

You see, when combined with Wall Street’s clearly misguided view of the company’s economic outlook and cost profile, shares are lower than they should be.

The company has two major catalysts coming up that could change this tide, however. First, any news on the Boeing Max jets will create instant speculation. The minute the planes are cleared to go back on the flight schedule, shares will certainly tick up for LUV.

Second, the company reports its second quarter results. If it can maintain its record growth pace – at least on the top line – and show stability in its margins, investors will come back.

There’s a real short-term upside potential here. Despite the negative press surrounding airlines, Southwest is in the pilot’s seat. As some form of certainty comes back into this industry (trade, prices, costs, the Boeing mess), investors will notice Southwest’s advantageous position.

Fortunately, there’s a great way to play it without needing to lay out a large bet on its shares.

A Strategy For Short Term Bulls

A bull call spread is a type of options trade that involves buying one call option and selling a second one with a higher strike price.

This reduces the entry cost of the trade in exchange for a capped profit potential. For a situation like this one, that’s a tradeoff worth taking.

You see, Southwest is misjudged right now. But it isn’t set for a triple digit rally overnight. As investors realize their mistake, shares will tick up… not skyrocket.

You can see what this strategy looks like here:

bullcallspread

Source: The Options Industry Council

Considering the two catalysts for Southwest’s late summer surge, there’s a perfect specific bull call spread forming right now.

A Specific Trade On LUV

Right now, a trader could buy a September 20 $52.50 LUV call for $3.12 per share and sell a September 20 $57.50 call for $1.09 per share for a cost of $2.03 per share. Since each represent 100 shares of LUV, that’s a total net debit of $203.

That’s the total amount at risk with this trade. No matter what happens over the next three months – with trade, prices, costs, etc. – that’s the only money the trader has at stake.

To find the maximum potential profit, take the difference in strike prices ($57.50 – $52.50 = $5), and subtract the cost ($5 – $2.03 = $2.97). On 100 shares, that’s a max return potential of $297.

In other words, if shares rise just $5 over the next three full months, the trader would see a return of 146% on the amount he has at risk.

With so much going Southwest’s way, despite how Wall Street is viewing things right now, a $5 share price jump is definitely on the table.

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