LUV: buy on the dip and buy as it rise.

LUV (SouthWest Airline) is a superb regional carrier that has one of the best operational efficiency and cost structure to maximize the profitability. LUV reports earning tomorrow morning. Regardless of the earning outcome, I think you should buy LUV. I expect moderate uptick in the share price in the morning once the company reports the earning. The company is expected to report 13 cents based on 2.28 B topline number. I expect the company to at least meet or exceed the estimate by a penny.

LUV ,in my opinion, has been unjustifiably punished for being the best in its class. While other legacy carriers have been fighting high fuel price last three years, smart LUV management team hedged the fuel price at much lower level than the market price. This hedging helped the company to withstand the negative impact of the elevated fuel cost and sustain the profitability at a remarkable level at a time other legacy carriers are fighting for their lives.

Ironically this smart hedging of the fuel is currently seen as a negative catalyst for LUV shares as the crude oil price is now dropping. While other legacy carriers will hugely increase its profitability, LUV is seen to be the less beneficiary of the lower fuel price; it is already enjoying the hedged fuel price of $49 ( ~ 85% of the fuel needs). Because this perception is moving investors out of LUV into legacy carriers such as AMR and CAL, LUV PE multiple has been shrinking while the company continues to achieve its best profitability performance.

I see LUV earning continuing to rise. LUV has been expanding its network footage in the US and is likely to see higher traffic volume. Also airfares have been slowly inching up, possibly giving better margin per traveler. Finally lower oil price still benefit LUV with un-hedged 15% of the fuel needs.

While LUV has enjoyed PE of anywhere between 24 to 40 times as a best airline carrier past three years, the PE multiple currently has shrunk to level just above 15 based on 2007 earning. I believe that PE multiple will likely to expand to at least 20 based on improved investor sentiment in the airline sector. Earning is likely to see slight upside to the consensus estimate of roughly $1. So taking $1.1 with PE of 20 yields the fair value of $22. I currently have my TP set at $21 for LUV. Consequently, there is still plenty of upside left from the current level of $16 and a change. And you don¡¯t have to worry about the direction of the fuel price so much with LUV, something that legacy carriers are not able to match. Consequently, I want you to take a position with LUV and enjoy the friendly ride.

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