Has Southwest Airlines Become the Perfect Stock?

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Every investor would love to stumble upon the perfect stock. But will you ever really find a stock that provides everything you could possibly want?

One thing's for sure: You'll never discover truly great investments unless you actively look for them. Let's discuss the ideal qualities of a perfect stock, then decide if Southwest Airlines (NYS: LUV) fits the bill.

The quest for perfection
Stocks that look great based on one factor may prove horrible elsewhere, making due diligence a crucial part of your investing research. The best stocks excel in many different areas, including these important factors:

  • Growth. Expanding businesses show healthy revenue growth. While past growth is no guarantee that revenue will keep rising, it's certainly a better sign than a stagnant top line.
  • Margins. Higher sales mean nothing if a company can't produce profits from them. Strong margins ensure that company can turn revenue into profit.
  • Balance sheet. At debt-laden companies, banks and bondholders compete with shareholders for management's attention. Companies with strong balance sheets don't have to worry about the distraction of debt.
  • Money-making opportunities. Return on equity helps measure how well a company is finding opportunities to turn its resources into profitable business endeavors.
  • Valuation. You can't afford to pay too much for even the best companies. By using normalized figures, you can see how a stock's simple earnings multiple fits into a longer-term context.
  • Dividends. For tangible proof of profits, a check to shareholders every three months can't be beat. Companies with solid dividends and strong commitments to increasing payouts treat shareholders well.

With those factors in mind, let's take a closer look at Southwest Airlines.

Factor

What We Want to See

Actual

Pass or Fail?

Growth

5-Year Annual Revenue Growth > 15%

10.8%

Fail

 

1-Year Revenue Growth > 12%

25.3%

Pass

Margins

Gross Margin > 35%

22.6%

Fail

 

Net Margin > 15%

1.1%

Fail

Balance Sheet

Debt to Equity < 50%

64.9%

Fail

 

Current Ratio > 1.3

0.86

Fail

Opportunities

Return on Equity > 15%

2.5%

Fail

Valuation

Normalized P/E < 20

28.13

Fail

Dividends

Current Yield > 2%

0.2%

Fail

 

5-Year Dividend Growth > 10%

0%

Fail

    
 

Total Score

 

1 out of 10

Source: S&P Capital IQ. Total score = number of passes.

When we looked at Southwest Airlines last year, it flew just as low, with only a single point. The company continues to struggle in a tough environment for airlines, and despite healthy revenue growth, Southwest's returns on equity and margins have only gotten worse.

Southwest has a strong reputation as one of the only consistently profitable airlines in a sea of long-term industry red ink, with an emphasis on customer service. Although Delta Air Lines (NYS: DAL) and United Continental (NYS: UAL) have pulled themselves up into the black recently on the back of baggage fees, fare hikes, and other charges, AMR (NYS: AMR) still hasn't gotten enough lift to turn profits.

Despite its strong reputation, Southwest has recently suffered alongside its industry peers. In its latest quarterly report, the airline reported earnings that fell by nearly half from last year's levels, as higher fuel costs finally took their toll. Although the company is well known for managing its fuel costs through hedging strategies, even Southwest can't hold off the impact of high energy prices forever, and that has hurt the company's margins.

Having acquired AirTran earlier this year, Southwest now faces the challenge of integrating new employees into its corporate culture as well as new assets into its fleet. Yet that acquisition is a big part of what gave Southwest its revenue boost over last year.

With competitors like Alaska Airlines (NYS: ALK) and Allegiant Travel (NAS: ALGT) posting better margins and seemingly having better prospects, Southwest faces a big challenge. With decades of outperformance behind it, though, the company clearly has what it takes to make a good attempt to fly higher toward perfection.

Keep searching
No stock is a sure thing, but some stocks are a lot closer to perfect than others. By looking for the perfect stock, you'll go a long way toward improving your investing prowess and learning how to separate the best investments from the rest.

Click hereto add Southwest Airlines to My Watchlist, which can find all of our Foolish analysis on it and all your other stocks.

Finding the perfect stock is only one piece of a successful investment strategy. Get the big picture by taking a look at our "13 Steps to Investing Foolishly."

At the time this article was published Fool contributor Dan Caplinger doesn't own shares of the companies mentioned. The Motley Fool owns shares of Allegiant Travel. Motley Fool newsletter services have recommended buying shares of Southwest Airlines. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool has a disclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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