Sold Cash Secured Put + Investment Thesis – Southwest Airlines, Co. (LUV) – $57.00 strike – July 28 Expiration

This trade was actually executed on Tuesday 07/25/17. I didn’t get a chance to write about it until today.  

But like I do with all my trades now, I twittered it:

Please follow me on the twitter for the most up to date information on my trades.

Please visit the core philosophies article on my investment thesis process for a deeper explanation of the components of this article.

I have updated the portfolio and income tracker pages to reflect this position.

Dividend Cycle

LUV should go ex-div sometime around the middle of August, like maybe 8/16? We’ll probably find out today by the time this post is published. The company is slated to announce earnings this morning before market open.

The most recent dividend distribution was $0.125/share which was a 25% increase from the previous $0.10. I would expect the payout to remain at that level for the next three quarters.

The company is a dividend challenger, having raised the payout for six consecutive years. The 1-yr, 3-yr and 5-yr DGR averages all exceed 30%.

The premium received for this contract is nearly the equivalent of three quarterly payments, but is only in force for 3 days.

Investment

# contracts

Strike

Expiration

Total Premium

Days in Force

Annualized Return

Closing Price

Downside Protection

1

$57

7/28/17

$34.65

3

73.96%

$58.82

3.09%

The QC (Quantitative Case)

Payout Ratio – EPS, FCF

37.5%, 36.5%

10 Year Revenue CAGR

10.1%

10 Year EPS CAGR (5 Year EPS CAGR)

32.3% (106.7%)

5 Year ave P/E – Current P/E (ttm)

+2.77

5 Year ave Yield – Current Yield  

-0.24%

10 year mean DGR (dividend growth rate)

34.10%

Debt/Market Cap

$3.07B/$35.99B (8.5%)

Total Cash

$3.48B

Return on Assets

10.52%

Return on Equity

26.52%

Profit Margin

10.16%

EBITDA/Revenue

$5.01B/$20.48 (24.5%)

Reverse DDM Fair Value DGR at Strike

9.16%

Assumed DGR (DDM valuation 10% disc.)

8.0% by rule ($25.00)

DGR Margin of Safety

-1.16%

Dividend Cushion Ratio (9.16% DGR)

5.567 (!)

Cash from Ops “cushion”

-34.65%

Capex “cushion”

+58.06%

DGR “cushion” (delta)

+76%

SPL (Strike Price Logic)

This is a play on the elevated volatility going into this morning’s earnings announcement. To be able to collect that kind of a premium for a 3 day contract is ridiculous. Even at these elevated vol levels, you can only get so much downside in that short a period.

With such a low dividend yield, the market implied DGR from DDM analysis isn’t very useful, so let’s take a look at FCF yield. FCF/share (TTM) is around $3.43 which is over a 6% FCF “yield” at my strike price. Do I think the company can grow FCF at a 4% rate or better? I do. Significantly.

Based on potential FCF growth rates, I’ll bet LUV is fairly priced as far up as the mid to high $60s (5% FCF growth with a 10% discount rate gives a fair value of $68.60).

Consider that FCF was $0.95/share in 2012. That works out to a 52.2% annualized growth rate over the last 5 years!

Plus there is a case to be made for $57 on the short-term technical level.

Looking at the 6-month chart for LUV it went on a rally from March 21 through July 7, with a low of $51.88 and a high of $64.24, for a total gain of $12.36. Assuming it retraces some of that gain according to fibonacci ratios, there’s support at $59.51, $58.06 and $56.60 at the 38.2%, 50%, and 61.8% retracement levels respectively.

072616 LUV 6mo chart.JPG

LUV 6 month Chart – Courtesy Yahoo Finance

The $57 strike price fits nicely in between the 50% and 61.8% retracements. I kind of doubt it’s going all the way back to $52, but who knows what the reaction to earnings is going to be this morning.

The RSI is at 39 which is pretty oversold already. If it does drop significantly on earnings, I don’t think it will stay down for long.

QWaF (Qualitative Warm and Fuzzy)

I recently transferred from Northern California to Denver Colorado. One consequence of this move is that my territory is much more spread out now; I’m covering NV, AZ, NM, CO, WY and TX. Other than WY and CO, I’m pretty much flying everywhere, and those states are all in the heart of Southwest’s coverage area.

What a well run operation! They’re completely unlike any other airline…like their profitable. They also provide way more efficient and cost effective air travel than any of their competitors. And the lower prices don’t come at the expense of shitty service or hidden bag fees or any of that “discount airline” baloney. Virtually every flight I’m on is completely full.

There are still a lot of airports they don’t fly to, so there’s lots of growth opportunity yet. It’s obviously a very different process that is a little weird for passengers not used to it at first, but anyone that travels regularly has to recognize how much more pleasant it is to fly SWA than any of the other options.

I firmly believe that they’re only going to keep gobbling up market share like they have been, and as they grow, their streamlined, customer service oriented model should help maintain their attractive margins.

Is it naive to “invest in companies you use and like”? Yeah, maybe. Sue me.

CPR (Cold and Prickly Risks)

The airline business is pretty tough. It’s incredibly capital intensive, highly regulated and yet still competitive. Customers practically expect it to be free, but complain vocally at the smallest inconvenience. It sounds awful.

Plus one of your single biggest costs (fuel) is a highly volatile commodity. If oil prices spike back up to pre-2014 levels, the industry is going to find it difficult to pass the cost along to the customer base, which means it’s coming out of the margins.

But honestly, if any airline company is going to be able to adapt through sheer efficiency and operational excellence, I think it’s Southwest.

The dividend yield is very small, but it’s extremely safe and poised to grow very rapidly.

Count me in.

Leave a Reply