New Stocks On Most Attractive And Most Dangerous Lists: March 2016

Figure 1: LUV NOPAT Growth Since 2008



Sources: New Constructs, LLC and company filings

Southwest’s return on invested capital (ROIC) has improved from 3% in 2008 to a top-quintile 17% in 2015. Over this same timeframe, the company’s NOPAT margin has grown from 3% to 14%, which further highlights the increased efficiency of operations at Southwest.

Impact of Footnotes Adjustments and Forensic Accounting

In order to derive the true recurring cash flows, an accurate invested capital, and a real shareholder value, we made the following adjustments to Southwest’s 2015 10-K:

Income Statement: we made $1.4 billion of adjustments with a net effect of removing $609 million (3% of revenue) in non-operating expenses. We removed $999 million in non-operating expenseand $390 million in non-operating income.

Balance Sheet: we made $8.4 billion of adjustments to calculate invested capital with a net increase of $2.9 billion. The largest adjustment was the inclusion of $2.9 billion related to off-balance sheet operating leases. This adjustment represented 22% of reported net assets.

Valuation: we made $11.4 billion of adjustments with a net effect of decreasing shareholder value by $7.2 billion. The largest adjustment, apart from the operating leases, was the removal of $2.5 billion due to the net deferred tax liabilities. This adjustment represents 9% of Southwest’s market cap. Despite the decrease in shareholder value, LUV remains undervalued.

Shares Are Significantly Undervalued

Even while LUV has increased over 77% over the past two years, shares still have upside. At its current price of $42/share, LUV has a price-to-economic book value (PEBV) ratio of 0.9. This ratio means that the market expects Southwest’s NOPAT to permanently decline by 10%. This expectation is in stark contrast from the profit growth achieved by Southwest over the past decade. If Southwest can grow NOPAT by just 5% compounded annually for the next decade, shares are worth $66/share today – a 57% upside.

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Disclosure: New Construct Staff receive no compensation to write about any specific stock, sector or theme.

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