Balance sheet.

It’s all about the balance sheet.

Summer 2024 hasn’t even started yet, and we already have our first storm of the season: Summer Storm Elliott.

Not to be confused with Winter Storm Elliott, which brought Southwest Airlines’s operation to a screeching halt during the 2022 Christmas season, Summer Storm Elliott is slightly… um… different.

Elliott Investment Management has issued a blistering press release calling for the replacement of Southwest Airline’s board and leadership. In the accompanying presentation, they lay out the airline's recent revenue and operational challenges, along with a long collection of quotes from frustrated employees and analysts.

But Elliott’s attack isn’t about revenue, and it certainly isn’t about Southwest’s operation. It’s about the balance sheet.

To first put this into perspective, how bad are things at Southwest Airlines?

Middle of the pack. Not great, particularly by Southwest’s pre-pandemic standards, but not terrible.

In comparison to the lackluster profit performance, however, Southwest still maintains an industry-leading balance sheet.

There are those two words again.

From an activist investor’s point of view, three key ingredients needed to line up to equal a smoking deal:

1. A strong balance sheet - (~17 billion of unencumbered assets) - check

2. A low market cap - (~$17 billion) - check

3. Frustrated analysts - check

But wait a minute. Did you miss that?

The amount of unencumbered assets on Southwest’s balance sheet equals the market capitalization for the entire company. $17 billion. Why is this important?

Southwest could theoretically buy itself with its own money. If only there were leadership willing to do that.

What would that do to the share price? Up.

What would that do to Elliott’s return? Very up.

How would that position Southwest for the future? Not so up - VERY not so up.

Southwest maintains an incredible balance sheet in reflection of the long-term focus and conservative approach of the company. It does this because the airline business is not a short-term business. Being stable and in a strong position for the long term is important to Southwest.

But what happens if the balance sheet is too strong?

Activist investors arrive with ways to make it… less strong.

Those ways include leveraging a once-stellar balance sheet to buy back shares, issue large dividends, pay activist investors to leave… you know, “ways”.

All of those options make big money for Elliott, but they effectively use Southwest’s balance sheet to do it. Leverage up. Pay out. Good luck in the future.

To be certain, Southwest has its challenges. Elliott isn’t wrong in their assessment that Southwest’s innovation and investment have been slow in recent years.

Yet, however much we agree with the severity of the symptoms, Elliott’s vaguely proposed cure is much, much worse.

And that proposed cure is incredibly vague in details. Essentially: “We put our guy in charge and then you trust us.”

Even though Elliot’s list of challenges at Southwest is accurate, nothing in the hostile letter or presentation from the activist investor suggests to us that Elliott actually knows how to fix the airline. From various meetings the group has had with analysts, we’re hearing much of the same.

But, as little as Elliott understands about ways to leverage Southwest’s opportunities in revenue, operations, and employee culture, the group has shown an incredible knowledge and capability to leverage one key item:

Balance sheet.

(Speaking of two words, if you are interested in our recommended two-word response for Southwest management and employees to send Elliott, let us know.

You can probably guess it. You don’t even need two words. Two letters will do it.)

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