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Investment Overview for Southwest Airlines (NYSE:LUV)
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Below are key drivers of Southwest Airlines value that present opportunities for upside or downside to the current Trefis price estimate.
Southwest Passenger Flights
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Southwest's Fuel Expense for Passenger Travel: Fuel expenses accounted for approximately 38% of Southwest's passenger revenues in 2012. Going forward, we expect this to increase to over 39% by the end of the Trefis forecast period on increases in fuel prices driven by the growing global demand for oil. If however, Southwest is able to pass on higher fuel prices to its customers through fare hikes such that its fuel costs remain stable as a percentage of its passenger revenues then there could be a potential upside of around 7% to the ${trefisprice}.
On the other hand, if stiff competition prevents the carrier from passing on higher fuel prices to customers and fuel costs rise to over 40% of Southwest's passenger revenues by the end of the Trefis forecast period, then there could be a potential downside of around 5% to the ${trefisprice}.
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Southwest Passenger Yield: Southwest’s Passenger Yield increased from $0.14 in 2008 to $0.16 in 2012 on growth in passenger fares. We expect it to continue to increase reaching $0.19 by the end of the Trefis forecast period. With a stable travel demand outlook, we expect Southwest to match other U.S. carriers as they increase air fares to pass on the rise in fuel prices and taxes. This would boost passenger yield levels of the carrier. If however, this figure increases to $0.21 then there could be a potential upside of nearly 5% to the Trefis price estimate of Southwest Airlines' stock.
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Southwest Airlines (NYSE:LUV) is one of the largest domestic carriers in the U.S.. Southwest thrives on maintaining low operating expenses through its point-to-point service model, modest on board services (with add-ons at an extra charge) and fuel hedging programs. Fuel hedging programs saved the carrier an estimated $1.1 billion in fuel costs in the year 2008. Savings through such an operating structure allow it to maintain low fares, which have been instrumental in increasing its market share over the past several years.
The point-to-point rather than hub-and-spoke service model allows the company to maximize the use of its key assets including aircrafts, gates and employees. This helps the company to provide its markets with frequent and conveniently timed flights at low fares.
The hub-and-spoke system concentrates most of an airline's operations at a limited number of central hub cities and serves most other destinations in the system by providing one stop or connecting service through a hub. Any issue at a hub such as bad weather or security problems can create delays throughout the system. By not concentrating operations through one or more central transfer points, the company's point-to-point route structure allows for more direct non-stop routing than the hub-and-spoke model and therefore better enables the airline to control delays and total trip time.
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The passenger flights segment is the most valuable to the company because of following reasons.
Low cost model of Southwest
The low cost model is a significant source of value for Southwest. The carrier achieves this by operating on a point-to-point route structure. This low dependance on hubs allows the airline to provide more direct service, utilize aircrafts, terminal gates and employees more thus helping to save on costs. It also provides modest on board services with add-ons at an extra cost.
This model allows it constantly price passenger fares at prices substantially lower to its legacy peers and thus cut in to their market shares.
AirTran integration presents opportunities to boost top-line
Southwest acquired AirTran in May 2011 and the two companies finalized the merger on March 1st, 2012. Southwest lists the AirTran integration as one of its largest initiatives and expects the integration to produce about $400 million net in synergies by 2013.
Potential synergies arise from optimization of the two route systems, especially the AirTran side of the route system and to drive substantial revenue gains as a result of that conversion. Latin American operations of AirTran also present the carrier with significant near term growth opportunities which were not available to it in the domestic U.S. market.
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Oil prices significantly impact Southwest's bottom line
Fuel expenses represent one of the largest single costs faced by airlines and account for over 30% of the costs for airlines.
Southwest expects to consume approximately 1.9 billion gallons of jet fuel in 2012. Based on this anticipated usage, a change in jet fuel prices of just one cent per gallon would impact the carrier's fuel and oil expenses by approximately $19 million for 2012. Information collected from Transtats indicate that fuel costs have risen approximately 29.7% for airlines in 2011 from 2010 levels. According to recent data compiled by IATA’s Jet Fuel Price monitor, there will be an increase of approximately $32 billion in the overall 2012 fuel bill for the airline sector.
Focus on keeping prices competitive in the airline industry prevents Southwest from immediately passing on price increases to its customers, so Southwest's expenses are heavily impacted by fuel prices and their volatility.
Weak macroeconomic conditions
The main challenge the global airline industry faces during 2012 and beyond is the state of the global economy. Europe’s sovereign debt crisis has created enormous uncertainty and is expected to impact the overall profitability of the sector. Tony Tyler, IATA’s director general believes that a failure on the part of governments to resolve Europe’s issues could lead to a loss of $8 billion in 2012 for the airline industry. As a result IATA has already downgraded its 2012 outlook for profitability to $3.5 billion from the $4.9 billion that was expected a few months ago.
According to IATA’s latest forecasts; North American carriers are expected to earn about $1.7 billion; Asia Pacific carriers about $2.1 billion; African airlines are expected to lose $100 million and European airlines are projected to take a loss of $600 million due to economic uncertainty and higher passenger taxes.
Cautious capacity stance
Due to rising fuel expenses and weak economic conditions, several airlines have been forced to cut back on routes. Capacity cuts that have occurred in developed markets in 2011 are expected to persist in 2012. On the other hand growth in capacity has been robust in international markets. According to TranStats, the total available seat miles (ASM) have increased in international markets from approximately 524 million miles during the first ten months of 2010 to 560 million miles during the same period in 2011.
Southwest is keeping capacity expansion disciplined and opportunistic. For 2011, Southwest reported an approximately 5% growth in available seat miles and is guiding for a flat y-o-y growth for 2012.
Growth in ancillary revenues
With profitability declining for the overall airline sector, many of the carriers are figuring out ways to improve income by increasing ancillary forms of revenues. Baggage fees have been one of the main drivers of profitability for many airlines. Airlines are adding various new features to help boost revenues such as WiFi, in-flight entertainment and improvements in lounge facilities.
According to a recent Amadeus/IdeaWorks study, North American airlines collectively produce the largest stream of ancillary revenues compared to other regions, with an estimated $15 billion in revenue in 2011. This represents a 70% jump over 2010, with the majority of the increases attributable to stronger merchandising efforts by the carriers as well as the addition of more à la carte services for sale.
The past year, Southwest revamped its frequent flyer program in favor of expenditure-based earnings system where points are awarded based on the amount of money spent on the carrier rather than the miles flown as in the earlier system. The improved program contributed to revenues by increasing business partner income as well as the premiums in fares paid by Rapid Rewards members.
Hedging of oil prices leads to significant cost savings
Southwest's key to financial success is its fuel hedging programs, where the company agrees to secure future fuel contracts at a particular price. Southwest hedges more oil than any other airline, which has ensured the lowest prices on jet fuel following the spike in oil prices in 2007 and 2008. In 2008, Southwest had 70% of its fuel needs hedged at $51 per barrel, when most other major airlines had only between 20% and 30% of their fuel hedged at an average $100 per barrel.
Southwest's hedging contracts extend until 2015, although the amount of oil hedged dropped steadily after 2009. As a result of this, Southwest will become more vulnerable to
fluctuations in fuel prices as its contracts mature. Southwest will follow a hedging strategy in 2012 whereby for the first half of 2012, the company has reduced its floor exposure, its premiums and also reduced its hedge protection. As a result of these actions, for the first half of 2012, Southwest has minimal protection but in the second half of 2012, it has got meaningful projection for WTI prices in excess of $100. This helps the company reduce its current premium review spend for 2012 to $48 million. That compares to a $114 million spend in 2011 and a $162 million in 2010 on a combined basis.
Southwest has 2,321 million gallons of fuel hedged over the 2012-2015 period as of December 31, 2011.
Growing preference for low-cost carrier model
During the past decade, low cost carriers have gained a lot of prominence in the overall airline industry. The total market share for these low cost airlines in the US on the basis of Revenue Passenger Mile (RPM) has risen from 7.1% in 1999 to 28.1% in 2009.
In countries where airlines are having difficulty creating joint ventures with other airlines, the creation of a new low cost carrier is being seen as a strong alternative. Singapore Airlines, for instance has confirmed the launch of a low cost carrier in the first half of 2012.
As demand for travel grows in developing markets, it is quite inevitable that low cost airlines will play a large role in meeting the needs of the growing population. According to IATA estimates, the number of people flying in Asia will increase to one billion by 2014.
How Does Trefis Modelling Work?
How do we get the historical numbers for this chart?
Trefis has a team of in-house Analysts who gather historical data from company filings and other verifiable sources. When historicals are available, we explain how we got them at the bottom of the Trefis analysis section below.
Who came up with the Trefis forecast for future years?
The Trefis team of in-house Analysts considers a variety of factors when projecting any forecast. The rationale for our projections is explained in the Trefis analysis section below.
How does my dragging the trendline on the chart impact the stock price?
- We use forecasts for business drivers to calculate forecasted Revenues and Profits for each division of the company.
- We then use forecasted Profits in a Discounted Cash Flow (DCF) model to obtain the Price Estimate for the company.
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