Southwest Airlines (NYSE:LUV) reported net income of $16 million in the third quarter compared to net loss of $140 million in the year-ago period.  Operating revenues were $4.3 billion, comparable to the third quarter of 2011. However, operating profit declined 77.3% y-o-y to $51 million on higher non-fuel costs. Fuel costs for the airline were comparable to the same period of last year.
The company also adopted a conservative capacity stance for the third quarter, reflected by a 0.7% y-o-y decline in Available Seat Miles (ASMs). This impacted its passenger traffic during the period. However, its overall passenger revenues increased on account of higher passenger fares.
We currently have a stock price estimate of $9.65 for the carrier, approximately 10% above its current market price.
Passenger fare hikes carry Q3 earnings despite higher non-fuel costs
Non-fuel costs increased y-o-y in the third quarter with the airline retrofitting its fleet. Retrofitting, which includes updating cabin interiors, has been completed in 147 of its Boeing 737-700s. Southwest plans to complete the retrofitting in all its 372 700s in the first half of 2013. AirTran’s 700s are also being retrofitted to Southwest’s cabin interiors. This fleet modernization plan, together with retrofitting, also includes the replacement of Southwest’s old aircraft with new ones. This plan is expected to generate annual pre-tax savings of $700 million for the carrier by 2015.
Passenger traffic for the carrier declined in the third quarter, indicated by a 0.6% y-o-y decline in Revenue Passenger Miles (RPM). However, the effect of higher non-fuel costs and lower passenger traffic was offset by higher passenger fares. Southwest has been raising passenger fares in 2012 due to rising crude oil prices. For the nine months ended September 30, 2012, the average passenger fare increased 3.6% y-o-y to $146.56.
Fuel costs remain flat y-o-y in Q3, but expected to rise considerably in Q4
The average jet fuel cost for the airline during the quarter was $3.16 per gallon, in-line with Q3 2011. However, Southwest expects this to increase to an all-time high of $3.45 per gallon in Q4 (based on oil prices as of October 15). This could seriously impact its margins given the limited possibility of raising air fares further in the weak economic environment currently.
AirTran integration generates significant pre-tax synergies
With regard to synergies from the AirTran acquisition, Southwest has produced approximately $110 million in pre-tax savings year-to-date. For the full year 2013, the airline expects to generate $400 million in pre-tax savings from synergies related to AirTran integration. Also, with regard to integration costs, the carrier has incurred cumulative pre-tax costs of $310 million by September 30, 2012, and it expects to incur total integration costs of $550 million. Thus, net savings from AirTran’s integration will contribute significantly to the carrier’s margins 2013 onward.
Overall, Southwest’s higher passenger fares have enabled it to offset the impact of higher non-fuel costs and lower passenger traffic in the third quarter. However, its margins could come under pressure next quarter from higher fuel costs anticipated due to the limited possibility of raising airfares in the persisting weak economic environment.Notes: