Southwest Posts Stellar 3Q Earnings Backed By Fuel Cost Savings And Capacity Expansions

Sailing on the lower oil price wave, Southwest Airlines (NYSE: LUV) posted a notable jump in its September quarter net profit on the back of lower jet fuel prices. The Dallas-based airline witnessed a significant growth in its revenue driven by rapid capacity additions during the third quarter, despite a drastic drop in its unit revenue. Moreover, the airline has used the fuel costs savings as a cushion to grow its operations internationally and expand its presence globally over the last few months. With a weak outlook for oil prices and strong domestic demand, coupled with Southwest’s low cost structure, we believe that the international expansion is a calculated risk on the part of the airline, which is likely to result in its favor in the long term. Let’s look at the key trends that we saw in the airline’s third quarter earnings release ^[1] and its guidance going forward.

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Rapid Capacity Expansions Boost Top Line

Unlike the legacy carriers, Southwest continued to grow its system capacity at a high rate during the third quarter, despite facing an investor sell-off in the second quarter over fears of a pricing war among airlines. The airline grew its capacity by 7.6%, which resulted in an increase to close to 9% in its passenger traffic ^[2]. The carrier also saw improvement in its load factor (occupancy rate) during the quarter, which implies that the airline flew fuller planes during the September quarter. Thus, it is evident that Southwest managed to attract more passengers for its new capacity, which translated into almost 11% growth in its 3Q revenue. Although the airline experienced a 4% drop in its unit revenue, much higher than its previous guidance of a 1% decline, the airline reported consolidated revenue of $5.3 billion, beating the market estimate of $5.1 billion.

Southwest Expands Operations From Dallas Love Field Airport

Source: Southwest Investor Presentation

Lower Fuel Costs Drive Margin Growth

Despite the slower-than-expected recovery of the oil prices in the third quarter, Southwest could not fully realize the benefit of lower fuel prices. This is because the airline had hedged its fuel consumption for the September quarter. As a result, the airline’s average fuel price stood at $2.20 per gallon for the latest quarter. While this was in line with its guidance, the fuel price could have been much lower without the hedging losses, which would have further boosted its earnings for the quarter. Nonetheless, the airline generated fuel cost savings of $450 million, resulting in a significant jump in its operating margin. Southwest’s operating profit (GAAP) almost doubled to $1.2 billion, translating into an operating margin of 23%, which is one of the highest in the industry. Further, due to Southwest’s buyback program, its earnings per share grew faster than its net income. The airline reported a net income of $584 million, 77% higher on a year-on-year basis, while its EPS was $0.89 per share, representing an increase of over 85%.

Outlook For 4Q And Beyond

Despite the fears of an oversupply of seats in the domestic market, Southwest expects to grow its system capacity by 7% during 2015. This will be largely due to expansions at Dallas Love Field where the airline has been growing its operations aggressively after the expiration of the Wright Amendment last year. The airline opened the Houston Hobby airport expansion last week, and will be operating four of the five gates at the airport to offer international flights. Southwest will soon launch flights to San Jose, Costa Rica; Cancun, Mexico City; Puerto Vallarta and Los Cabos, Mexico; and Belize City, Belize. For 2016, the airline aims to expand its capacity by 5-6%. Based on the current bookings for the fourth quarter, the company sees an improvement in its unit revenue by around 1%. On the cost side, based on the current oil prices, Southwest anticipates its December quarter fuel prices to average $2.05 to $2.10 per gallon, lower than the $2.62 per gallon recorded in the same quarter last year.

Source: Google Finance

Thus, we figure that while the fuel costs will continue to drive Southwest’s earnings for the next few quarters, its international operations will play a significant part in its value in the long term.

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1. Southwest Announces 3Q Results, 22nd October 2015 [↩]
2. Southwest Form 8-K, 22nd October 2015 [↩]