2015 Earnings Review: Southwest’s Earnings Surged Driven By Lower Fuel Costs And Capacity Expansions

Much like its peers, Southwest Airlines (NYSE:LUV) reported one of the best years in its history on 21st January 2016, posting a 46% rise in its earnings on the back of depressed fuel costs in 2015 ^[1]. However, unlike its competitors, the airline managed to improve its top line driven by rapid capacity expansion in Dallas, and growth in passenger traffic. Going forward, the Dallas-based airline has announced an accelerated share repurchase program and its plans to replace its existing fleet with next generation aircraft over the next couple of years, to leverage the weak outlook for the oil markets. In this note, we discuss the key highlights of Southwest’s latest earnings release and its guidance for the next year.

Source: Google Finance

Capacity Expansions Boost Southwest’s Revenue

Despite facing a severe investor sell-off in the second quarter over fear of an excess supply of seats in the market, Southwest grew its capacity by 7.2% in 2015, particularly in its hometown, Dallas, leveraging the expiration of the Wright Amendment. Further, the airline finally completed its integration with AirTran, which allowed the airline to access a number of new markets and expand its network. The rapid capacity additions and access to new markets allowed the airline to grow its passenger traffic by 8.8% on a year-on-year basis. Besides, the domestic carrier improved its load factor (occupancy rate) by 110 basis points to 83.6% in 2015, implying that the airline’s new capacity has strong demand. However, the airline experienced domestic pricing pressures due to competition from smaller carriers, which led to a 3.4% drop in its unit revenue. Yet, Southwest reported operating revenue of $19.8 billion, representing a rise of 6.5% over the previous year.

Lower Fuel Costs Drive Southwest’s Earnings

The 50% fall in crude oil prices in 2015 caused Southwest’s fuel expense to drop almost 30%, averaging at $2.07 per gallon for the year. This resulted in fuel cost savings of approximately $1.3 billion during the year. Moreover, the airline managed to keep its non-fuel unit costs flat for the year, augmenting its operating income. The airline recorded adjusted operating income of $3.9 billion, and adjusted net income of $2.3 billion, or $3.52 per share, 75% higher compared to the prior year. This marked one of the highest earnings delivered by the airline in its history.

Returning Value To The Shareholders

Driven by the fuel cost savings, Southwest generated record operating cash flow of $3.2 billion, of which the airline returned $1.4 billion to its shareholders in the form of share repurchases and dividends. Apart from this, the airline announced its plans to launch a $500 million accelerated share repurchase program, which will leave $200 million remaining on its outstanding 1.5 billion buyback authorization. Additionally, Southwest repaid $213 million of its long-term obligations during 2015, and issued a $500 million senior unsecured note at an all-time low 2.65%. This enabled the airline to obtain an upgrade to BAA1 by Moody’s in July. In addition to this, the airline announced its plans to order 33 new 737-800s from Boeing, spread out for delivery in 2016-2018. The airline estimates a capital budget of $2 billion for 2016 with a purpose to accelerate the re-fleeting program. This accelerated plan is expected to generate cumulative EBIT improvement of approximately $200 million over the next couple of years.

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Going forward

In 2015, Southwest built an international terminal at the Houston Hobby airport, which will enable the airline to launch international flights to and from the airport in the coming years. As a result, the airline aims to grow its system capacity by 5%-6% in 2016, driven by its international expansion plans. On the cost side, the airline forecasts the oil market to remain weak, and consequently, expects its fuel price to average at $1.70 per gallon in the first quarter. Based on the current oil prices, Southwest estimates its full year 2016 fuel price to be in the range of 1.70 to $1.75 per gallon. Further, the airline targets to restrict its unit costs (excluding fuel costs) from growing by more than 1% during the year.

Overall, we expect Southwest to post remarkable improvement in its earnings driven by its fuel cost savings and rapid capacity expansions in the next few quarters. In the long term, however, the airline’s international operations will play a crucial role in its growth.

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1. Southwest Announces 2015 Results, 21st January 2016, www.southwest.com [↩]