Southwest Airlines reported operating sales of $23.8 billion in FY '22, up from $15.8 billion in FY '21. Rising fuel costs outweighed controlled expenditure across other operating cost drivers, and operating income dropped from $1.72 billion to $1.02 billion over this period, in turn causing EPS to drop from $1.65 to $0.91 in FY '22.
Below are key drivers of Southwest Airlines' value that present opportunities for upside or downside to the current Trefis price estimate.
Southwest's Fuel Expense for Passenger Travel: Fuel expenses are the largest operating expense incurred by an airline. For Southwest, it has averaged around 26% (as a percentage of its revenue) over the last 7-8 years. It stood at 30% of its revenue in 2014. However, due to plummeting crude oil prices since mid-2014, fuel expenses have been reduced substantially for the airline. Fuel expenses as a percent of revenue fell to 20% in 2016 due to the depressed oil prices. However, through 2022, crude oil prices witnessed a steady surge in prices, leading to a jump in the key metric to about 28%.
We expect the fuel costs to drop gradually over the near term. If, however, crude oil prices jump further, and fuel expenses rise to 32% instead of the current end of the period forecast, then there could be a potential downside of around 20% to the Trefis price estimate for Southwest Airlines's stock.
Southwest Passenger Yield: Southwest’s Passenger Yield has steadily increased over the last few years to $0.163 in 2014. However, due to increased competition in the domestic market, the airline experienced pricing pressure which led to a sharp fall in its passenger yield in 2015. Southwest's passenger yield declined to $0.156 during the year, falling further to $0.149 in 2017 and even further to $0.136 by 2021, before surging to $0.173 in 2022.
We expect the airline to take measures to reduce the rising competition. Consequently, we estimate that the airline's passenger yield will grow steadily to $0.19 by the end of the Trefis forecast period. If, however, the carrier's passenger yield rises more than anticipated to grow to $0.21, then there could be a potential upside of almost 15% to the Trefis price estimate of Southwest Airlines' stock.
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 onboard services (with add-ons at an extra charge), and fuel hedging programs. Savings through such an operating model allow the carrier to maintain low fares, which have been instrumental in growing its market share over the past several years.
The point-to-point model rather than the hub-and-spoke service model allows Southwest to maximize the use of its key assets, including aircraft gates and employees. This also helps the company 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, Southwest's point-to-point route structure allows for more direct non-stop routing than the hub-and-spoke model.
The low-cost model is a significant source of value for Southwest. The carrier has achieved and maintains a low-cost operating model by operating on a predominantly point-to-point route structure. Low dependence on hubs allows the airline to provide more direct service, utilize aircraft, terminal gates, and employees more, saving costs. Southwest also flies a single aircraft type - the Boeing 737. This helps lower its personnel training, spare part maintenance, and costs. This low-cost operating model translates into a significant competitive advantage for Southwest. Low costs allow the airline to offer lower fares, attracting passengers from competitors.
Southwest's launch of flights to near international destinations in the Caribbean will likely grow its results. We believe Southwest's zero baggage and ticket change fee will attract passengers in the international market as it has in the domestic market.
Fuel expenses constitute the single largest cost head for airlines, making them vulnerable to hikes in crude oil prices. For Southwest, fuel costs constitute around a third of its total operating expense. To reduce vulnerability to fuel price volatility, Southwest engages in fuel price hedging.
Demand for flights is highly correlated to global economic growth. Thus, a decline in economic growth, or recession, reduces demand for flights, impacting passenger traffic for airlines. On the contrary, steady growth in the global or U.S. economy, grows demand for air travel, allowing airlines to raise their airfares, occupancy rates, and profits.
Many airlines, including Southwest, are figuring out ways to grow their top lines through ancillary means such as baggage fees, access to onboard WiFi/food/drinks, etc. Accordingly, airlines are investing to enhance their product offerings which include in-flight WiFi and other entertainment options, improved lounge facilities, and extra-legroom seats.
According to an Amadeus/IdeaWorks study, North American airlines collectively produce one of the largest streams of ancillary revenues compared to other regions. A majority of the increase is attributable to stronger merchandising efforts by the carriers as well as the addition of more à la carte services for sale.
During the past decade, low-cost carriers such as Southwest and JetBlue have gained significant market share in the U.S. Looking ahead, we believe these low-cost carriers to continue to grow their market share, as their lower fares attract passenger traffic.
The U.S. airline industry has seen many mergers and acquisitions in the last decade including the five big combinations of US Airways and America West, Delta and Northwest, United and Continental, Southwest and AirTran, and American and US Airways.
A more consolidated industry has worked to improve the profits of all airlines. Fewer players in the market have made it easier for those remaining airlines to add capacity with restraint. Prior to this consolidation in the airline industry, individual airlines were adding capacity at higher rates in an attempt to grow their market shares. This rapid capacity addition resulted in an oversupply of seats, reducing the margin and profits of all carriers.
Going forward, we believe as long as airlines add capacity with discipline, the industry will remain profitable overall.
