Higher fares and synergy benefits from the AirTran integration supported Southwest‘s (NYSE:LUV) revenue growth in the first quarter. The carrier’s passenger traffic also increased marginally on support from growth in its flying capacity. In all, Southwest’s revenues increased by 2.3% year-over-year to $4.1 billion in the first quarter. 
However, its profits declined by nearly 40% y-o-y to $59 million due to lower gains from fuel hedging and other special items. Excluding special items, Southwest’ profits were $53 million in the first quarter, compared to a loss of $18 million in the prior year period. 
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Looking ahead, the carrier looks poised to realize $400 million (pre-tax) synergy benefits in 2013 from its AirTran integration.  The carrier has completed a crucial network rationalization of the Southwest and AirTran networks that will allow customers to fly connecting itineraries between the two carriers. Southwest’s fleet modernization is also on track and will likely bring greater benefits to its results over the remainder of 2013.
Mitigating this, in the second quarter the carrier’s profits will likely get impacted from lower unit revenues – the average revenue generated from a passenger for a mile of flight – due to lower demand driven by sequester. Southwest announced in its earnings release that it expects lower year-over-year unit revenues in April, however, this revenue weakness will likely get offset in part from lower fuel prices.
We currently have a stock price estimate of $14 for Southwest, just ahead of its current market price.
Lower Gains From Fuel Hedging Weigh On Profits
In the first quarter, Southwest realized net gains of around $46 million from its mark-to-market fuel hedges, down from around $170 million mark-to-market fuel hedge gains in the year ago period.  This decline in gains from fuel hedges impacted the carrier’s profits in the quarter. However, these are special items separate from the carrier’s core business where results actually improved year-over-year in the first quarter. This is reflected by growth in the carrier’s operating income to $70 million in the first quarter compared to $22 million in the prior year period. 
Ongoing AirTran Integration And Fleet Revamp Will Bring Greater Benefits In Future
In addition, in the first quarter, Southwest reached an important milepost in its network integration with AirTran. The networks of the two carriers now allow a customer to fly connecting itineraries to the extent that all 97 destinations under the combined networks of Southwest and AirTran can be flown on a single itinerary. Bookings driven by such connection capabilities will provide an upside to Southwest’s revenues over the remainder of 2013.
This capability will also help Southwest optimize the operations of the two carriers at Atlanta, which is a hub of AirTran with hub-and-spoke operations. Southwest believes that it can now transition Atlanta’s operations to its own model of point-to-point operations. This will likely bring cost savings through increased employee productivity and better flight scheduling.
At the same time, Southwest will also realize greater cost and revenue benefits over the coming quarters from its ongoing fleet modernization. In the first quarter, Southwest continued to retrofit its 737-700s with the Evolve interior. As of March 31, the carrier had installed these interiors in over 90% of its -700s with the remaining expected to be retrofitted by the end of the second quarter.  These new interiors increase the on board seating capacity of the airplane from 137 to 143 providing revenue growth opportunities. 
Southwest also took delivery of nine new Boeing 737-800s in the first quarter and retired four older 737s from its fleet.  Lower maintenance and operating costs resulting from the ongoing replacement of older 737s with new 737-800s will help in the carrier’s margin expansion. (See How Is Southwest’s Fleet Modernization Aiding Its Growth?)Notes: