Unit Revenues To Improve In Q4’16 For Southwest, But High Labor Costs To Continue To Weigh On Earnings

Southwest Airlines (NYSE:LUV) is slated to release its quarterly and full year earnings on the 26th of January, 2017. The company having missed the consensus estimate for revenues in Q3’16, was seen to be trading almost 8.5% lower, after that announcement. Most of the decline seen in revenues and earnings was attributable to the technology outage episode that occurred in July (accounting for $55 million worth of losses), worsened by the 5% drop in air fares. However, since then the carrier’s stock price has recovered, probably on the back of improvement in unit revenues and continued success of its premium seating Mint program. In the upcoming quarterly results, we expect the company to grow its revenues at a modest pace due to disciplined capacity growth and improvement in yields. However, the bottom line may continue to suffer due to higher unit costs. In the following article we discuss some of the trends which are expected to be seen in the upcoming quarterly results.

Key Trends:

• The decline in Southwest Airlines’ passenger revenue per available seat mile (PRASM) has been much lower than that witnessed by its peers in the first half of the year. However, the technology outage episode caused the third quarter unit revenues to decline at -5%. In the fourth quarter, the company expects to see the decline in unit revenues to moderate to (3%)-(4%). This is attributable to the carrier’s efforts at lowering capacity from the highs of 10% y-o-y to approximately 5% y-o-y, and the improvement seen in yields due to the holiday season.

• Despite the arrest in the fall in unit revenues, the decline continues to be higher than that seen by legacy carriers, Delta and United, likely due to the stark difference in capacity strategy of the airlines. While the legacy carriers grew their yearly capacity at a maximum rate of 2%, Southwest’s full year capacity was up by as much as 5%, low by its own standards but high as compared to the industry.

• On a positive note, despite the high capacity, the company has shown improvement in occupancy rate, which is an indicator of how efficiently the company is using its capacity. We can expect the improvement in unit revenue, alongside the occupancy rate to have a supporting impact on the top line.

• We have recently seen some recovery in oil prices, owing to the OPEC countries’ decision to restrict their combined oil output to 1.2 million barrels of oil per day (Mbpd) over the coming months. In addition to this, the Non-OPEC members, such as Russia, also supported the OPEC’s move by offering to bring down their production by roughly 600,000 barrels of oil per day. In response to the news, crude oil prices have shot up by around 10% over the last one month, reinforcing to investors that the commodity markets are on the path of recovery. The increase is likely to impact the airline’s fuel expenditure, but not by much, as the prices continue to be much lower than the historical $100 per barrel.

• On account of Southwest’s new agreement with its pilots to raise pay by 15% with effect from late 2016, and then by 3% a year for the next four years (2020), we saw a hefty rise in unit costs in Q3’16. Since the contract is to be back dated to when the discussion regarding the agreement began (2013), providing an overall increment of close to 30% to its 8,500 pilots, we expect to see a continued increase of 5%-6% in unit costs in the upcoming quarterly results. This, in turn, will increase the company’s operating expenses, and consequently pressure the carrier’s margins.

Have more questions about Southwest Airlines (NYSE:LUV)? See the links below:

• How Did Southwest Perform Operationally In December?
• Increasing Costs At Southwest Airlines And What They Mean For The Carrier
• How Did Southwest Perform Operationally In October?
• Southwest Faces Market Heat As It Reports Disappointing Q3’16 Results; Future Guidance Bleak
• Southwest Q3’16 Earnings Preview: Labor Agreement, Rising Oil Prices To Weigh On Earnings
• How Did Southwest Airlines Perform Operationally In September?
• Will International Expansion Be A Big Part Of Southwest’s Future Growth Strategy?
• How Did Southwest Airlines Perform Operationally In August?
• What Are The Factors That Have Strengthened Southwest’s Domestic Presence?
• Has Southwest Been Able To Provide Meaningful Returns To Its Investors?
• How Has Southwest’s Cost Efficiency Improved?
• Tracking Southwest’s Capital Expenditure: How Has It Trended?
• How Has Southwest Utilized Its Cash Flows?
• How Will The New Labor Contract Affect Southwest?

Notes:

1) The purpose of these analyses is to help readers focus on a few important things. We hope such lean communication sparks thinking, and encourages readers to comment and ask questions on the comment section, or email content@trefis.com

2) Figures mentioned are approximate values to help our readers remember the key concepts more intuitively. For precise figures, please refer to our complete analysis for Southwest Airlines

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