5 Things Southwest Airlines Co. Management Wants You to Know

Southwest Airlines reported another quarter of rapid earnings growth last week, with adjusted EPS climbing 71% year over year to a Q3 record of $0.94. After the earnings release, Southwest executives spent about an hour talking to analysts and the media about how they plan to sustain these strong results. Here are five key issues they discussed.

 

Strong results in Dallas could get stronger

The financial performance out of Dallas has been superb from day one. So the improvement may not be as sharp in those markets as it will be in some others, but nonetheless, I absolutely would expect they will continue to see improvement from that capacity.
-- Southwest Airlines CEO Gary Kelly

The Wright Amendment expired about a year ago, allowing Southwest Airlines to start expanding rapidly at Love Field in Dallas. By the end of Q3, Southwest was offering nearly three times as much capacity as a year earlier. Southwest is starting to lap that growth this quarter.

 

While most of Southwest's new routes in Dallas have performed very well, their financial performance is likely to strengthen further as they mature. The company also has opportunities to improve its results in Dallas by tweaking its schedule based on what's worked and what hasn't worked as well in the past year. This should drive further margin expansion in Dallas.

 

Unit revenue continues strengthening

On a unit basis, our third quarter operating revenues declined 0.4% on a 7.6% capacity increase. And we are pleased with this very solid performance, especially considering the impact of increased stage length ... as well as the high percentage of development markets...
-- Southwest Airlines CFO Tammy Romo

Southwest Airlines' unit revenue declined 4.7% year over year in Q2 because of a weakening fare environment in the U.S. Last quarter, Southwest's unit revenue trend improved dramatically, registering a decline of just 0.4%. About 2.5 percentage points of the sequential improvement was driven by Southwest's revised credit card agreement with JPMorgan Chase.

 

Leaving that aside, Southwest saw solid demand during Q3, which is continuing into Q4. The carrier is also benefiting from the maturation of a large swath of new routes added in the past year or so. As a result, Southwest expects to return to year-over-year unit revenue growth of about 1% this quarter.

 

Higher aircraft utilization fueling low-cost growth

While we have significant opportunities, we also have significant access to low-cost incremental capacity to pursue these opportunities. And that's through the restoration of our aircraft utilization to more historic levels.
-- Gary Kelly

Southwest CEO Gary Kelly also noted that Southwest has been able to ramp up its growth this year at a very low cost by increasing aircraft utilization. For the past few years, the AirTran integration has hurt utilization as there were always some planes being converted to the Southwest configuration, or in the process of leaving the fleet.

 

Indeed, while Southwest's capacity rose 7.6% year over year last quarter, it ended the quarter with 692 aircraft, up just 1% from 685 a year earlier. That's a big part of why Southwest has been able to hold its non-fuel unit costs (excluding special items) flat this year, despite a massive increase in profit sharing payouts to employees.

 

Southwest should get additional gains in aircraft utilization during 2016, though on a more modest scale. The resulting efficiency benefits should offset some of its labor cost headwinds.

 

Plenty of domestic growth opportunities left

[In the U.S.], we have a variety of opportunities to add nonstop segments. And especially in short-haul markets, if those markets begin to return to pre-2000 traffic levels, we'll have a lot of opportunities to add frequencies in those markets as examples.
-- Gary Kelly

Earlier this month, Southwest Airlines opened its new international terminal in Houston with great fanfare. However, while the international market is a key growth opportunity going forward, Southwest expects the bulk of its growth to remain in the domestic market.

 

CEO Gary Kelly sees a particularly big opportunity in the short-haul market. Low fuel prices are allowing Southwest Airlines to offer lower fares on shorter routes, stimulating traffic as people opt to fly rather than drive. Other airlines aren't well-positioned to compete in the short-haul market, so Southwest could potentially capture most of the growth in short-haul flying.

 

Load factor gains may slow, though

Last year, Mike, we were at 83% annual load factor. That's 15 points higher than what we produced 15 years ago in the year 2000. ... So it seems to me unless we continue to evolve more toward trying to fill airplanes up with connections, we're going to be somewhere here in the low 80s.
-- Gary Kelly

One area where Southwest Airlines may be running out of opportunities is in filling empty seats. Historically, the company has had a lower load factor than the industry, which Gary Kelly attributes to its focus on point-to-point traffic. By contrast, many airlines schedule their flights to maximize connecting opportunities, which keeps their planes fuller.

 

Southwest has increased its load factor from 68% to 83% since 2000, seeing this as a way to boost unit revenue while keeping fares low. Without retooling its flight schedule to optimize connections -- which would be a departure from its profitable point-to-point model -- Southwest may not be able to pack planes much fuller than that. Future unit revenue gains will have to come mainly from higher fares.

 

(Adam Levine-Weinberg - The Motley Fool)