Southwest's Passenger Fares And Fuel Costs Are The Keys To Earnings

| About: Southwest Airlines (LUV)

Southwest Airlines (NYSE:LUV) will announce its fourth-quarter earnings on Thursday, Jan. 24. The airline posted strong growth in revenues and earnings in the first three quarters of 2012 on higher passenger traffic and fares. Revenues grew 12% y-o-y to $12.9 billion and earnings were $0.45 per share in the nine months ended Sept. 30, up from $0.03 per share in the year-ago period.

However, in the fourth quarter, the carrier slightly lowered its flying capacity, in line with the demand environment in the domestic U.S. market, which resulted in a decline in passenger traffic. If the hikes in passenger fares do not offset the decline in passenger traffic, we may see a marginal decline in Southwest's top-line in the fourth quarter. The carrier also forecasts significantly higher fuel costs in Q4 which will likely impact its earnings.

For full-year 2012 though, revenues and earnings will post impressive growth on strong performance in the first three quarters. We currently have a stock price estimate of $9.54 for Southwest, approximately 15% below its current market price.

Lower Passenger Traffic

In the fourth quarter, Southwest launched its service in a few cities such as Key West, a popular tourist destination in Florida. But these additional flights could not offset the decline in the carrier's flying capacity on certain other routes. As a result, Southwest's overall flying capacity declined marginally in the fourth quarter.

Stiff competition from other airlines in the domestic U.S. market also saw the load factor (percentage of occupied seats in a flight) for Southwest decline 0.9 points to 79.6% in the fourth quarter. Lower capacity and load factor in effect mean lower passenger traffic. However, if lower passenger traffic is not offset by higher fares, the carrier's revenues and earnings will be negatively impacted.

Southwest Forecasts Higher Fuel Costs

Additionally, Southwest expects its jet fuel costs to increase to $3.45 per gallon (based on oil prices as on Oct. 15, 2012) in Q4 from $3.16 per gallon in Q3. Though crude oil prices declined marginally from their October 15 levels over the remainder of Q4, jet fuel costs are expected to be considerably higher on a year-over-year basis in Q4.

Marginal Impact From Sandy

The impact of superstorm Sandy will be marginal as the carrier is less dependent on northeast United States (where the storm caused maximum damage) for passenger traffic compared to some of its competitors like JetBlue (NASDAQ:JBLU). Southwest cancelled around 1,750 flights due to the storm. To provide context, the carrier operates around 3,800 flights per day.

Induction of Boeing 737-800

On the bright side, Southwest’s induction of new Boeing 737-800s to its fleet will help its Q4 earnings. This larger aircraft allows the carrier to seat more passengers at a lower cost per seat. During 2012, Southwest was to receive 34 of these aircraft, of which it received 26 through Oct. 17, 2012. The addition of these aircraft to Southwest's fleet will contribute towards lower non-fuel costs in the fourth quarter and thereby improve earnings.

Disclosure: No positions.