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The leading low cost carrier, Southwest Airlines Co. (LUV) is slated to release its second quarter earnings on August 4 before market opens. The current Zacks Consensus Estimate for the second quarter is pegged at 21 cents, representing a decline of 29.02% from the year-ago level.

With respect to earnings surprise, over the trailing four quarters, Southwest Airlines has outperformed the Zacks Consensus Estimate for all the four consecutive quarters with average positive surprises of 7.77%.

We expect the airline to report strong revenue growth and achieve solid cost control in 2011 as it continues to explore and plan for revenue-producing opportunities going forward, thereby increasing earnings for the company. Management seems confident of its target to produce a sustainable 15% pre-tax return on invested capital and 15% annual earnings growth by 2012.

First Quarter Flashback

In the first quarter, Southwest Airlines’ adjusted earnings were at par with the Zacks Consensus Estimate as well as year-ago earnings. The company delivered strong results in terms of revenue and traffic growth that largely offset higher fuel and oil expenses.

Total revenue in the first quarter increased primarily on the strength of load factor coupled with strong passenger revenue yields and higher EarlyBird Check-In revenues. However, operating expenses rose year over year primarily on steeply rising fuel prices.

Agreement of Analysts

Estimates for the second quarter have been showing no change over the last 7 days but indicate a downward trend over the last 30 days. Over the last 7 days, none of the analysts out of 12 have made any revision in either direction. Over the last 30 days, 5 analysts reduced their estimates while none made a positive revision.

For fiscal 2011, out of 11 analysts, none revised the estimate in the last 7 days. Over the last 30 days, no positive revision was made to the estimate, while 6 revised their estimates downward. This reflects a downward trend by the analysts.

For fiscal 2012, out of 13 analysts, none revised the estimate in the last 7 days and no positive estimate revision was made over the last 30 days. However, 6 analysts revised their estimates downward in the last 30 days. This reflects a downward trend by the analysts yet again.

Given the surging fuel prices that have shown continued negative impact on air carriers in the first quarter of 2011, the analysts maintain a cautious outlook on the second quarter financials of the company. Moreover, Southwest Airlines is increasingly being exposed to price competitiveness as other low-cost carriers as well as major airlines are slashing fares to attract customers. Southwest Airlines competes with Delta Air Lines (DAL), United Continental Holdings (UAL), AMR Corporation (AMR) and US Airways (LCC). Hence, skyrocketing fuel prices coupled with fare price volatility portend a challenging second quarter for Southwest Airlines.

Magnitude — Consensus Estimate Trend

Over the last 7 days, the magnitude of second quarter estimate revisions remained unchanged at 21 cents but dropped from 23 cents over the last 30 days.

For fiscal 2011, the Zacks Consensus Estimate remained static at 64 cents over the last 7 days but fell from 70 cents over the last 30 days.

Similarly, fiscal 2011 estimate revisions remained unchanged at $1.05 over the last 7 days but fell 5 cents over the last 30 days.

Our Analysis

We believe Southwest Airlines is well positioned for growth due to its cost leadership position, strong balance sheet, low cost, flexibility, network optimization, and increasing revenue initiatives such as new frequent flyer program and the introduction of Boeing 737-800 fleet into its network.

However, we remain cautious due to rising fuel prices, which might adversely affect the ongoing recovery of the airline industry. The failure to successfully integrate AirTran, technology investment, competitive threats, and concerns on labor costs may limit the upside potential of the stock. Hence, we are maintaining our Neutral recommendation on the shares with a target price of $11, based on 16.2x our earnings estimate for 2011.

Currently, we are maintaining a long-term Neutral recommendation on Southwest Airlines, supported by a Zacks #3 (Hold) Rank.

Source: Southwest Airlines: Earnings Preview