Southwest Q3 Preview: Trends We're Watching

| About: Southwest Airlines (LUV)

Southwest Airlines (NYSE:LUV), will release its third quarter results this Thursday, Oct 20, along with its low cost peer Alaska Airlines (NYSE:ALK). Legacy carriers including American Airlines (AMR), Delta Air Lines (NYSE:DAL) and United Continental (NYSE:UAL), which compete with Southwest in the domestic market, released their Q3 results this Monday. Revamped loyalty programs, additional ancillary products and continued progress with AirTran integration were amongst the highlights of the quarter for Southwest. Unit growth remained robust in the last two months of the quarter, though rising fuel costs continue to depress margins. Below, we take a closer look at the trends that were seen in the last quarter at Southwest and how these could impact the prospects for the carrier.

See our full analysis of Southwest

Unit Revenue Growth Remains Strong Aided by Higher Ancillary Revenues in Q3

Southwest recorded year-on-year passenger revenue growth of 1% in July, 6% in August and 12% in September, on overall 4.7% higher capacity in the third quarter. The carrier is guiding to low to mid single digit unit revenue gain for the full quarter.

The discount carrier expects third quarter ancillary revenues (including AirTran) to rise above $223 million, as recorded in Q2 2010. The increase is expected to be driven by business partner income and EarlyBird revenues. EarlyBird allows customers to automatically obtain a reserved boarding position before general check-in begins. For 2011, Southwest is on pace to achieve over $100 million in revenues from its EarlyBird Check-in product. With the March launch of the new Rapid Rewards Program, the carrier’s loyalty program, business partner revenues are growing.

(Chart created by using Trefis' app)

Rising Unit Cost Pressures Mitigated By Merger Cost Synergies

According to initial guidance issued by Southwest, the average third quarter fuel price is expected to be in the $3.20-$3.30 per gallon range, over 30% higher than the same quarter last year. The airline estimates non-fuel unit costs to be 1% higher in Q3 on a y-o-y basis. The increase is driven primarily by higher advertising and airport costs.

During Q2 2011, the merger with AirTran led to streamlining of Southwest’s back office functions including procurement, which created immediate efficiencies and cost savings with Southwest’s significant buying power. Modest cost synergies are being realized with the modification of AirTran’s existing contracts, primarily in the finance, treasury and maintenance areas. These are expected to ease the burden on margins, from rising fuel costs.

(Chart created by using Trefis' app)

AirTran Integration Presents Opportunities to Boost Top-Line

Southwest acquired AirTran in May, this year and the two are currently operating separate airlines, policies, procedures and product features until receipt of a single operating certificate by the regulators. As the AirTran integration begins in 2012, Southwest sees opportunities to optimize the two route systems, especially the AirTran side of the route system and drive substantial unit revenue gains with that conversion.

With the acquisition of AirTran, Southwest now has the opportunity to serve Hartsfield-Jackson Atlanta International Airport, the world’s busiest airport. In September, the carrier announced plans to expand its service plan for the airport next year with two additional nonstop destinations, Las Vegas and Phoenix. By revamping the hub, Southwest expects to boost sales by $750 million to $1 billion.

We have Trefis price estimate of $10.60 for Southwest, implying a premium of ~20% over the current market price.

Disclosure: No position