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We are likely near the beginning of a long-term uptrend for airline stocks. The operating environment for airlines is improving due to capacity reductions and moderating jet fuel prices. All the major airlines are expected to see substantial profit improvement next year, in spite of a weak economic forecast. If the economy does continue to improve over the next few years, then airline stocks will have even more upside.

Southwest Airlines (LUV) has long been considered a leader in the airline sector, and for good reason. While competitors Delta (DAL), United (UAL), US Airways (LCC), and now American (AMR) have all declared bankruptcy over the past ten years, Southwest has enjoyed 38 consecutive years of profitability (and this year should be year 39, though just barely).

However, the bankruptcies of all of these competitors have allowed them to drastically reduce their cost structures. Southwest's CEO, Gary Kelly, told employees in a memo last week that competitors are finally catching up to Southwest. Kelly claimed that the cost gap between Southwest and the legacy carriers has been cut in half. This has pressured Southwest's profits in recent years.

Aside from the overall narrowing cost differential, there are two major reasons why Southwest shares are not likely to rise as quickly as those of United, Delta, and US Airways. First, Southwest has invested in offering better service than other carriers, yet has been unable to thereby achieve a revenue premium. The most important way in which Southwest has tried to differentiate itself from competitors has been in its "Bags Fly Free" campaign. All of the legacy carriers charge for the first and the second checked bag, while JetBlue (JBLU) charges for a second checked bag.

The legacy carriers earn about $60 each way for passengers who check two bags, while Southwest does not charge such passengers unless their bags exceed the size/weight limits. The result is that Southwest has less ancillary revenue than its competitors. Free checked baggage is essentially an amenity that Southwest offers. Southwest (like the other airlines) needs to support a baggage crew on the ground, but unlike other carriers, has to pay these costs out of the base airfares it charges, instead of baggage fees.

The problem is that most customers just look at the base airfare when choosing which ticket to purchase. Super low-cost carriers like Allegiant (ALGT) rely on this, as they sell base airfares at or below cost, and make their profit on fees and commissions. Sure, passengers might get angry when they feel like they are being nickel-and-dimed. But ultimately, they will pay up, and will do the same thing again the next time they fly. This idea is supported by comparing airline revenue statistics.

Last quarter, pro forma PRASM (the key airline revenue metric) grew 6.4% for Southwest, while the same figure grew 10.1% for United and 10.9% for Delta. Thus, Southwest cannot charge a higher base airfare than competitors, and since it has fewer ancillary revenue streams, it ends up taking in less revenue than competitors. Given the cost pressure that all airlines have felt this year due to high jet fuel prices, it is no wonder that Southwest's profits have been falling.

The second issue for Southwest is the integration of AirTran. Merger integration processes are traditionally difficult for airlines. One typical stumbling block is the integration of seniority lists between the two carriers. Fortunately, this issue has been resolved, after initial difficulties lead executives to float the idea of operating AirTran as a separate, wholly-owned subsidiary. However, it is still unclear how the integration will affect overall costs. AirTran pilots (and other employees) tend to be paid below the industry average, whereas Southwest employees have industry-leading compensation plans. For equivalent positions, Southwest pilots can make anywhere from 30-100% more than their colleagues at AirTran.

When the pilots sign a joint contract, don't expect them to meet in the middle; AirTran pilots will get a substantial salary bump that will cut into the "merger synergies" that Southwest expects to achieve. A second issue is the transition of AirTran's Atlanta hub into a Southwest "point-to-point" focus city. While Southwest expects this move to generate substantial additional revenue, it is not clear that the company will be able to replace all of AirTran's connecting traffic with nonstop customers immediately. While Southwest builds its presence in Atlanta, it will likely face an initial decrease in traffic, as connecting passengers from smaller markets (that Southwest is exiting) and those who want business-class seating defect to Delta.

I have no doubt that Southwest will sort through all of these issues over the long haul and will continue to be an industry leader in the airline sector. If you want exposure to the airline sector but can't tolerate the risk inherent in the legacy carriers' balance sheets, then Southwest may be worth a look. But until Southwest catches up with its peers on the revenue side, I think other airlines have better near term profit growth potential. I recommend United, US Airways, and Delta as better picks than Southwest.

Source: Southwest Airlines' Stock Will Lag Peers