Southwest Airlines: Earnings Preview

| About: Southwest Airlines (LUV)

The largest U.S. low-cost carrier Southwest Airlines Co. (NYSE:LUV) is slated to release its fourth quarter and fiscal 2011 earnings on January 19 before the opening bell. The current Zacks Consensus Estimates for the fourth quarter and fiscal 2011 are 6 cents and 41 cents, respectively. This represents a respective 59.9% and 42.78% decline from the year-ago level.

Looking at surprises, Southwest had negative surprises of 6.60% in the last four quarters. But in the third quarter, the company had surprised us positively by reporting 15.38% higher earnings than what we had expected.

In the third quarter conference call, Southwest projected modest growth in fourth quarter unit costs from the year-ago level of 7.72 cents (excluding fuel and special item). Fuel costs, including fuel taxes are estimated at approximately $3.30 per gallon for the fourth quarter.

According to management projections, while the purchase of AirTran earlier this year would result in acquisition and integration costs of approximately $500 million for fiscal 2011, it will also likely be accretive to its fully diluted earnings per share in 2011.

Third Quarter Flashback

Southwest Airlines reported third quarter adjusted earnings of 15 cents that outpaced the Zacks Consensus Estimate by 2 cents but remained way behind the year-ago earnings by 11 cents.

Total revenue improved from the year-ago quarter and surpassed the Zacks Consensus Estimate on strong growth in the All-New Rapid Rewards program and EarlyBird Check-In revenues. Airlines traffic showed an impressive growth of 32.2% with strong increases in capacity (or, available seat miles) and load factor (percentage of seats filled with passengers).

Escalating fuel prices drove operating expenses higher. Unit cost (cost per available seat mile) excluding fuel and special items, dipped 1%.

Agreement of Analysts

Estimates for the fourth quarter have been trending upward over the last 7 days with 2 out of 12 analysts making upward revisions. None of them made a downward revision. Over the last 30 days, estimates are trending downward with 3 analysts moving in the same directions while 2 moving opposite.

For fiscal 2011, out of 10 analysts, 2 revised their estimates upward over the last 30 and last 7 days each. 3 analysts made negative revisions to their estimates over the last 30 days and none revised the estimate downward over the last 7 days.

The analysts have turned positive based on Southwest’s profitable actions to endure surging fuel prices and ongoing market turmoil. Despite the recent topsy-turvy in financial markets, the company imposed nine successful broad fare increases in the last year, thanks to the rise in travel demand.

Additionally, hedging strategies provide a cushion to the rising fuel prices and are being used extensively by Southwest Airlines. For the fourth quarter, the company has hedged 10% of expected fuel consumption at crude prices of $100–$110 per barrel, 45% at $110–$120 per barrel, and 40% above the price of $120 per barrel.

The analysts expect Southwest to report strong revenue and earnings growth this fiscal year on the back of new reservation system, Rapid Rewards frequent flyer program and increased ancillary product offerings such as EarlyBird check-in, unaccompanied minor travel and pet fees. The company is adding improved features to their services as well as introducing new products, which is enhancing its value and profitability. Additionally, the company is trimming its domestic flights while increasing international voyages.

Further, the purchase of AirTran has boosted its flying capacity by 25%. Southwest will soon introduce services to new and unexplored domestic markets and debut in the Caribbean and Mexico. The transaction is expected to generate net synergies of more than $400 million by 2013. As of the third quarter of fiscal 2011, Southwest generated $60 million of annual synergies.

Moreover, Southwest’s strong balance sheet with manageable debt maturities added to the analysts’ optimism for making upward revision to the stock.

Magnitude — Consensus Estimate Trend

The Zacks Consensus Estimate for the fourth quarter remained static at 6 cents over the last 7 days but fell by a penny over the last 30 days.

Over the last 7 and 30 days, the magnitude of the fiscal 2011 estimate revisions remained unchanged at 41 cents.

Neutral Recommendation

We believe Southwest Airlines is well positioned for future 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 The Boeing Co. (NYSE:BA) 737-800 fleet into its network.

However, labor costs concerns, rising fuel prices, stiff competition from major rivals like United Continental Holdings Inc. (NYSE:UAL) and Delta Air Lines Inc. (NYSE:DAL) and higher technology investments keep us on the sidelines. Additionally, we believe Southwest profits might be restricted going forward due to possible increases in labor costs on the integration of AirTran expected this year.

We are currently maintaining our long-term Neutral rating. The stock retains a Zacks #3 (Hold) Rank for the short term.

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