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Southwest Airlines (NYSE:LUV) is expected to announce its second quarter earnings on Thursday, July 19. The company posted better-than-anticipated results in the previous quarter due to hikes in passenger fares. However, since then, Southwest has been cautious about raising air-fares further in an attempt to prevent a decline in demand for flights. Thus, in the absence of significant fare hikes, the trends that will matter the most for the airline for this quarterly earnings include the AirTran acquisition (benefits vs. acquisition costs), average fuel costs incurred for the quarter, and operational performance.

We currently have a Trefis price estimate of $12.50 for Southwest, approximately 30% above its current market price.

AirTran acquisition - benefits vs. acquisition costs

Southwest reportedly spent $155 million in AirTran acquisition and integration costs till the end of previous quarter, while it expects to spend a total of $500 million in acquisition and integration costs. We anticipate the airline to incur substantial AirTran integration costs during the second quarter as well, and these could exceed the financial benefits achieved during the period from the acquisition. As a result, this extra cost head will weigh heavily on the already thin margin for the airline. However, over the long term, we anticipate the financial benefits from the acquisition to far outweigh the integration costs.

High fuel costs

The airline anticipates to incur fuel costs in the range of $3.40 to $3.45 per gallon, which will likely depress its profit margins. In the past, Southwest was able to withstand pressure from high fuel costs due to its fuel hedging program that covered a large percentage of its fuel needs. However, the amount of fuel hedged has been steadily declining since 2009. As a result, the airline had minimal protection in the first half of 2012 from high fuel prices, but it has meaningful protection in the second half. Hence, the airline needs to maximize operational efficiency during the quarter.

Average operational performance

However, in its June traffic report, Southwest reported declines of 0.3 point in load factor, 1.6% in revenue passenger miles (RPM) and 1.2% in available seat miles (NYSEMKT:ASM) during the second quarter of 2012, on a year-over-year basis. The figures indicate average operational performance by the airline during the quarter.

Thus, on the whole, the airline has another tough quarter to navigate, with AirTran acquisition costs, high fuel prices and average operational performance to weigh on margins.

Disclosure: No positions.

Source: Southwest Airlines Will Face Earnings Headwinds, But Stock Is Still Cheap