Fuel Hedging To Help Southwest, Not Peers

About: Southwest Airlines Co. (LUV), Includes: DAL, SAVE, UAL
by: Ezra Weener

As a domestic airline, Southwest is free of pressure from a pending trade war and currency exchange risk.

The company has become more fuel-efficient and maintains growth in terms of ASM per gallon of fuel.

The company is highly hedged against rising fuel prices and will experience less downward pressure on earnings.

This should cause them to outperform their peers in Q2 2018.

Southwest Airlines (LUV) has had a tough year. Since this time last year, they have watched their stock price tumble almost 16%. This comes from a lack of growth in terms of operating margin and a decrease in average fare revenue in comparison to the first quarter from the previous year. Since this release, the company has had a fairly steady decrease in stock price. Will these factors cause the company to continue to feel the pain or will they dampen to allow the company to grow? To see we must look at four main factors: oil spot prices/hedged prices, Revenue per Available Seat Miles and overall fare revenue, macroeconomic factors such as disposable income and jobs reports, and lastly competitive pressure.

The first item I want to look at is the increase in disposable income. As can be seen from the graph below, per capita disposable income is on the rise. This historically has proven to be a large factor as it costs money to fly, especially for non-business purposes, and disposable income is a metric of the amount of available cash for consumers to spend on non-staples such as airfare.

Another item to look at when discussing macro-economic trends is the pending trade war with China. While other international airlines such as Delta (NYSE:DAL) and United (NASDAQ:UAL) have the possibility for increased taxation from other countries and other international pressures, such as currency exchange risk, Southwest avoids all that by being almost completely domestic airline serving only 10 countries they claim to be “near-international” such as Mexico and Cuba. This allows them to stay out of the EU and China where sanctions and trade discussions could put a dent in companies’ profits.

Next, I would like to bring into picture how Southwest has done a great job reducing the impact of the rise in cost of oil on the business. From 2013 to 2017, the company increased the number of ASM per gallon of fuel from 71.7 to 75.2. This trend is set to continue with the company having replaced a significant portion of their fleet with newer, more efficient models as per their 10k “The Company focuses on reducing fuel consumption and improving fuel efficiency through fleet modernization and other fuel initiatives. For example, during 2017, the Company continued to replace its older aircraft with newer aircraft that are less maintenance intensive and more fuel efficient. The Company retired all remaining Boeing 737-300 aircraft.”

To compare the first quarter of 2018 versus the same quarter in 2017, the company saw an increase in fuel consumed of only .4% while ASM increased 1.8%. While this definitely isn’t enough of a reduction to pretend that fuel prices don’t matter, it is hopeful to see that despite a 3% rise in fuel prices, operating expenses per ASM only rose .1%. While this is partially due to increases in fuel efficiency, it is more importantly due to increased operating efficiency in terms of fleet management and other operating metrics.

At the end of the day, however, the company is still heavily reliant on fuel prices as can be seen below. As is displayed, fuel costs are nearly 24% of costs per ASM.

While Southwest is definitely reliant on fuel prices and has large exposure, the company also is largely hedged down to offset portions of the rise. For example, Southwest saw their average fuel cost increase 3% in economic terms from 1Q2017 and 1Q2018. In the same exact period, we can see Delta had an increase of 22% for fuel prices, United an increase of 23.4%, and Spirit (NASDAQ:SAVE), their low-cost competition, an increase of 21.5%.





While Delta and United are less exposed to fuel in terms of percentage of total operating costs, with Delta at 20.3% and United at 22.4% of total operating expenses, this change will affect their business to a significantly higher degree than Southwest. Even more affected will be Spirit with their fuel costs coming in at 27.5%.

With oil prices having continued to rise since then and only starting to slightly pull back now, we can expect second-quarter profits to have taken a hit. While Spirit, United, and Delta will all take a big hit on their profits from the increase in oil prices, Southwest’s hedges should help shield them from feeling the loss to such a significant degree.

We can see from their 10Q that they are heavily hedged and should be only mildly adversely affected.

As we conclude what is likely the most important short-term factor for profits, we should look at more long-term factors such as fare growth and Revenue per ASM. The first metrics I want to look at is revenue from passengers carried and enplaned passengers. These numbers look positive as they have grown 6.1% and 5.5%, respectively, in comparison to the first quarter of last year.

However, as we get further into the details we see that Southwest actually had revenue per ASM decrease as their average flight distance for passengers decreased 2.1% and the average fare decreased 4.9%. While more flights were flown, they were flown for shorter distances and less money. This downward price pressure comes as Domestic carriers grow their fleets and try to expand their offerings and Ultra-Low cost carriers (ULCC) such as Spirit and Frontier reduce their fares as well.

As we can see from both the lack of international risk and the favorable terms of their fuel hedges, the company has a large advantage over the industry in regards to their current profitability. While they are witnessing fare price decline and competitive pressure, it is likely that ULCCs will need to raise prices to maintain their profits with rising fuel prices. When this happens, Southwest will be able to take advantage of this increased fare rate without the significant dampening of income all the other companies will feel.

This article is in no way meant to forecast future price of fuel, but to show how the prices of fuel will have affected each airline in the industry in addition to other mentioned factors. Due to these factors, I believe the company will positively surprise when it comes time for their 10Q, especially in comparison to other airlines, with Spirit likely to be the most affected.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in LUV over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.