While Southwest Airlines (NYSE: LUV) has been having a turbulent 2017, smooth skies are ahead as the airline announces its service to the Hawaiian Islands. Also, by retiring the 737-300 fleet and replacing it with the 737 MAX, Southwest has reduced operating costs, and can compete with longer haul airliners. These benefits will not be realized immediately as Southwest must prepare for its Hawaii service by setting up its ground operations on the islands as well as receiving an Extended-range Twin-engine Operational Performance Standards (ETOPS) certification for all of the aircraft that will fly to Hawaii, which is a long and expensive process. Even though the benefits are not immediate, the outlook is positive, and I rate Southwest as a Buy.
Hawaii is one of the largest tourist destinations by volume in the United States. According to the Hawaiian Tourism Authority, 8.9 million people visited the islands in 2016, a 3% increase from 2015. This marks the 5th straight year of record tourism growth. Southwest is trying to cut into the current market and grow the market utilizing its strong brand loyalty. However, one of the main competitors, Hawaiian Airlines (NASDAQ: HA), has a tight grip on the airline market in Hawaii. In 2016, Hawaiian flew around 11 million passengers to and from Hawaii. Assuming that most of these passengers had round trip flights, Hawaiian brought around 5.5 million people to Hawaii, over half of the 8.9 million people who visited.
While Hawaiian has a large market share, Southwest will be able to use many of its advantages to break into the market. First is the brand loyalty customers have towards Southwest. Southwest has numerous loyal customers who almost exclusively fly Southwest. With the new service to Hawaii, customers will no longer need to find a different airline that will take them to their Hawaiian vacation. Also, Southwest will add growth to the market by bringing loyal passengers who would not have considered a flight to Hawaii if it was not on Southwest. The next advantage is Southwest’s ability to keep its fares low. In recent years, flights to Hawaii on average range from $350 to $450 depending on what part of the country the flight leaves. While there is no direct comparison for Southwest fares to Hawaii, in 2016, Southwest had an average domestic fare of $149. This is significantly lower than the average fare to Hawaii. It is understood that flights to Hawaii will be more expensive than $149, but Southwest has been able to find ways to offer cheaper flights to many destinations when compared to competitors. This trend of keeping fares lower than those of competitors is likely to continue which will allow Southwest to attract more customers.
Hawaiian Service Risks
There are hindrances to Southwest’s service to Hawaii that may ground the operation before it takes off. One of the biggest obstacles Southwest faces is getting a 180 Minute ETOPS certification for its 737-800 series aircraft that will fly to Hawaii alongside the 737 MAX. This certification is required to ensure that a twin-engine aircraft can fly on one engine in case of emergency until it can reach the nearest airport. In the case of Hawaii, there are not a lot of airports in the middle of the Pacific, making the ETOPS certification a must. This certification is very costly because more training for the crew and mechanics is necessary. Southwest will need an ETOPS program that will maintain the fleet of aircraft, which will not be cheap. Also, engines are required to be replaced more often, further adding costs to the airline. Another risk can be seen in past failures by airlines who try to take part of the Hawaiian market and did not anticipate certain problems. Allegiant Air (NASDAQ: ALGT) tried to move into the Hawaiian market after purchasing 757 aircraft and getting them ETOPS certified. However, the low-cost carrier came upon many unforeseen problems that eventually caused the airline to stop flying to Hawaii. Many of these problems came from maintenance costs and customer service issues that hurt business. While Southwest is known for exceptional customer service, maintenance costs are a large concern.
Operational Cost Decline
With the delivery of the 737 MAX 8 aircraft, and the future delivery of the 737 MAX 7 aircraft, Southwest will be able to cut operational expenses tremendously. According to Boeing, the 737 MAX delivers 8% lower operating expenses compared to competitors. Also, the split winglet on the MAX will increase fuel efficiency by 1.8%. Southwest has 170 MAX 8 and 30 MAX 7 aircraft on order which will help save costs in the future. Also, Southwest’s fleet of 737-300 aircraft was retired a day before the MAX made its first revenue flight. These aircraft were very costly to maintain and will also help reduce operational expenses.
Although there are many costs for Southwest to start servicing the Hawaiian Islands, the airline is in a solid position that will allow for growth in the Hawaiian market in the future. Also, with the order of 200 new aircraft, Southwest will be able to reduce operational expenses with the new, efficient aircraft and by retiring older models that cost a significant amount to maintain. With all these factors considered, I rate Southwest as a Buy.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in LUV over the next 72 hours.