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Southwest's Declining Edge?

In the not-so-distant past, things couldn't have looked much better for Southwest Airlines (NYSE: LUV  ) . So-called legacy carriers like AMR (NYSE: AMR  ) and UAL (Nasdaq: UAUA  ) , the parent companies of American Airlines and United Airlines, were struggling with sky-high fuel prices and burdensome labor expenses. While Southwest remains a fierce competitor, a quick comparison of data from Southwest's and AMR's most recent quarterly reports shows how times have changed.

Southwest has used a variety of tactics over the years to outdo rivals. But in two areas where it used to have a competitive advantage -- fuel and labor expenses -- Southwest's edge appears to have eroded.

As for fuel, the airline long had an advantage thanks to savvy hedging. Even as crude prices peaked at $78 per barrel in July 2006, Southwest investors could revel in the knowledge that their management had locked in 81% of its third-quarter 2006 fuel needs at $41 per barrel. The latest quarterly report, though, indicated that it is approximately 95% hedged for 2007 at about $50 per barrel.

While that's below the current per-barrel price of $53, Southwest clearly doesn't have the kind of fuel advantage it had in the past. Granted, if fuel costs surge again, it will be in a great position, but one has to consider the chances of a reoccurrence of the confluence of events that created the last price spike.

As the company's hedging contracts expire, higher fuel prices already are taking a bigger bite out of earnings. In the fourth quarter, its fuel expense rose 41% year-over-year. By comparison, AMR, which hasn't had much success hedging, saw its fuel expense decline 8.5%.

In a perhaps more troubling sign, Southwest's labor advantage appears gone. Salaries, wages, and benefits expense rose 9.7% in 2006 vs. 2005. The cost per employee at the end of the fourth quarter was $93,436. In contrast, AMR's expense in this area inched up just 0.9% last year, and its 2006 cost per employee was $79,965.

Admittedly, Southwest's fourth-quarter earnings were still more than three times those of AMR, despite having generated less than half of AMR's revenue. And Southwest carries far less debt. Nevertheless, investors should take note that some of Southwest's edges have been blunted.

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Fool contributor Brian Gorman does not own shares in any of the companies mentioned. The Fool's disclosure policy prefers pretzels to peanuts.

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