Southwest Airlines Races for the Integration Finish Line

Southwest planes on the tarmac (Photo: Southwest Airlines)

On Thursday, Southwest Airlines (NYSE: LUV  ) joined the chorus of U.S. airlines reporting record third-quarter results. Adjusted earnings per share more than doubled year over year from $0.13 to $0.34. Unit revenue grew 4.5% while unit costs declined as fleet modernization efforts reduced fuel and maintenance expenses.

While the results were a quarterly record for Southwest, CEO Gary Kelly made it clear that the company has plenty of upside left. Indeed, the company's 9% operating margin last quarter was well below the levels Southwest typically achieved prior to the Great Recession.

Southwest plans to deliver on this upside by moving quickly to integrate the AirTran and Southwest brands and optimize the company's combined route network. This process has been slowed by fleet and technology issues, but both issues are receding. The optimization process should drive Southwest's unit revenue significantly higher while keeping costs in line, boosting profitability.

Optimizing the route network
For the first two years following Southwest's acquisition of AirTran, the two airlines ran as completely separate entities. The two companies had incompatible reservation and technology systems, and whereas Southwest only flies Boeing (NYSE: BA  ) 737s, AirTran has a mixed fleet of 737s and smaller Boeing 717s. As a result, there were no revenue synergies between the two.

Earlier this year, Southwest was finally able to begin "code-sharing" between its namesake brand and AirTran. A customer can now book a single ticket through Southwest or AirTran that includes flights on both airlines. Southwest stated that it achieved $45 million in incremental revenue last quarter from this code-sharing process.

An equally big opportunity lies ahead, as Southwest is on the verge of completely retooling its Atlanta operations. AirTran historically operated a hub in Atlanta, with most of its flight activity clustered in the early morning and the evening in order to facilitate connections. However, Delta Air Lines (NYSE: DAL  ) is a formidable competitor in Atlanta, where it operates the largest hub in the world, with nearly 1,000 daily departures.

The result is that Delta has been able to offer much better travel schedules for passengers. This has helped it maintain a near monopoly on local traffic (i.e. non-connecting passengers). Southwest is fighting back by dismantling the AirTran hub and instituting a point-to-point operation, which features flights to large cities spread across the day.

The new schedule goes into effect next month, and Southwest's management team seems very pleased with the advance booking levels so far. Since local customers tend to pay higher fares than connecting passengers, Southwest has a big opportunity to boost its revenue if it can capture some of the local market from Delta.

Fleet modernization
The other big stumbling block in the AirTran integration has been AirTran's fleet of Boeing 717s. Southwest has decided to stick with the larger 737 as its only airplane; doing so vastly simplifies its operations. Last year, the company struck a deal with Delta Air Lines, under which Delta will lease all 88 of AirTran's 717s. These AirTran 717s will be replaced by Southwest-branded 737s.

The first 717 was delivered to Delta in August, and Southwest expects to deliver a total of 16 in 2013, followed by 36 more in each of 2014 and 2015. Southwest is currently replacing the 717s with 737-800s that have 50% more passenger capacity and significantly lower unit costs. The rapid replacement of AirTran 717s with Southwest 737s will improve Southwest's cost structure over the next two years, offsetting expected wage increases.

A big opportunity
In short, by 2015, Southwest should have completed the AirTran integration and boosted its profit margin to near pre-recession levels. The company is just beginning to optimize the combined route network, which should improve unit revenue, while the retirement of AirTran's 717s in favor of 737s will help keep costs down.

This will provide a strong platform for growth into new markets like Canada, Latin America, or Hawaii in the second half of this decade. In light of Southwest's likely margin expansion and its continued long-term growth prospects, I believe that the risk to reward trade-off remains favorable for investors, even with Southwest stock trading near multi-year highs.

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