Investors had high expectations for Southwest Airlines (LUV 5.30%) and Hawaiian Holdings (HA +0.00%) leading up to their earnings reports last week. Between late June 2016 and mid-January, shares of Hawaiian Holdings climbed 50%. Southwest Airlines stock was close behind, with a gain of more than 35% over that period.
Southwest Airlines vs. Hawaiian Holdings Stock Performance, data by YCharts.
When expectations are that high, investors won't have much tolerance for even the slightest disappointment. Southwest Airlines managed to keep up its momentum with a big earnings beat and strong guidance. This helped its stock rally another 9% on Thursday.
By contrast, while Hawaiian Airlines reported a record Q4 profit and solid guidance for Q1, investors were displeased by its rising costs. As a result, Hawaiian shares sank nearly 6% on Wednesday.
Southwest Airlines charts a path back to earnings growth
For the fourth quarter, Southwest Airlines posted adjusted earnings per share of $0.75. That was down significantly from $0.90 a year earlier. Nevertheless, it easily beat the average analyst EPS estimate of $0.70.
The main cause of Southwest's earnings beat was better than expected unit revenue performance. Earlier this month, the company projected that revenue per available seat mile (RASM) fell 3%-4% during the fourth quarter. That would have been better than its initial guidance for a 4%-5% RASM decline.
Ultimately, Southwest's unit revenue declined 2.9%: slightly ahead of its updated guidance. Management attributed this relatively solid performance to an improvement in travel demand -- and especially last-minute bookings -- that occurred after the election in November.
Southwest Airlines has seen a rebound in travel demand recently. Image source: The Motley Fool.
Just as importantly, Southwest expects unit revenue trends to strengthen further this quarter. It projected that RASM would decline no more than 1% in Q1.
On the other hand, Southwest's adjusted non-fuel unit costs are expected to rise 6%-7% year over year in Q1, before the impact of profit sharing. Meanwhile, fuel costs will reach $1.95-$2.00 per gallon, including the impact of hedging, up from $1.78 per gallon a year earlier. These cost headwinds will drive a significant year-over-year margin decline at Southwest this quarter.
However, investors were willing to let this slide because the longer-term cost outlook is much more favorable. For the full year, non-fuel unit costs will rise just 3%, with even better cost performance expected in 2018. Moreover, Southwest is still paying above-market fuel prices this year because of hedging losses, but its hedge positions are currently showing gains in 2018 and beyond. That could lead to lower economic fuel costs next year.
The net result is that Southwest Airlines' earnings declines should moderate as the year progresses. By 2018, it is likely to be posting strong profit growth again.
Hawaiian Airlines can't keep investors happy
By any objective standard, Hawaiian Airlines delivered better financial results than Southwest last quarter. Whereas RASM "only" declined 2.9% year over year at Southwest, Hawaiian posted a stellar 6% RASM gain. This met the high end of its revised guidance (provided in early December) and soared past the company's original forecast for a 0.5%-3.5% increase.
On the cost side, a 16.1% decline in Hawaiian's average economic fuel cost per gallon almost fully offset a 6.3% increase in its adjusted non-fuel unit costs. As a result, Hawaiian Holdings' adjusted EPS skyrocketed 50% year over year to $1.28. This met the average analyst estimate.
Hawaiian Airlines' 50% EPS growth wasn't good enough for investors. Image source: Hawaiian Airlines.
Unit revenue will remain strong looking ahead into 2017. For Q1, Hawaiian expects a 4%-7% RASM increase. Costs are rising too, but not quite as much as at Southwest. (Hawaiian Airlines currently projects that adjusted non-fuel unit costs will rise 3%-6% this quarter.)
However, investors still weren't satisfied, primarily because Hawaiian doesn't expect cost relief in the near future. Adjusted non-fuel unit costs will likely rise at a mid-single-digit rate for the full year. Furthermore, whereas a new pilot contract is driving a large part of Southwest's cost inflation this year, Hawaiian Airlines is still negotiating a new agreement with its pilot group. That could drive incremental cost increases later this year or in 2018.
That said, Hawaiian will see some notable unit cost tailwinds starting next year and increasing in 2019 as it replaces its eight remaining 767s with state-of-the-art A321neos. The smaller size of the A321neo will also provide unit revenue benefits, by allowing Hawaiian Airlines to better tailor capacity to demand in individual markets.
Two overreactions
Hawaiian Holdings' recent fall from grace shows the danger of investing in high-flying stocks. Even a minor, temporary setback can throw the stock off-course. On the bright side, if Hawaiian shares continue to decline, they may become an attractive long-term investment opportunity again, because of the profit growth potential from adding the A321neo to the carrier's fleet.
Meanwhile, Southwest Airlines has become the high-flying airline stock of the day. Shares now trade for more than 14 times forward earnings, which is rather pricey for an airline stock. If the company hits any turbulence in the next year, the stock could quickly correct downward.
