America's two largest low-fare carriers, Southwest Airlines (NYSE:LUV) and Alaska Air (NYSE:ALK), released their first-quarter earnings reports this week. Both carriers have historically been among the most profitable airlines in the world, and that didn't change last quarter.
That said, both companies did report substantial earnings declines in Q1. Furthermore, while Alaska and Southwest both hinted at better performance in the quarters ahead, investors were hoping for stronger outlooks.
Fuel takes a bite out of Alaska Air's earnings
Like most of its peers, Alaska Air reported a steep drop in its earnings for the first quarter. Adjusted EPS fell to $1.05 from $1.45 a year earlier, even though revenue surged 30% year over year, driven by the company's recent acquisition of Virgin America.
Rising fuel prices were Alaska Air's biggest earnings headwind last quarter. The company paid an average of $1.78 a gallon, up from $1.29 a gallon in the first quarter of 2016 (which was when fuel prices bottomed out). Given that Alaska consumed 184 million gallons of fuel last quarter, the increase in fuel prices cost the company $90 million before tax, or about $0.45 per share on an after-tax basis.
Unit revenue also declined modestly last quarter, pressuring profitability. On a combined basis -- including last year's results for Virgin America -- Alaska Air's revenue per available seat mile (RASM) slipped 2.6% year over year.
On the plus side, Alaska Air's management noted that unit revenue trends improved as the first quarter progressed. For Q2, the company expects RASM to increase, even excluding a benefit from the timing of Easter. Fuel cost inflation will start to subside as well, with jet fuel prices up about 20% year over year.
However, non-fuel unit costs are on pace to tick up about 3% year over year in Q2, after a modest 0.1% increase last quarter. That will limit Alaska's EPS growth this quarter.
Looking further ahead, management expects RASM growth to tail off in the second half of 2017, because Alaska Air's capacity growth is set to tick up into double-digit territory then. This prediction may have spooked investors, who have been desperate to see signs of a durable unit revenue recovery.
Rising costs continue to dog Southwest Airlines
Meanwhile, rising non-fuel costs are the biggest impediment to profit growth at Southwest Airlines, after the company handed out big raises to several employee groups in late 2016. Excluding special items and profit sharing, Southwest's non-fuel unit costs surged 6.9% year over year last quarter.
Southwest Airlines' revenue performance was also disappointing. Last month, the company slashed its Q1 RASM outlook by 2 percentage points, blaming a variety of factors. Ultimately, RASM fell 2.8% year over year, near the bottom of Southwest's updated guidance for a 2%-3% decline.
Southwest didn't face as big a cost headwind from rising oil prices as its fellow airlines, because it lost so much money on fuel hedges a year ago. (Its economic fuel cost per gallon increased about 10% year over year in Q1.) Nevertheless, due to its revenue and non-fuel cost headwinds, Southwest's adjusted EPS plunged more than 30% year over year, to $0.61.
The outlook for the second quarter was somewhat better. On the revenue side, Southwest has forecast that RASM will rise 1% to 2%, helped by the Easter shift. That said, it expects non-fuel unit cost growth to remain elevated this quarter, at around 6%. As a result, Southwest's EPS will decline year over year again in Q2.
The long-term outlook is better
Alaska Air and Southwest Airlines are both in transitional periods right now. Alaska Air is early in the process of integrating its Virgin America merger. One key initiative associated with the merger is a big growth push in the San Francisco Bay Area that will begin this fall. In the short run, this growth will depress RASM. However, it will significantly improve the combined company's relevance to business travelers in the Bay Area, enabling future market-share gains.
Additionally, Alaska Air has acknowledged that most of its expected merger synergies won't show up until 2019 and 2020. Thus, while it will face some margin pressure in 2017, Alaska is positioning itself for a surge in earnings toward the end of the decade.
As for Southwest, the current bout of cost pressure will end abruptly later this year. By Q4, the company will lap most of its big wage increases, while it will have retired the last of its aging, inefficient 737-300s. This will pave the way for strong unit cost performance and a return to profit growth in late 2017 and 2018.
Shares of Alaska Air and Southwest Airlines have declined since the first-quarter earnings reports came out. Given that both companies have solid long-term profit growth prospects, this could be a good opportunity for investors to pick up some shares at a discount.