Entering 2018, Southwest Airlines' (LUV -0.54%) management told investors that achieving unit revenue growth would be a priority this year. However, revenue per available seat mile (RASM) was flat during the first quarter, which fell short of the company's guidance.
Furthermore, in conjunction with the first-quarter earnings report, Southwest Airlines warned that unit revenue was likely to decline during the second quarter. In an investor update published on Monday, management acknowledged that the carrier is facing even more unit revenue pressure than it initially expected.
Nevertheless, investors shouldn't panic about Southwest's poor results in the first half of 2018. Much of the weakness stems from temporary factors -- and management is taking action to accelerate Southwest Airlines' recovery.
Another guidance cut
In mid-April, Southwest Airlines suffered its first customer fatality in nearly half a century of service, when debris penetrated the fuselage of one of its planes after an engine failure.
Following the accident, Southwest "turned off" all of its marketing. Most Southwest Airlines ads are upbeat and lighthearted, and management quickly determined that it would be insensitive to keep running them in the immediate aftermath of a fatal accident. This exacerbated the short-term drop-off in bookings that would have occurred anyway.
Southwest recently cut its unit revenue guidance for the second time in 2018. Image source: Southwest Airlines.
As a result, Southwest Airlines' initial guidance for the second quarter called for RASM to decline 1% to 3% year over year. On Monday, Southwest updated that projection, stating that RASM is likely to fall 3% this quarter. The one silver lining is that the company attributed this decline to lower marketing, which means the decrease in unit revenue may be partially offset by better non-fuel unit cost performance.
This, too, shall pass
It's disappointing that RASM isn't recovering as fast as Southwest Airlines had hoped, but there isn't much cause for alarm. The drag from reduced marketing and a dip in Southwest's brand image is probably starting to dissipate and should fade to nothing by year's end.
Additionally, Southwest announced on Monday that it is trimming its capacity outlook for the second half of 2018. The carrier had previously planned to increase capacity by more than 7% in the second half of the year, but it now expects 6% year-over-year capacity growth. Cutting unproductive capacity is generally good for unit revenue -- and for the bottom line.
Southwest Airlines will also get a unit revenue tailwind in the second half of 2018 as it returns to a more normal flight schedule. For the past several quarters, it hasn't had enough planes in its fleet, forcing it to operate more early morning and late-evening flights that aren't as popular with customers. However, Southwest will add 46 planes to its fleet during 2018, allowing it to steadily improve its flight schedule over the course of the year.
Southwest is waiting for 737 MAX planes to replace aircraft it retired in 2017. Image source: Southwest Airlines.
Lastly, a brutal competitive battle between Southwest and Alaska Air (ALK -1.89%) that has been playing out over the past year is starting to let up. Alaska Airlines has cut several routes where it had been encroaching on core Southwest Airlines markets. Meanwhile, Southwest Airlines is set to reduce its capacity in San Francisco, where Alaska Airlines is now the second-largest carrier.
A more rational level of competition should boost unit revenue. Alaska Airlines has a strong incentive to avoid a repeat of the recent fare wars, as it has experienced significantly more margin erosion than Southwest Airlines recently.
This could be a good time to buy
Wall Street analysts have slashed their 2018 earnings-per-share estimates for Southwest Airlines by about 10% since April, and estimates could continue to move lower in light of the recent guidance update. 2019 EPS estimates have also come down.
That said, Southwest has a good chance of bouncing back strongly next year and surpassing these reduced EPS estimates. The company recently announced a new $2 billion share repurchase program, which will add some momentum to its EPS growth, particularly if the stock price remains depressed for an extended period of time.
Meanwhile, Southwest Airlines stock has lost almost a quarter of its value since hitting a new all-time high in late 2017. The stock now trades for less than 10 times Southwest's estimated 2019 EPS. Considering the company's strong competitive advantages, meaningful growth opportunities, and rock-solid balance sheet, Southwest Airlines stock looks very appealing today. I have moved it up to the top of my watchlist accordingly.
