Southwest Airlines Co. Earnings: Moving in the Right Direction Again

The second quarter of 2018 was challenging for Southwest Airlines (LUV 0.14%) on many levels. Most importantly, it had to cope with the first accident-related fatality of a Southwest Airlines customer in the company's history. In addition to being a terrible tragedy, this mid-April incident also hurt Southwest's revenue performance last quarter.

Nevertheless, the popular low-cost carrier posted solid earnings results on Thursday morning, especially by airline industry standards. Furthermore, its outlook for the rest of 2018 suggests that Southwest Airlines is quickly getting back on track for long-term earnings growth.

Southwest Airlines results: The raw numbers

Data source: Southwest Airlines Q2 earnings release. Chart by author.

What happened with Southwest Airlines this quarter?

The biggest event to affect Southwest Airlines during the second quarter was the April 17 engine malfunction on Flight 1380. Not surprisingly, the carrier experienced a slowdown in bookings following the incident. This was exacerbated by a decision to "turn off" all of the company's marketing activity temporarily. Southwest Airlines ads generally have a lighthearted tone, and management wisely recognized that this would be inappropriate in the days following a passenger fatality.

Southwest Airlines estimates that the effects of the fatality reduced passenger revenue by about $100 million last quarter. That equates to more than half of the company's 3% decline in revenue per available seat mile (RASM). This RASM result was at the low end of Southwest's original forecast range, but right in line with its updated guidance published last month.

On the bright side, Southwest Airlines' nonfuel unit costs dropped 0.8% excluding special items. If profit sharing is also excluded, adjusted nonfuel unit costs rose 0.4%. This was better than the company's guidance for a 1% to 2% increase.

Finally, Southwest Airlines decided to take advantage of its slumping stock price by returning more cash to shareholders over the next year or two. In May, the board raised Southwest's dividend by 28% and announced a new $2 billion share repurchase program.

What management had to say

While Southwest Airlines' operating margin fell by nearly 4 percentage points last quarter, management struck a confident tone about the future. According to CEO Gary Kelly:

We expect the revenue impact from [the fatal accident] to be temporary and subside in third quarter 2018 and are encouraged by the solid rebound in demand. Separately, we deployed additional revenue management tools and techniques during second quarter 2018, and we continue to expect to generate incremental improvements in pre-tax results of $200 million this year from the investment in our new reservation system. Our second half 2018 flight schedule is better optimized, and our Rapid Rewards Program and other ancillary products continue to perform very well.

Kelly also noted that nonfuel unit costs will start to move upward again -- albeit very modestly -- in the second half of 2018. However, he emphasized Southwest's commitment to avoiding long-term cost creep, stating, "We expect higher unit costs as we move into second half 2018, due largely to shifting spending from first half 2018. With the completion of major revenue initiatives over the last several years, we will refocus our efforts to control costs and drive efficiency, especially in light of higher fuel prices."

Southwest's management is fairly optimistic about the rest of 2018. Image source: Southwest Airlines.

Looking forward

Southwest Airlines expects unit revenue to improve sequentially in the third quarter, with RASM roughly flat (plus or minus 1%). This includes headwinds totaling 2 percentage points related to (1) an aggressive fare sale rolled out in May to counter the softness in bookings; (2) continuing to run a suboptimal schedule; and (3) a change in accounting rules.

The good news is that Southwest currently estimates that none of these three factors will have a significant impact on unit revenue in the fourth quarter. That could set the stage for a return to meaningful RASM growth.

On the cost side, adjusted nonfuel unit costs are expected to rise 2% to 3% in the third quarter but just 0% to 1% for the full year. Meanwhile, the company estimates that it will pay $2.25 per gallon for fuel this quarter, up from $2.07 per gallon a year earlier. This is a much smaller headwind than what other airlines are facing, primarily because Southwest Airlines incurred massive fuel hedging losses last year.

Southwest's third-quarter forecast suggests that its operating margin may fall by about 3 percentage points. This would again lead to modest earnings-per-share growth, driven by a lower tax rate and a lower share count. That wouldn't be a bad result considering all of the headwinds Southwest Airlines is currently facing.