Please ensure Javascript is enabled for purposes of website accessibility

Southwest Airlines' Outlook Continues Improving

By Adam Levine-Weinberg - Sep 16, 2018 at 9:05AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

After a weaker-than-expected performance year to date, Southwest Airlines is finally getting back on track.

In early September, JetBlue Airways and United Continental tweaked their Q3 unit revenue forecasts higher, reflecting strong demand. Last week, low-fare airline giant Southwest Airlines (LUV 4.47%) followed suit.

Over the past year, Southwest's revenue performance has been undermined by suboptimal fleet scheduling caused by a temporary aircraft shortage. A fatal accident in April created further pressure on unit revenue. That said, the recent guidance increase is an encouraging sign that Southwest Airlines is on track for better unit revenue trends in the quarters ahead.

Revenue guidance rises

Back in July, Southwest Airlines projected that revenue per available seat mile (RASM) would be roughly flat year over year in the third quarter. Management noted that strong demand was being offset by three factors: continuing to run a suboptimal schedule; an aggressive fare sale launched in May to counter a slowdown in bookings following the April accident; and the implementation of new accounting rules. Together, these factors were expected to reduce RASM by about 2 percentage points.

On Wednesday, Southwest raised its RASM growth outlook to a range of 1% to 1.5%. The carrier said that flight cancellations related to severe storms in July and August reduced capacity in the quarter by about 1 percentage point, boosting unit revenue by between 0.5 percentage points and 1 percentage point.

A Southwest Airlines plane preparing to land

Southwest Airlines raised its Q3 unit revenue guidance last week. Image source: Southwest Airlines.

However, the rest of the guidance increase was driven by strong demand. This led to higher fares for last-minute bookings, more than making up for a modest decline in Southwest Airlines' load factor (the percentage of seats filled with paying customers) in July and August.

Cost pressure continues

While weather-related flight cancellations have positively impacted Southwest's third-quarter unit revenue performance, the resulting reduction in capacity growth has put further pressure on unit costs.

Entering the quarter, management was already expecting non-fuel unit costs (excluding profit sharing) to rise 2% to 3% year over year, driven in part by the timing of expenses within the year. Including the impact of the July and August cancellations, Southwest Airlines is now on track to report a 3% to 3.5% increase in non-fuel unit costs (again excluding profit sharing) for the third quarter.

On balance, Southwest's guidance update implies that Q3 earnings will be slightly better than what was indicated by its initial forecast. The carrier's adjusted pre-tax margin will likely decline between 2.0 percentage points and 2.5 percentage points year over year. This points to earnings per share slightly above the current average analyst estimate of $1.04.

Good news for the future

While the change to Southwest's third-quarter unit cost guidance offset most of the increase in its RASM forecast, the strong demand environment should lead to better results in the fourth quarter and beyond.

Importantly, Southwest Airlines will lap the September 2017 retirement of its 737 Classic fleet at the end of this month. That means the headwind from suboptimal scheduling -- which has hurt unit revenue over the past year -- will turn into a tailwind next quarter. Additionally, demand appears to have fully recovered from the dip experienced after the accident in April. A recent move to increase the price of EarlyBird check-in for most flights should also boost RASM going forward.

In short, Southwest Airlines could be reaching an inflection point for unit revenue. While RASM came in worse than expected during the first half of 2018, the combination of stronger demand, increased ancillary revenue, and a more optimal schedule should drive solid RASM growth in the fourth quarter. Easy year-over-year comparisons in the first half of 2019 could enable another step up for unit revenue.

This improving RASM trend puts Southwest in good position to increase its profit margin, despite continuing to face high fuel costs. Shareholders are counting on this margin expansion to keep Southwest Airlines stock on an upward trajectory.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Stocks Mentioned

Southwest Airlines Co. Stock Quote
Southwest Airlines Co.
LUV
$45.11 (4.47%) $1.93

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning service.

Stock Advisor Returns
338%
 
S&P 500 Returns
119%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 05/17/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.