For most of its history, Southwest Airlines Co. (NYSE:LUV) has grown rapidly, using its low cost structure to gain market share in the U.S. airline industry. As recently as 2012, Southwest boosted its capacity more than 6%. However, in recent years, growth may have come at the expense of profitability.
After missing its return on invested capital goal by a wide margin in 2012, Southwest executives decided to clamp down on growth until returns improved. With EPS doubling year over year in 2013, one might have expected a return to growth this year. Instead, Southwest is planning to keep capacity roughly flat in 2014.
Southwest's pre-tax return on invested capital reached 13.1% last year -- just shy of its goal of 15%. Given the solid demand outlook -- both for Southwest individually and the airline industry as a whole -- Southwest is likely to hit its return target by the middle of this year. That will set the stage for a return to growth in late 2014 or early 2015.
Holding down capacity
In 2013, Southwest Airlines increased its available seat miles (a common measure of capacity) just 1.7% -- well below the company's typical growth rate. Moreover, Southwest actually reduced its number of flights by 3.6% year over year. The growth in capacity was driven not by adding flights but by an increase in the average length of each flight, and a shift toward larger planes.
One factor holding capacity growth down is the integration of the AirTran and Southwest aircraft fleets. AirTran's Boeing 737s are gradually being converted to the Southwest livery and interior. Southwest has to take these planes out of service for a while to do this work. Meanwhile, AirTran's 88 Boeing 717s are being leased to Delta Air Lines, which means removing all of those aircraft from service and replacing them with additional 737s.
In fact, Southwest is actually taking delivery of 45 additional Boeing 737s next year, including 33 new 737-800s (a larger model that seats 175 in Southwest's configuration) and 12 used 737-700s (which will have 143 seats).
The next stage of growth
As one of the largest airlines in the U.S., Southwest clearly does not have the same growth prospects it once did. However, it still has several significant growth opportunities.
First, Southwest finally has the capability to fly internationally, and that creates growth options in the northern half of Latin America, the Caribbean, and even Canada. Southwest is currently building a five-gate expansion at Houston's Hobby Airport to serve as an international gateway to Latin America. This facility is scheduled to open in late 2015. (Fort Lauderdale could also support flights to Latin America and the Caribbean.)
Domestically, Southwest's acquisition of 737-800s gives it the ability to fly to Hawaii if it wants to expand that way. The company also has a significant growth opportunity in Dallas, where its service is currently constrained by legislation that for decades has prevented long-haul flights from Love Field. However, all of these restrictions will be lifted in October, which will pave the way for a significant increase in Southwest's capacity in Dallas.
From an aircraft perspective, Southwest will have the flexibility to grow starting in 2015. It has 24 aircraft on order for 2015, followed by 31 firm orders and 12 options in 2016, and 29 firm orders and 12 options in 2017. Additionally, in 2015, it will regain some capacity in the form of former AirTran 737s that will be out of service in 2014 for conversion to the Southwest format.
Foolish bottom line
Southwest has taken a big pause from growth in 2013 and 2014. So far, this has had the intended effect of allowing it to optimize its route network and thereby boost its return on invested capital significantly.
However, Southwest is likely to return to moderate growth in late 2014 or early 2015. It will have additional capacity available, and it will have meaningful growth opportunities, particularly in Dallas and in international markets that it does not currently serve. Most importantly, by then the company's returns will probably have improved to a level that would justify expansion.
If Southwest returns to a mid-single-digit-growth rate within the next year or two, it could start putting pressure on the legacy carriers' margins. These companies have benefited significantly from Southwest's recent capacity restraint. A growing Southwest could become a disruptive force in the U.S. airline industry once again.
Fool contributor Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.