Southwest Airlines Co. Is About to Hit a Major Milestone

Historically, Southwest Airlines Co. (LUV -0.54%) has been the most profitable airline in the U.S. Indeed, it has racked up an impressive streak of more than 40 consecutive profitable years, while almost all of its competitors have gone through bankruptcy at least once.

More recently, Southwest has come under pressure as legacy carriers like American Airlines (AAL -2.18%) have reduced their costs in bankruptcy and a new crop of "ultra-low-cost carriers" have become the airline price leaders. High fuel prices and the ongoing integration of AirTran have also been a drag on profitability.

As a result, Southwest has had trouble hitting its 15% return on invested capital target in recent years. However, Southwest is very close to hitting this target, and it should exceed a 15% return on invested capital in 2014. This will provide the foundation for Southwest to start growing again next year.

Profitability surges
Last week, Southwest reported that its Q1 adjusted profit soared from $0.07 to $0.18. This solid increase was particularly impressive because Southwest faced three significant headwinds during the quarter. First, the shift of Easter and Passover from March to April pushed a peak travel season from Q1 to Q2, causing March unit revenue to increase just 1%.

Southwest posted strong earnings growth last quarter despite major headwinds. Photo: The Motley Fool

Second, Southwest's Q1 results were negatively affected by severe winter storms that touched every major airline. Southwest estimated that the storms reduced its operating income by $50 million. Third, integration activities are forcing Southwest to keep more of its planes idle this year, increasing unit costs.

Southwest's rising profitability allowed it to reach a return on invested capital of 14.2% for the last 12 months, up from 8.3% in the 12 months before that. Southwest is thus on track to hit its ROIC target next quarter, and could post a ROIC well above 15% for the full year.

A return to growth?
Last year, Southwest told investors that it would keep capacity roughly flat in 2014 and that it would not start growing again until it reached the 15% ROIC target. Now that Southwest is on the verge of hitting that target, the company is looking ahead to growth again. A growing Southwest will create incremental challenges for American Airlines and other legacy carriers.

For 2015, Southwest is projecting fairly modest 2%-3% capacity growth. While Southwest is scheduled to take delivery of 47 planes in 2014 and another 24 in 2015, it is also removing 66 planes from AirTran's fleet during 2014 and retiring some older Southwest planes, which will make it hard to grow any faster. In 2016 and beyond, Southwest will have more flexibility to grow if doing so makes sense.

Among the major airlines, American Airlines will feel the biggest impact from Southwest's growth in 2015. This is because Southwest's growth will currently be focused in Dallas (which is American's biggest hub market) and at Washington Reagan Airport (arguably American's most profitable hub).

American Airlines will see the biggest impact from Southwest's growth. Source: American Airlines.

Southwest's planned growth in Washington and Dallas will begin later this year, but the biggest impacts will be felt in 2015. Southwest's expanded presence in Washington and its new long-haul flights from Dallas will represent American's first meaningful competition on numerous routes. This will make it difficult for American to maintain its recent trend of strong domestic unit revenue growth (up 6.3% last quarter).

Foolish conclusion
Southwest Airlines is on the verge of hitting its 15% ROIC target. When it does, the company is likely to return to growth. Due to its massive size, even a 3% annual capacity growth rate could create meaningful threats to other major carriers.

In the near term, American Airlines is the most vulnerable to a return to growth at Southwest Airlines. Southwest's most attractive growth opportunities for late 2014 and 2015 are primarily markets dominated by American today. While American Airlines has plenty of profit growth drivers of its own, the emergence of tougher competition will put pressure on its earnings growth potential for 2015.