On Thursday, leading low-fare airline Southwest Airlines (NYSE:LUV) reported very strong earnings results for Q3. Excluding special items, Southwest Airlines earned $382 million during the quarter: an all-time record. This translates to adjusted EPS of $0.55, compared to the average analyst estimate of $0.53.
Southwest achieved solid improvements for just about every important metric: revenue, EPS, operating margin, free cash flow, and return on invested capital. However, its earnings power is actually even better than what its Q3 results showed.
The keys to Southwest's Q3 earnings
Southwest benefited from its domestic focus last quarter, as summer travel demand was very strong and industry capacity growth was quite modest. As a result, passenger unit revenue rose 4.9% in Q3, while total unit revenue rose 4.5%. Both figures were better than what most of Southwest's competitors reported.
Meanwhile, unit costs remained flat year over year (excluding special items). Lower fuel costs fully offset higher profit-sharing expense and modest increases in other costs, particularly driven by higher payroll costs.
The remarkable thing about Southwest's strong earnings report is that it has dramatically boosted its earnings power despite still being in the midst of integrating its AirTran acquisition. The integration process has created lots of temporary inefficiencies, most of which will be resolved by next year.
First, the integration process has put many planes out of commission. All of AirTran's planes are being repainted and retrofitted with new cabins over a 2-3 year period. Some of these planes are then reentering the Southwest Airlines fleet, while others are being subleased to Delta Air Lines.
The result is that Southwest has had an average of about 20 planes out of service this year as they were undergoing modifications. Meanwhile, Southwest has to put former AirTran pilots and flight attendants through a training process before they move over to the Southwest brand. Both of these issues reduce productivity.
Second, Southwest has made significant changes to its route network while integrating AirTran. The company has dropped many of the smaller cities that AirTran served, and it implemented a completely new strategy in Atlanta, which had been AirTran's big hub.
These changes are expected to significantly improve profitability in the long run. However, in the short run, about 15% of Southwest's capacity is deployed to markets under "development" -- meaning that Southwest began flying those routes within the past year. New routes tend to be less profitable initially.
These two factors constraining Southwest's profitability will recede within the next year or two. Additionally, Southwest continues to take delivery of larger, more efficient aircraft, in order to reduce unit costs.
Improved aircraft utilization will allow Southwest to increase capacity by perhaps 4% in 2015 without significantly growing its aircraft fleet. The phasing out of the AirTran brand at the end of this year will also allow Southwest to put the remaining AirTran employees through training programs in the first half of next year.
Meanwhile, the final wind-down of AirTran will result in more markets under development for Southwest Airlines in 2015. New opportunities in Washington, D.C., and Dallas are also contributing to this issue.
Considering all these issues together, Southwest Airlines CEO Gary Kelly has described 2015 as being significantly better than 2014, while 2016 will be a relatively "clean" year. In other words, as Southwest winds down the AirTran integration process over the next year or so, it will benefit from significant earnings tailwinds that will continue into 2016.
Cheap oil always helps
Southwest Airlines has posted record earnings in 2014, but it has done so with one hand tied behind its back. Profitability has actually been constrained by productivity decreases related to the AirTran integration process and having an unusually high level of capacity on new routes.
As Southwest completes the integration process in the coming year, both of these headwinds will disappear. At the same time, Southwest is poised to benefit from lower fuel costs, as jet fuel spot prices have declined by about $0.40/gallon since early September.
This is setting up Southwest Airlines for another big jump in earnings in 2015 -- and possibly in 2016 as well. For Southwest Airlines shareholders, the good times are about to get even better.