Southwest Airlines Co. (NYSE:LUV) and JetBlue Airways Corporation (NASDAQ:JBLU) both rose to prominence as low-cost carriers that offered friendlier service than legacy carriers. Today, they are the two largest airlines in the U.S., aside from the big three legacy carriers.

However, in recent years, Southwest and JetBlue have had to rethink how they do business. As their workforces and aircraft fleets have aged, unit costs have risen. Legacy carriers have also made their own costs more competitive through bankruptcy restructuring. Southwest and JetBlue can no longer rely on low fares as their key differentiating point.

Rising costs are forcing Southwest and JetBlue to adapt their strategies. Source: JetBlue Airways.

Southwest and JetBlue have adopted similar -- but not identical -- strategies in adapting to this new environment. Which of these two airlines is likely to be a better long-term investment?

Losing the low-cost game

Less than a decade ago, Southwest Airlines and JetBlue Airways had significant cost advantages over legacy carriers. However, unit costs have been rising at both airlines.

In 2007, Southwest Airlines' adjusted CASM (cost per available seat mile, excluding fuel, profit sharing, and special items) was $0.0656. Adjusted CASM was even lower at JetBlue that year -- $0.0547 -- although some of that difference could be attributed to its focus on longer flights.

Legacy carriers such as Delta have significantly narrowed the cost gap with Southwest and JetBlue.

By contrast, through the first three quarters of 2014, JetBlue's adjusted CASM rose 4.6% year over year to $0.0756. Southwest's adjusted CASM rose 2% to $0.0804. Meanwhile, Delta Air Lines' adjusted mainline CASM has risen less than 1% year over year to $0.0846.

The "low-cost carriers" still have some cost advantage over legacy carriers, but it's very small these days. Meanwhile, several airlines have adopted an "ultra-low-cost carrier" format and have opened up a big cost advantage compared to Southwest and JetBlue.

Southwest: bigger planes, big cities, and big business

Southwest Airlines has pursued a number of initiatives to boost revenue and offset some of its cost increases. As one of the largest airlines in the U.S., Southwest has become much more assertive in big travel markets and has courted lucrative business travelers.

Less than 10 years ago, Southwest had many big holes in its route map. Southwest served some big cities like New York and Boston through alternative airports 50 miles away. It completely avoided some other big cities like Atlanta and Denver. Today, Southwest serves all of these cities at their main airports -- Atlanta and Denver are even among its top 10 focus cities.

With no service to numerous key airports for business travel, Southwest couldn't compete well for corporate travel contracts before. However, Southwest now serves every major domestic market, making it a much more viable option for business travelers. It has also introduced refundable "Business Select" fares -- which include priority boarding and a free drink -- to target business travelers.

Southwest has pursued more business travelers in the last 5-10 years.

With more flights going to big cities with plenty of air travel demand, Southwest Airlines has added bigger planes to its fleet. In the past three years, it has purchased about 80 Boeing 737-800s with 175 seats, while starting to phase out 122-seat 737-500s and 117-seat 717s. The majority of Southwest's future orders are for 175-seat planes.

Southwest also installed slim-line seats on the 737-300s and 737-700s that make up the bulk of its fleet, increasing seating capacity from 137 to 143. These changes are helping to mitigate cost increases.

JetBlue: getting paid for perks

Some of JetBlue's profit improvement initiatives are similar to those of Southwest. It has converted most of its aircraft orders away from the 100- and 150-seat aircrafts it previously favored, instead choosing 190-seat Airbus A321s that have lower unit costs. JetBlue has also added flights to various business markets from its Boston focus city in order to win more corporate travel contracts.

Another objective is to boost ancillary revenue by "getting paid" for the amenities JetBlue offers. JetBlue has increased revenue from its "Even More" extra legroom and expedited security programs from $85 million in 2010 to an estimated $190 million in 2014.

JetBlue has seen early success in improving margins with premium seating on transcontinental flights. Source: JetBlue Airways.

It also recently introduced premium seating on transcontinental flights from New York to Los Angeles and San Francisco. Looking ahead, JetBlue is planning to roll out "fare families" in 2015, which will unbundle some of JetBlue's current amenities (like a free checked bag and free high-speed Wi-Fi), creating new ancillary revenue streams.

Southwest vs. JetBlue

So far, Southwest has been more successful than JetBlue in revitalizing itself. Through the first three quarters of 2014, JetBlue's operating margin was 7.9% -- up slightly from 7.7% in 2013. By contrast, Southwest's operating margin (excluding integration costs) reached 12.2% -- up from 7.8% last year.

This makes Southwest Airlines the safe choice for investors. However, it is pricier than most airline stocks for that reason. Southwest shares currently trade for 1.3 times sales, 21.9 times trailing earnings, and 15.4 times 2015 earnings estimates.

By contrast, while JetBlue's trailing earnings multiple is similar, the stock trades for just 0.6 times sales and 12.1 times forward earnings -- despite growing faster than Southwest. If JetBlue can eventually catch up to Southwest from a margin perspective and match its price to sales ratio, JetBlue shares could double relative to Southwest shares.

The critical question is whether JetBlue faces structural problems that prevent it from hitting the same margin goals as Southwest. This doesn't seem to be the case -- JetBlue is simply a year or two behind on initiatives like increasing aircraft size and boosting business travel revenue. Just last year, analysts were chastising Southwest for lagging financial and stock performance.

JetBlue has more upside

Southwest's strong profit margin and rock-solid balance sheet make it a relatively safe choice among airline stocks. However, the biggest gains may be in the past for Southwest investors.

On the other hand, JetBlue appears to be a year or two behind Southwest on its turnaround trajectory. Investors who missed the big gains in Southwest Airlines stock have a second chance to capitalize on the same trends. Over the next five years, JetBlue is likely to close most of the margin gap and valuation gap with Southwest Airlines -- potentially leading to big share price gains.