Southwest Airlines Co (NYSE:LUV) held an investor meeting on Monday where it laid out its strategy, and provided initial guidance about the upcoming year. Southwest's profit has surged to record levels this year, which means the company will be up against tough comparisons in 2015.
Nevertheless, Southwest's management is projecting another year of strong earnings growth. This growth will be driven by three key tailwinds: more efficient fleet utilization, the opening of key markets where Southwest wasn't previously allowed to fly, and lower fuel costs.
For the past couple of years, Southwest executives have repeatedly reminded investors that the integration of AirTran was limiting aircraft utilization rates. As Southwest refurbished its fleet of Boeing 737s to add an extra row of seats, prepared its Boeing 717s to exit the fleet on sublease agreements, and reconfigured AirTran's 737s as Southwest aircraft, it had to leave many planes out of service.
All of the 717s will be removed from service by the end of 2014, and most of the AirTran 737s have already been converted to Southwest. As a result, Southwest expects to have, on average, 20 fewer out-of-service aircraft during 2015. This will contribute about three percentage points of year-over-year growth.
Southwest is also continuing to increase its "gauge" -- the average size of its planes. It has been retiring the AirTran 717s, which have 117 seats, and its 737-500s, which have 122 seats, while adding dozens of 175-seat 737-800s.
The combination of higher fleet utilization and larger airplanes will allow Southwest to grow capacity 6% next year without increasing its fleet size. Having fewer former AirTran employees in training to join Southwest will simultaneously boost employee productivity. As a result, Southwest expects its non-fuel unit costs to decline 1%-2% before the impact of profit sharing.
New market opportunities opening up
It's great that Southwest will be able to increase its capacity by 6% next year without having to increase the size of its fleet. (Buying 20 new Boeing 737s would cost more than $1 billion.) Still, the carrier needs to find places to deploy this extra capacity profitably. Fortunately, several new opportunities have recently opened for Southwest Airlines.
First, Southwest bought many of the slots divested by American Airlines as part of its merger with US Airways. This has allowed Southwest to add flights at two popular, crowded airports. It acquired six new slot pairs at LaGuardia Airport in New York, and 27 slot pairs at Reagan Airport near Washington D.C. Each slot pair allows an airline to operate one daily roundtrip flight.
Second, restrictions on long-haul flights at Dallas Love Field -- Southwest's home airport -- were finally lifted in October. In the past month, Southwest has started nonstop service from Dallas to more than a dozen top destinations like New York, Chicago, Washington, D.C., Orlando, Las Vegas, and Los Angeles.
Growth in New York, Washington, D.C., and Dallas will account for five percentage points of Southwest's 2015 capacity increase. The other 1% will come from new international routes. There is strong pent-up demand for Southwest service in all of these markets. That means they will become profitable much faster than a typical new route.
Lower fuel costs
Lower fuel costs represent the third and final pillar of Southwest's expected profit growth in 2015. Southwest expects to pay $2.90-$2.95/gallon on average for jet fuel in 2014. However, jet fuel costs have fallen more than $0.40/gallon since the beginning of September.
As a result, Southwest Airlines currently projects that economic fuel costs will average $2.60-$2.70 in 2015. This alone would result in about $500 million in year-over-year savings.
Additionally, Southwest's move to larger aircraft is improving its fuel efficiency. Fuel efficiency increased from 68.3 available seat miles per gallon in 2011 to an estimated 72.8 ASMs per gallon in 2014. That is expected to improve again to about 74 ASMs per gallon in 2015. That would represent a more than 8% improvement in fuel efficiency compared to 2011.
Southwest Airlines stock has tripled since the summer of 2013, and has risen more than 30% just in the last month. On Tuesday, it hit the $40 mark for the first time ever.
Despite these massive gains, Southwest still appears to have upside for investors. Southwest stock trades for about 20 times expected 2014 earnings, and it's well positioned to boost its pre-tax margin by several percentage points next year if fuel costs remain near today's levels.
Southwest also has one of the best balance sheets of any airline, which allows it to return most of its copious free cash flow to shareholders through dividends and share buybacks. With so many things going its way, Southwest stock may be able to fly even higher in 2015.