Unlike its legacy airline peers, Southwest Airlines Co (NYSE:LUV) avoided bankruptcy during the last aviation downturn. But even Southwest has faced lean times -- every single year for more than a decade, it missed its target of a 15% pre-tax return on invested capital.
However, the tide is turning quickly. Southwest Airlines reported last week that it easily beat its ROIC target in 2014, with a pre-tax ROIC of 21.2%, up from 13.1% in 2013. Moreover, a combination of strong demand, low fuel prices, and cost-effective growth will allow Southwest to produce even more impressive results in 2015 and beyond.
Regaining cost leadership
As Southwest Airlines struggled to meet its internal targets in recent years -- while one-time laggards like Delta Air Lines saw an upsurge in profitability -- pundits increasingly speculated about how Southwest had lost its way.
Just last year, The Wall Street Journal ran a piece highlighting a variety of problems at Southwest. These included rising costs, labor strife, poor operational reliability, and a loss of its position as America's low-fare leader.
From today's perspective, many of those issues seem to be in the rearview mirror. At its Investor Day back in November, Southwest laid out an ambitious target of keeping its unit costs roughly in line with those of the ultra-low cost carriers. Management sees that as the only way to maintain Southwest's positioning as a low-fare carrier.
Matching the costs of competitors like Spirit Airlines will be a tall order, but any improvements at all will be positive for Southwest's long-term profitability and competitiveness. Southwest will take a step in the right direction in 2015 -- it expects non-fuel unit costs to decline 1%-2% this year.
Returning to growth
One way that Southwest is reducing its costs is by increasing the productivity of its assets. For the past several years, numerous planes have been out of service as part of the AirTran integration process. Employee productivity has also suffered as AirTran employees had to undergo training to join the Southwest brand.
With the AirTran brand having been retired in December, those headwinds will be much smaller in 2015 (before disappearing entirely next year). This will allow Southwest Airlines to increase capacity 6% this year without significantly increasing its aircraft fleet size.
Southwest's move toward larger airplanes will also help it reduce its unit costs. Historically, Southwest mainly operated Boeing 737s outfitted with 137 seats. A few years ago, the company began retrofitting those planes with new seats, increasing seating capacity to 143 in the process.
Around the same time, Southwest began flying the 737-800: a larger variant with 175 seats. For the past few years, all of its new planes have been 737-800s, which are more fuel-efficient and have lower non-fuel unit costs than its 143 seat 737-700s. Southwest has also capitalized on the industry shift toward bigger planes to bolster its fleet of 737-700s with cheaper used planes.
Both of these trends will continue in 2015, and in future years Southwest has the right to switch 737-700 orders to the larger 737-800 model. In all likelihood, it will take Boeing up on that option, given that air travel demand has been robust and supply remains constrained.
Southwest is also in negotiations with many of its union groups on new contracts. The company may try to bargain for the right to add the even larger Boeing 737-900ER (and its successor, the 737 MAX 9) to its fleet. These planes could fit about 200 passengers in Southwest's single-class setup, further reducing unit costs.
Between its current productivity efforts and potential initiatives like adding the 737-900ER (or 737 MAX 9) to its fleet, Southwest should be able to keep its unit costs flat or declining in the next few years. This will improve its long-term competitiveness. Including the impact of lower fuel prices, Southwest is on pace to reward investors with the best profit margins in its history in 2015 and beyond.