Southwest Airlines (NYSE:LUV) has broken out of the doldrums in a big way in the past couple of years. This continued last week as the company turned in a very strong Q2 earnings report.
Furthermore, Southwest's management said that demand has seemed to improve in recent weeks. The company is also poised to recognize big gains in the revenue from its co-branded credit card contract with JPMorgan Chase. This points to there being many more strong quarters for Southwest Airlines in the year ahead.
Adjusted earnings per share at Southwest Airlines jumped 47% year over year to $1.03 last quarter, sliding in just ahead of the average analyst estimate of $1.02. The company produced a record quarterly operating margin of 22.5%. Of the airlines that have reported Q2 earnings so far, only Alaska Air has managed to best that figure.
Southwest's profit growth was powered primarily by the impact of lower fuel prices. Economic fuel expense -- which includes settled hedging losses -- declined from $3.02/gallon in Q2 2014 to $2.02/gallon in Q2 2015. Southwest's fuel efficiency also improved, and nonfuel unit costs declined 1.8% year over year before the impact of profit sharing.
On the flip side, revenue per available seat mile declined 4.7% year over year. That was better than what some of Southwest's competitors managed, but still not a great outcome.
But Southwest Airlines' management pointed out that much of the decrease in unit revenue was caused by longer average trip lengths and flying larger planes. Both factors drive large offsetting cost benefits, leaving Southwest better off on a net basis. Most of the rest of the decline came from having a disproportionate amount of capacity in new markets.
A new tailwind arrives
In the long run, Southwest's profit growth will be driven by steady expansion into new markets beyond the continental U.S., along with a gradual fleet shift toward larger planes with lower unit costs.
In the short run, Southwest's next leg of profit growth will come from its new credit card deal. Credit card issuers have been competing fiercely for the right to issue popular rewards cards lately. As one of the largest airlines in the country, Southwest Airlines definitely constitutes a big prize, giving it a lot of bargaining power.
The result is that Southwest expects to get an extra $125 million in quarterly revenue from the new credit card arrangement. That represents a roughly 2.5% bump to its total revenue -- and this extra revenue is essentially pure profit.
The improved credit card agreement is the main reason why Southwest expects its unit revenue declines to moderate to 1% this quarter. Since poor unit revenue performance has been holding back Southwest stock lately, this boost to the unit revenue trajectory could get the stock moving in the right direction again.
The road ahead
Unfortunately, just when Southwest Airlines is poised to benefit from a stronger unit revenue trend, it is going to be facing somewhat higher fuel prices. The company made a tactical blunder by entering some new fuel-hedging contracts as oil prices rose during Q2. Oil prices have since collapsed again, but Southwest is locked into higher prices starting in Q3.
In total, if oil prices remain on their current trajectory, Southwest would incur $1.3 billion of hedging losses over the next several years. That's a significant amount, but quite manageable, considering that Southwest's pretax income totaled $1.7 billion in the first half of 2015 alone.
With the benefits from Southwest's improved credit card deal offsetting higher hedging losses, Southwest Airlines is well-positioned to continue its string of solid profits. Yet the stock is currently trading at just 10 times earnings, which is quite cheap given that Southwest has strong margins, a solid investment-grade balance sheet, and steady free cash flow that it is using for dividends and share buybacks.
On the other hand, there are lots of other airline stocks that are even cheaper at the moment, as investors' enthusiasm for the airlines has dropped significantly this year.
Furthermore, Southwest is facing increasing labor strife. Its flight attendants recently rejected a tentative new contract agreement by a huge margin (87% of those who participated voted no). Pilots are also getting restless. Eventually, both labor groups will get big raises that could cut into Southwest's profitability.
Southwest Airlines is on track for a great year and is certainly a solid investment candidate based on its long history of consistent profitability. But it still faces some notable risks and other airline stocks may offer a better risk-reward trade-off at this point.