We are maintaining our long-term Neutral recommendation on the largest U.S. low-cost carrier Southwest Airlines (LUV) following its first quarter 2011 results. The stock retains the Zacks # 3 Rank (Hold).
Southwest Airlines delivered strong results in terms of revenue and traffic growth that largely compensated higher fuel expenses. First quarter earnings were in line with the Zacks Consensus Estimate as well as the year-ago numbers.
The drop in demand caused by the massive earthquake and tsunami in Japan on March 11 has affected the whole airline industry. Since Southwest Airlines currently operates on domestic routes, it did not have to bear the brunt.
However, the surging fuel prices took a toll on the company’s profitability in the recently reported quarter. Southwest is trying to combat rising fuel prices with increasing fares and extra fees yet consistently offering the lowest and simplest fares.
We expect the airline to report strong revenue growth and achieve solid cost control in 2011 as it continues to explore and plan for revenue-producing opportunities, thereby improving its earnings prospect.
The company is benefiting from increased ancillary product offerings such as EarlyBird check-in, unaccompanied minor travel and pet fees. It has begun the multi-year process of replacing the reservation system to pave the way for international destinations, along with other customer service and revenue enhancements.
Southwest continues to install WiFi connectivity in its existing 737-700 fleet and plans to introduce new larger Boeing 737-800 into its fleet in 2012. Additionally, the company focuses on yielding benefits from the recent launch of new Rapid Rewards that has the potential of contributing incremental revenues over the next several years.
Further, Southwest completed its previously announced $1.4 billion merger with AirTran Holdings on May 2, following all the necessary clearances. The merger will provide healthy returns based on expected synergies and benefits.
The company will improve its revenue and operating income with the introduction of its services to new and unexplored domestic markets and debut in the Caribbean and Mexico markets. Southwest gained a valuable market presence in Atlanta, the busiest airport in the U.S., post merger.
However, we remain cautious on rising fuel prices, which might adversely affect the ongoing recovery of the airline industry. The failure to successfully integrate AirTran, heavy investments and concerns related to labor costs may limit the upside potential of the stock.
Southwest faces stiff competition from other low-cost carriers as well as from major airlines that cut fares to woo customers. It competes with Delta Air Lines Inc. (DAL), United Continental Holdings (UAL), American Airlines, a wholly owned subsidiary of AMR Corporation (AMR)and US Airways (LCC).
Additionally, Southwest is dependent on Boeing Co. (BA) as its sole supplier for aircraft. If Southwest is unable to acquire additional aircraft from Boeing or if the latter is unable to provide adequate support, the company’s profitability will inevitably be hampered.
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