We have downgraded our long-term recommendation on Southwest Airlines Co. (LUV) to Neutral from Outperform as the positive impact of falling fuel prices has largely been priced in the stock. In addition, a weakening economy is restricting the demand for business travel that would hurt the carrier’s profitability going forward.
The company reported impressive earnings in the second quarter, outpacing the Zacks Consensus Estimate and the year-ago earnings. But volatility in fuel prices, high maintenance costs associated with the fleet modernization program, increased salaries, wages and airport fees, and the ongoing market turmoil are keeping the prices of Southwest at check.
Further, new advertising rules and stiff competition from United Continental Holdings Inc. (UAL) and Delta Air Lines Inc. (DAL) keep us cautious on the stock. Besides, 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.
Nevertheless, we are encouraged by the company’s cost-cutting measures, fleet rightsizing, network optimization, Evolve retrofit program, steady capacity growth, All-New Rapid Rewards program and several ancillary revenues. The overall fleet modernization plan will likely boost pre-tax income by about $70 million in 2012, $300 million in 2013, $500 million in 2014 and $700 million in 2015. Further, the Evolve retrofit program and fleet rightsizing have revenue potential of roughly $200 million and $100 million, respectively, for this year.
The AirTran merger is also providing additional synergies. The transaction is expected to generate net synergies of more than $400 million by 2013 on full integration. The company expects to produce half of the net synergies ($200 million) this year, with two-thirds realized from revenue and one-third from cost savings. Till the first half of the year, Southwest generated $180 million in annual synergies.
Consequently, the stock also holds a short-term Hold rating with the Zacks # 3 Rank.
BOEING CO (BA): Free Stock Analysis Report
DELTA AIR LINES (DAL): Free Stock Analysis Report
SOUTHWEST AIR (LUV): Free Stock Analysis Report
UNITED CONT HLD (UAL): Free Stock Analysis Report
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