We recently upgraded our long-term recommendation on Southwest Airlines Co. (LUV) to Neutral from Underperform following better-than-expected first quarter earnings results and strong growth opportunities.
The company reported lower year-over-year earnings in the first quarter but outpaced the Zacks Consensus Estimate. Despite surging fuel prices, the better-than-expected performance in the quarter was credited to robust revenue growth driven by fare hikes, cost-cutting measures, network optimization, All-New Rapid Rewards and synergies from the AirTran acquisition. (Read our full coverage on this earnings report: Southwest Beats, Upped to Neutral)
Southwest Airlines is working on a number of initiatives to increase revenue and reduce costs over the next three years. The companyis expected to improve its revenue and earnings on the back of fleet rightsizing, the Evolve retrofit program, steady capacity growth, All-New Rapid Rewards and several ancillary revenues. The AirTran merger will also provide additional synergies when fully integrated with the company’s fleet.
Southwest is streamlining its cost structure including fuel and non-fuel, which is boosting profits amidst high fuel prices and the ongoing market turmoil. The company is successfully passing on the increased cost to customers in the form of fare hikes. Additionally, the company is using fuel-hedging strategies and cutting capacities to manage the rising fuel prices.
Though fleet modernization planswill dilute profitability in the short term, these are expected to boost pre-tax income by about $70 million in 2012, $300 million in 2013 and $500 million in 2014.
In addition, we expect AirTran merger to be accretive to Southwest’s earnings and generate net synergies of more than $400 million by 2013 on full integration. On the other hand, the successful integration of AirTran would result in a one-time charge of $500 million, of which $155 million has been exhausted until the first quarter. Further, Southwest expects non-fuel costs to grow due to higher labor, maintenance and airport costs.
Moreover, 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.
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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