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Southwest Airlines Company (LUV)Stock (Airlines Industry, Transportation Industry)
 Southwest Airlines (NYSE:LUV) is the 7th largest airline by passengers carried. However, it has consistently outperformed all other airlines as an investment. The company has been profitable every year since 1973 -- a feat that no other airline has accomplished. Southwest's costs are among the lowest in the industry, due to a combination of no-frills service, higher productivity (Southwest has only 70 employees per plane compared with an industry average above 90), and a series of fuel hedges that locked in low oil prices years ago. As a result, to be profitable, Southwest only needs fill 64% of its seats, compared to up to 80% for other airlines. Southwest has used its cost advantages (both operational and fuel) as a competitive lever to undercut legacy airlines on price, forcing them to cede market share or respond by operating at a loss. Southwest is growing its capacity more rapidly than any airline other than ATA, and Recent bankruptcies at United, Delta, and Northwest can be traced, in part, to their inability to compete with Southwest on cost. As with other airlines, Southwest is vulnerable to dropoffs in consumer demand for air travel, which are often a consequence of high profile terrorist attacks or a slowing economy. However, as a result of its fuel hedges, Southwest is less vulnerable to oil price fluctuations than less fortunate airlines, whose profits can vanish when oil prices rise. These hedges expire in 2009, at which point Southwest's fuel cost advantages may decrease or disappear.
[edit] HistorySouthwest Airlines' first flights, in 1971, were from Love Field in Dallas to Houston and San Antonio, short hops with no-frills service and a simple fare structure, features that became the basis for Southwest's popularity and rapid growth in the coming years. From the start, Southwest eschewed the expensive hub and spoke route structure common to legacy carriers in favor of point to point direct flights. This allows Southwest to cherry-pick only the most profitable routes. But this focus comes at a cost -- Southwest's network is not as deep or broad as many legacy carriers, which makes it difficult to attract lucrative business travelers. Southwest is one of only a handful of airlines (including JetBlue and ATA) who are rapidly expanding by adding new airplanes and new destinations. As shown in this table tracking Southwest's key operating metrics over the last few years, this expansion has only marginally impacted Southwest's industry-leading non-fuel costs of under 6.5 cents per Available seat miles (ASM).
[edit] Company Overview[edit] CapacityThe total supply of available seats is a key driver of airline profitability, as it impacts carriers' ability to keep prices high. Seat supply is tracked as Available Seat Miles (ASM), the total number of available seats times the number of miles flown. All else being equal, as industry-wide ASM drops, airlines have an easier time raising fares and remaining profitable. As more capacity is added to the system, however, prices tend to drop dramatically. With a limited number of customers and an oversupply of capacity, carriers often cut fares to attract customers to fill what would otherwise be empty seats. Airlines' decisions to increase or decrease capacity create a prisoner's dilemma which has historically led to price cuts and has contributed to the difficulty airlines have remaining profitable. If all carriers were to restrict supply, prices would stay high and all would earn profits. However, as some carriers are restricting capacity, any individual carrier has an enormous incentive to increase it's own capacity, steal market share, and earn greater profits. but if all carriers were to behave in this manner, available seats would outstrip demand and the industry's profits would likely vanish as airlines compete to fill their planes with passengers. [edit] Importance of Capacity at the Regional LevelLarge carriers tend to focus on specific regional markets where they have high market share. For example, Delta Airlines (DAL) has XX% of ASM flying into and out of Atlanta, and Southwest's largest markets are in Texas and California. Because airlines compete in some markets and not others, nation-level changes in ASM can be misleading. For example, if American Airlines (AMR) increases flights between Chicago and Dallas, that change is unlikely to affect JetBlue Airways (JBLU), which does not fly to either market. [edit] Factors Impacting Capacity: Mergers, BankruptciesWhen carriers merge or aquire, they tend to cut redundant flights, reducing capacity for the industry overall. As such, airline mergers tend to benefit the entire industry, not just the companies that combine. Airlines in bankruptcy proceedings often cut capacity in an attempt to reduce costs and return to profitability. This reduction in capacity can benefit the entire industry, so a single airline's bankruptcy can provide its competitors more room to maneuver. [edit] Recent Trends in CapacityOverall industry ASM fell 5% in the six months ending XXXX -- a potential harbinger of good times to come. However, this industry-wide trend masks company-specific changes. Northwest Airlines (NWA), Delta, and United, saddled by debt and amidst bankruptcy proceedings, have reduced capacity dramatically while Southwest and other carriers have seized the opportunity to grow aggressively, ordering new planes, increasing flights, and expanding into new markets. [edit] Customer DemandAirline profits are highly susceptible to economic downturns, terrorist attacks and other trends that can reduce passenger numbers. Fewer passengers is a double whammy for the airline industry -- leading to fewer filled seats, and fiercer competition for the remaining passengers which can knock down fare prices. News items highlighting geopolitical instability or a slowing economy can send the price of airline stocks tumbling. [edit] Importance of business travel and route breadthBusiness travelers are attractive to airlines because they are less price sensitive than leisure travelers, and because business traveler demand is less cyclical than that of leisure travelers. For example, economic downturns may lead leisure travelers to cancel their vacation in the bahamas, but business travel is impacted less dramatically. Unfortunately, Southwest has had limited success attracting business customers. Southwest's single-cabin service makes it difficult to attract lucrative business executives seeking business-class seats. Additionally, Southwest's limited route map and codeshare partnerships make it difficult for a company to use Southwest for all its travel needs, and most companies choose a single favored carrier. [edit] Operating costs Airline operating costs are measured in CASM (Cost / Available Seat Mile). CASM is frequently split into ex-fuel and fuel components to isolate the impact of the price of oil from other effects. Southwest has the lowest ex-fuel operating costs of any U.S. airline, largely due to higher employee productivity -- faster turn-around times between flights, more flying time per pilot, and fewer total employees per aircraft. This allows Southwest to undercut competitors' prices while still remaining profitable. Profitability at large carriers has been elusive in large part because of Southwest's efficiency. When Southwest moves into a new market, it cuts prices below the break-even point for other carriers, forcing them to match and operate at a loss. Known as "the Southwest effect", Southwest's low operating costs have made it the price leader in the aviation industry, and has spawned an entire industry of low-cost airlines such as Jet Blue (JBLU) and ATA. When Southwest cuts or raises prices, other airlines typically follow suit. Recently, legacy carriers have been able to reduce their costs through a combination of service reductions (such as eliminating meals in coach class) and negotiations with unionized workers for more hours and less pay (Southwest's workers are not unionized). Bankrupt legacy carriers have used the courts to jettison generous union contracts. As a result, Southwest's cost advantage is not as pronounced as it once was - while American (AMR) and US Air, for example, had ex-fuel CASMs 65% above Southwest's in 2001, their CASMs were only 25% above Southwest's in 2005. [edit] Fuel Perhaps no other industry has as much exposure to fuel prices as the airline industry. Fuel represents approximately 30% of an airline's costs. Due to narrow industry margins, small fluctuations in the price of oil can eliminate -- or double -- an airline's profits. Airlines sometimes hedge the price of oil to insulate themselves from significant price swings -- essentially buying insurance to guarantee the price they will pay for fuel, regardless of market conditions. However, with the exception of Southwest, most of this hedging is done only for a small percentage of an airline's fuel purchases. Southwest substantially increased its hedging in 2001 in response to projections of increased crude oil prices. The use of these hedges helped Southwest maintain its profitability during the aftermath of the September 11, 2001 attacks and the oil shocks related to the Iraq War and later Hurricane Katrina. As a result of different hedging strategies at each of the major airlines, oil fluctuations impact each of them differently (See graph describing how a variety of airlines' EPS would be impacted by changes to the price of a barrel of oil. Southwest is the least impacted, as its costs are locked in with hedges. United (UAUA), which has not hedged fuel prices at all, is the most exposed to changes in oil prices).  When Southwest's current hedges expire in 2009, Southwest's fuel costs will go up around 1 cent per ASM, bringing its fuel costs in line with those of other airlines. While this is bad news for Southwest, it is good news for other airlines, who have been forced to compete against a company that purchases fuel at below market rates. [edit] Comparison to CompetitorsSouthwest is not the largest airline (it is the seventh largest by passengers carried) but it is among the fastest growing, and it is certainly the only US airline to post profits for three decades without interruption. Southwest has the strongest balance sheet in the industry -- meaning that it has low levels of debt and large stockpiles of cash. This balance sheet allows Southwest to expand quickly into new markets when it sees an opportunity, and lock in the price of fuel when it is low (airlines with poor balance sheets have had less success hedging fuel because they cannot afford the hedges). Southwest's main competitors are American Airlines (AMR) (in Chicago, Texas, Los Angeles, and Miami), Continental (CAL) (in Cleveland and Houston), United (UAUA) (in Los Angeles, San Francisco, Portland, Chicago, and Washington, D.C.), and US Air (LCC) (in Baltimore, Phoenix, and Las Vegas). Southwest is compared to these competitors along key metrics in the table below. Because Southwest's costs are so low, it has the lowest break-even load in the industry. This means that Southwest breaks even as long as its planes are 64% full. In contrast, it is not uncommon for other carriers to have break-even loads above 80% (Delta's (DALRQ) break-even load was 93% in 2004, a year before it declared bankruptcy.
 Southwest Airlines Company2004 Data 2005 Data 2006 Data 2007 Data 2008 Data Most Recent Data Available [edit] References
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