|Table of Contents|
|Intro and Overview|
|Valuation and Trends|
|Key Trends and Forces|
Southwest Airlines (NYSE:LUV) is the largest domestic carrier by total passengers, carrying over 101.9 million passengers in 2008 on over 1.18 million flights. Southwest thrives on maintaining low operating expenses, primarily through its extensive fuel hedging, which saved the company an estimated $1.1 billion in fuel costs in 2008. Because of its low costs, Southwest was able to remain profitable for 35 consecutive years, a feat unmatched in commercial aviation history. However, the percentage of fuel costs the company has hedged declines precipitously beyond 2009, and the drop in fuel prices caused by the global economic crisis renders Southwest's key advantage - its low fuel costs in comparison to its competitors - much less valuable. For the first time, Southwest reported quarterly losses in Q3 and Q4 of 2008, as well as Q1 of 2009.
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 other airlines, whose profits can diminish when oil prices rise. For example, in 2008 Southwest had 70% of its fuel needs hedged at $51 per barrel, while most other major airlines had only between 20% and 30% of their fuel hedged at an average $100 per barrel. Because of its hedges, Southwest maintained an industry-leading  average price of $2.44 per gallon of jet fuel in 2008.
Southwest's hedging contracts extend until 2012, although the amount of oil hedged drops steadily after 2009, with only 15% of its oil needs in 2012 hedged at $63 per barrel. Therefore, Southwest will become more vulnerable to fluctuations in fuel prices as its contracts mature.
Southwest Airlines offers short domestic-only flights with minimal service and a simple, cheap fare structure. Southwest replaced the expensive hub and spoke route structure common to most other carriers in favor of short, point to point direct flights using its homogenous fleet of 537 Boeing 737 aircraft. Using its point to point flights, Southwest offers frequent direct flights over short distances, like from Los Angeles to Las Vegas. In 2008, Southwest served 438 nonstop city pairs, in 64 cities in 32 states and carried over 101.9 million passengers , the most of any domestic carrier. As the low-fare leader, Southwest's average ticket price was $119.16 in 2008 , up from $106.60 in 2007 compared to an average price of $139.40 in 2008 at its closest competitor, JetBlue Airways (JBLU).
Southwest's operating metrics are shown below.
Southwest Key Operating Metrics
|ASM in thousands (seat capacity x miles flown)||65,295||68,887||71,790||76,861||85,173||92,780||99,636||103,271|
|RPM in thousands (filled seats x miles flown)||44,494||'45,392||47,942||53,418||60,223||67,954||72,319||73,491|
|Filled seat percentage (Load)||68%||66%||67%||69%||71%||73%||72.6%||71.2%|
|Revenue per filled seat mile (Yield), in cents||12.1||11.7||12||11.8||12.1||12.9||13.08||14.35|
|Cost per Available Seat Mile (CASM), in cents||7.5||7.4||7.4||7.7||8.0||8.7||9.10||10.24|
|Non-fuel (CASM) (cents)||6.34||6.28||6.29||6.42||6.48||6.46||6.40||6.64|
|Fuel cost per gallon (dollars)||1.16||1.12||1.11||1.28||1.52||2.24||1.77||2.32|
Southwest's low cost structure enables the company to offer low prices to its customers. The company minimizes its costs through its use of a single type of aircraft, efficient point to point route structure, highly productive employees, and its hedging of oil prices. For example, Southwest paid an average $2.44 per gallon of fuel in 2008, compared to American Airlines (AMR) average $3.03 per gallon. As a result of its low costs and low-fare position, Southwest has maintained 35 years of consecutive profitability. Although the company had net income of $178 million in 2008 , from 3Q08 to 1Q09, Southwest has reported quarterly losses, including a $91 million loss in 1Q09.  Moreover, because of its low operating expenses, Southwest became the second most profitable domestic carrier in the U.S. in 2007 (Northwest was the most profitable but it was acquired by Delta Air Lines Inc. (DAL) in October 2008), earning $645 million in net income.
2008 marked 36 years of consecutive profitability for Southwest, the longest streak in the airline industry. Southwest's low fares have helped the company grow by more than 66% since 2003, increasing its fleet by 149 aircraft during the period. Additionally, the company's annual passengers carried has increased by more than 36% between 2003 and 2008, as the company expanded its fleet and its flight destinations. However, in 1Q09, Southwest reported net operating losses of $50 million, ending a 71 quarter streak of operating profit. Also, in 1Q09, the company had a net loss of $91 million.
In 2008, Southwest earned $11.023 billion in revenue, an 11.8% increase from 2007, that was driven primarily by a $1.1 billion (11.5%) increase in passenger revenue (ticket sales). Unlike in 2007, when an 8.5% growth in operating revenue as compared to 2006 was spurred by an 8% increase in fleet size and flights and a 7.5% growth in capacity, or available seat miles (ASM), the revenue growth in 2008 was due to increased fare prices. Between 2007 and 2008, average fare per passenger increased by 11.8%, from $106.60 to $119.16, the same as growth in operating revenue. Given Southwest's reputation as a low-cost airline, this source of revenue growth is not sustainable in the long-term. However, Southwest's revenue yield per passenger miles (RPM) or its revenue divided by passenger miles flown, increased from 13.08 cents in 2007 to 14.35 cents in 2008, a 9.71% increase , as compared a 1.16% increase between 2006 and 2007.
Southwest's operating expenses increased 16.6% in 2008, as opposed to 11.3% in 2007 , outpacing its 3.6% growth in capacity, which is usually the main driver of increases in operating expenses. As a result, Southwest's Cost per Available Seat Mile (CASM) increased 12.5% compared to 2007. The company attributes approximately 80% of this increase to higher fuel costs, which rose by 33.3% in 2008. The remaining increase in costs is due to higher maintenance costs, which rose 12.9% in 2008 because many of the engines in Southwest's newest aircraft, the 737-700, underwent their first major overhaul. To mitigate higher fuel costs, Southwest implemented several initiatives in 2007 aimed at reducing its non-fuel costs. For example, Southwest reduced the amount of employees per aircraft to 66 in 2007, down from 68 in 2006 which helps the company save on wage and compensation expenses. However, by 2008, that number increased to 89, which offset the gains from previous years .
Southwest earned $178 million in net income in 2008, a 72.4% decrease from $645 million in 2007, which was primarily due to the increase in fuel expenses  and losses due to SFAS 133, which concerns accounting rules regarding derivative instruments . As previously mentioned, Southwest benefited greatly from its hedging program, which saved the company an estimated $686 million in 2007. However, in 2008, despite 78% of its fuel needs hedged using fuel derivatives instruments, fuel related expenses still increased by over $1 billion from 2007 . Further, with the precipitous decline in crude oil prices in 4Q08, Southwest's fuel costs per gallon will exceed unhedged prices by between $.08 and $.17 from 2009 to 2013 . Therefore, Southwest must balance the risk of rising fuel costs in the future with the lack of flexibility if company's use of fuel derivative instruments locks in a price above market value.
Southwest rebounded from 1Q09, which broke its streak of 71 consecutive quarters with operating income, to report $54 million of net income in 2Q09, though this figure was 83% lower than in 1Q09. With 50% of its fuel needs hedged for 2Q09, and 47% overall for 2009, LUV was able to decreases its average cost per gallon of fuel by 19.4%, to $1.95. Already a low-cost airline, Southwest further decreased average passenger fare by 3.5%, which corresponds to the 3% fall in Available Seat Miles (ASM), to 25,552,927,000. Although load factor increased from 75.2% to 77%, the decline in operating revenue yield per ASM outpaced that in operating expenses per ASM, with 6% and 3.6% declines, respectively.
In 3Q09, the company reported operating income of $22 million; however, Southwest ultimately had a net loss of $16 million. Still, this represents a $104 million improvement as compared to 3Q08. Although the company's revenue declined by 7.78%, a 4.7% increase in revenue passenger miles and an 8.0 bps increase in load factor suggest that demand for airline travel may be increasing.