Southwest Airlines recovery begins in earnest

Southwest Airlines (NYSE: LUV) disappointed shareholders in 2021. As the low-fare airline giant quickly expanded its route network into new cities to meet increasing demand it was previously unable to service, it failed to see the financial benefits bullish investors had expected.

For the full year, Southwest lost about $1.3 billion, excluding subsidies received from the federal airline’s payroll programs. And while Southwest Airlines shares rose to a multi-year high of nearly $65 last April, the shares have since lost about a third of their value, closing at $42.93 last week.

Southwest Airlines stock performance, data by YCharts.

Fortunately, Southwest Airlines finally turned profitable last quarter. In addition, the company’s results should improve significantly in the coming years as air traffic normalizes.

A solid end to the year

In October, Southwest forecast fourth quarter revenue to fall 15% to 25% compared to 2019. Coupled with rising fuel prices and inflation in non-fuel unit costs, this meant it would post another quarterly loss.

However, on the airline’s investor day in early December, management revealed that demand had recovered rapidly in recent weeks, particularly around the Thanksgiving holiday. In addition, Southwest Airlines signed a new co-branded credit card agreement with Chase in early December, with improved economic conditions. That put the company on track to turn a profit in the fourth quarter.

Ultimately, Southwest posted $5.05 billion in fourth quarter revenue, down 11.8% from 2019 on a 8.3% capacity reduction. This allowed the company to withstand higher fuel prices and a 10.6% increase in adjusted unit costs for non-fuels compared to two years earlier and achieve earnings of $0.14 per share. That beat the analyst consensus of $0.07.

Expect a quick rebound from the ommicron variant

At the time of Southwest Airlines investor day, management expected the company to make a profit in every quarter of 2022. Unfortunately, the severe impact of the ommicron variant on demand and staffing has thrown those plans into disarray.

Southwest estimates that it will lose $330 million in revenue in January and February combined because of this brief slump in demand. As a result, Q1 sales will decrease by 10% to 15% compared to Q1 2019 with approximately 9% less capacity.

Southwest Airlines aircraft in a gate area of ​​the airport.

Image source: Southwest Airlines.

Meanwhile, the impact of capacity reductions and an incentive program to keep planes flying despite an increase in sick leave will lead to a 20% to 24% increase in non-fuel unit costs over the same period. Fuel costs have also increased. As a result, Southwest posted a loss for the first quarter.

However, with the number of COVID-19 cases starting to decline again in the US, demand is already recovering. By March, Southwest expects to be back in the black, and profitability should continue to increase through 2022 as demand improves and cost pressures ease.

Finally worth it again

For most of 2021, investor euphoria over the potential recovery after the pandemic caused Southwest Airlines shares to trade at levels that didn’t leave much room for error. Not surprisingly, this led to poor share price performance, as the airline experienced several setbacks in the second half of the year.

By contrast, Southwest Airlines stock is now trading at an attractive valuation of 10 times 2019 adjusted earnings per share (EPS) of $4.27. Southwest has a number of initiatives to drive EPS above that level, including fleet upgrades and efforts to increase fares by attracting more business travelers. In addition, the company has a significant amount of excess cash that it will likely return to shareholders once restrictions on dividends and redemptions expire later this year.

Frankly, I continue to worry about Southwest’s rising costs. Management projects that have adjusted unit non-fuel costs will increase by 12% to 16% this year compared to 2019, before declining slightly in 2023. Other airlines have done a better job of finding permanent cost savings in the past two years. Higher costs could offset much of the benefit from Southwest’s revenue initiatives.

Still, the risk of rising costs weighing on profitability appears to be ingrained in Southwest Airlines’ stock price today. That makes this stock worth checking out for investors looking to bet on a recovery in the airline industry.

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Adam Levine-Weinberg has no position in any of the listed stocks. The Motley Fool recommends Southwest Airlines. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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