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Earnings Preview: LUV

Zacks Equity Research

The largest U.S. low-cost carrier Southwest Airlines Co. (LUV) is slated to release its second quarter 2012 earnings on July 19 before the opening bell. The current Zacks Consensus Estimate for the second quarter is 32 cents, representing a substantial 113.33% increase from the year-ago level.

Looking at surprises, Southwest had positive earnings surprises of 18.85% in the last four quarters.

Over the past two months, fuel price, the major threat to the company’s profitability, dropped to a certain extent, which has made airline operations less expensive.

At the first quarter conference call, Southwest projected second quarter unit costs (excluding fuel and special items) to increase from the year-ago level and fuel price, including taxes in the range of $3.40–$3.45 per gallon. It also predicted strong passenger revenue in the second quarter.

First Quarter Flashback

Southwest Airlines’ earnings surpassed the Zacks Consensus Estimate by a couple of cents but remained below the year-ago earnings. Better-than-expected performance was attributable to robust revenue growth driven by fare hikes, cost-cut measures, network optimization, All-New Rapid Rewards and synergies from the AirTran acquisition that offset rising fuel costs in the quarter.

Airlines traffic showed an impressive growth of about 23.4% on strong capacity growth, which was partially offset by the decline in load factor (percentage of seats filled with passengers).

On the cost side, total operating expense, excluding special items, spiked 33% year over year. Fuel expenses surged 45.2% in the first quarter.

Agreement of Analysts

Estimates for the second quarter of 2012 have been trending upward over the last 7 and 30 days with 3 and 4 out of 13 analysts making upward revisions, respectively. None of them made a downward revision. For fiscal 2012, out of 15 analysts, 3 and 5 made positive revisions over the last 7 and 30 days, respectively, while 1 moved in the opposite direction in both periods.

The analysts believe that Southwest is poised to benefit from its fleet modernization plan, Evolve retrofit program, All-New Rapid Rewards, AirTran merger synergies and several ancillary product offerings such as EarlyBird check-in, unaccompanied minor travel and pet fees. The company is also improving its services and introducing new products, which are enhancing its value and profitability.

The analysts believe the lower fuel expenses along with the cost-cutting measures would offset high maintenance costs associated with the fleet modernization program as well as other operating costs including higher salaries, wages and benefits, and airport costs amidst the ongoing market turmoil.

The fleet modernization plan will boost pre-tax income by about $70 million in 2012, $300 million in 2013 and $500 million in 2014. Additionally, the Evolve retrofit program and the addition of new The Boeing Co. (BA) 737-800 planes have revenue potential of roughly $200 million and $100 million, respectively, for this year.

Further, the AirTran merger would generate net synergies of more than $400 million by 2013. Half of this ($200 million) is expected this year, with two-thirds realized from revenue and one-third from cost savings.

Most of the analysts are also encouraged by Southwest’s plan to double shareholders return. The company boosted its quarterly dividend by 122% to one cent per share. This marks the first increase in nearly a decade. Moreover, Southwest also increased its share repurchases authorization to $1 billion from $500 million.

Southwest is the first low-cost carrier to pay dividend to its shareholders, and thus strengthen its position against its major rivals - JetBlue Airways Corporation (JBLU) and Spirit Airlines Inc. (SAVE).

Magnitude — Consensus Estimate Trend

Over the last 7 days, the magnitude of second quarter estimate revisions increased by 2 cents over the last 7 days and 30 days.  

The Zacks Consensus Estimate for 2012 remained static at $1.08 over the last 7 days and grew by 3 cents over the last 30 days.

Outperform Recommendation

We are upgrading our long-term recommendation on Southwest Airlines from Neutral to Outperform based on falling fuel prices and strong growth opportunities. Falling fuel prices, fare hikes, hedging strategies, cost-cutting measures, network optimization and All-New Rapid Rewards are expected to generate strong profitability going forward.

For the short term (1-3 months), the stock holds a Zacks #2 (Buy) Rank.

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