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Southwest’s Margins Should Improve despite Slowing Revenue Growth

Ally Schmidt

Southwest Airlines' 1Q16 Results: What the Analysts Are Saying

(Continued from Prior Part)

Strong EBITDA estimates

For 1Q16, Southwest Airlines’ (LUV) EBITDA is expected to grow by 18% to $1.2 billion. In 2Q16, it is expected to increase by 20% to $1.6 billion.

In 3Q16, Southwest’s EBITDA growth is expected to slow to 1.3%, improving slightly to 5.3% in 4Q15. For the full year, the airline is expected to clock EBITDA growth of 10% to $5.7 billion.

However, Southwest Airlines’ (LUV) margins are expected to improve throughout the year. Analysts are estimating EBITDA margins to improve to 27% in 2016 from 25.9% margins in 2015. For 2017, the company’s EBITDA growth is expected to remain flat, and margins are expected to fall again to 25.7%.

There are a few things that investors should keep in mind. Estimates suggest that analysts might be expecting the industry margins to have peaked in 2016. However, new information or trends in the business can lead to margins being revised higher or lower.

Improving utilization

These growth estimates are supported by better utilization. Southwest Airlines is the only carrier to have improving utilization for the last eight consecutive quarters. Southwest expects its capacity utilization to continue this trend in 2016.

Falling oil prices

Oil prices form a major cost component of airlines, and the 60% decline in crude prices has helped improve margins. Fuel costs fell from $2.92 per gallon in 2014 to $2.07 per gallon in 2015.

For 2016, Southwest Airlines expects its fuel costs to fall further to $1.70–$1.75 per gallon. This is slightly higher than its legacy peers American Airlines (AAL), Delta Air Lines (DAL), and United Airlines (UAL) due to Southwest’s huge hedging losses.

Southwest Airlines (LUV) forms 0.5% of the iShares Russell Mid-Cap ETF (IWR).

Hedging losses

Early in 2015, Southwest Airlines unhedged its fuel consumption, but it added some new positions in the second half of 2015. This resulted in further losses after the recent price slip. Southwest Airlines has an expected $1 billion or more in unrealized hedging losses for 2016–2018 as of the end of 2015. This could rise even higher after the recent drop in oil prices.

We do not expect any incremental fuel cost savings for Southwest Airlines. In the next part, we will analyze Southwest’s leverage situation.

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