Southwest Earnings: Costs Growing Faster and Capacity Slower Than We Expected; Fair Value Lowered 9%

Southwest Airlines LUV reported record quarterly revenue and double-digit operating margin in the second quarter of 2023, but updates to management’s longer-term growth plans gave us pause. As a result of less-steep capacity growth than we expected, and permanent increases in the company’s cost structure, we’ve lowered no-moat Southwest Airlines’ fair value estimate to $39 from $42.90.

As this busy and nearly fully booked summer unfolds, we see the basis of our longer-term thesis playing out. As long as industry capacity is constrained by pilot hiring, delayed delivery of planes from Boeing—most of which affects U.S. airlines equally, though Southwest is entirely dependent on Boeing for its 737 fleet—we see the existing competitive dynamics as stable and revenue yields and booking rates boosted across the board. Meanwhile, as Southwest continues to plot capacity expansion beyond 2019 levels, spending billions on new planes, the company is also renegotiating labor agreements with pilots, flight attendants, and other employee groups, which is beginning to add costs as wage agreements catch up to cost of living and other adjustments. Low fuel prices and unusually full planes will pay for these increases in wages and capacity, but once either wavers, we expect lower profitability and the return of risky price competition.

Our 2027 midcycle forecast for Southwest includes a 16 cent per revenue passenger-mile passenger revenue yield, 15% share of revenue passenger miles, and load factors in the low 80s. It also incorporates higher depreciation as Southwest takes delivery of new planes. More important, our forecast locks in almost 1.5 cents per available seat mile of structural unit costs that materialized at the end of the prepandemic period. Southwest only booked about 3.5 cents per available seat mile of spread between its passenger revenue and nonfuel recurring costs before the pandemic, so this change accounts for the bulk of our lower forecast operating margins.