Pandemic Causes Southwest's Passenger Traffic to Dry Up

No-moat-rated Southwest Airlines LUV reported a challenging second quarter, as the coronavirus pandemic ravaged commercial airline passenger traffic over the period, and we’re maintaining our $44 per share fair value estimate.

Revenue declined roughly 87%, in line with peers, on 55% lower capacity, a load factor of 31%, and yield declines of roughly 21%. Notably, while varying disclosures between carriers makes it difficult to fully ascertain, it appears that the firm reduced capacity by much less than peer carriers and reduced yields by much more than legacy carriers’ domestic operations. We think the airline is attempting to take domestic market share, while the legacy carriers are unable to defend their position. If Southwest can retain this share when airline operations return to profitability, we think it would be a savvy move. But the strategy could backfire if passenger traffic deteriorates over the next few months as a result of the variable costs associated with additional flights. Another potential explanation for the difference in capacity and yields is that Southwest overshot demand in the second quarter and cut prices to attract passengers.

Turning to expenses, excluding the federal coronavirus stimulus and fuel, the firm cut out about 24% of operating expenses, less than peers. Much of this is due to the firm cutting capacity by less than peers, which increases variable costs. The firm was able to get 27% of its workforce to participate in voluntary furloughs, including about 25% of high-cost pilots, and announced that it does not intend to pursue layoffs at this point. While we think that this program may not cut as much labor expense as peers’ involuntary plans, we think this is the correct move for airlines that can afford it, as it engenders goodwill from employees and allows flexibility on a potential recovery. We highlight our Exemplary stewardship rating for the firm. If the pandemic gets materially worse, Southwest may need to reverse course.

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