Southwest Airlines Earnings: Pivots Some Capacity and Takes Unit Cost Hit, Most of It Is Temporary

As we expected, Southwest Airlines LUV reported a first-quarter net loss due to extra costs and $325 million of lost revenue in January and February related to the firm’s disruptive cancellation of more than 16,700 flights in late December. After reviewing Southwest’s first-quarter results and adjusting for a revised 2023 outlook, we’ve lowered our fair value estimate approximately 2% to $54 per share.

The biggest wrinkle in Southwest’s earnings announcement was management’s revised expansion plans and their effect on 2023 capacity measured as available seat miles, or ASMs. Southwest announced that it will receive 20 fewer new 737s from Boeing this year than it originally planned. As a result, Southwest is shuffling around planes on its order calendar with Boeing and trimmed its projected capacity expansion for 2023 by some 2.5 billion ASM (for perspective, a Boeing 737MAX-7 of the sort Southwest has on order, can “produce” roughly half a million seat miles in a day). The problem for Southwest is that most of the costs of running an airline are not variable, at least in the short run, so all its labor contracts, lease agreements, and vendor contracts, etc., will stay in place but will be divided over fewer flights, fewer miles, and fewer opportunities to have a paying passenger fly those miles. What’s more, Southwest (along with other airlines) is experiencing some growth in some of those costs, chief among them its labor agreements.

We now forecast Southwest’s operating margin will come in under 10% this year, before returning to low teens as it fleshes out its expanded network and puts newer, more-efficient planes to work.

Over the next five years, we model Southwest’s consolidated revenue to grow at about a 4% average annual pace as continued capacity expansion is partially offset by moderating yield. We continue to peg a 14%-14.5% operating margin as a reasonable midcycle assumption.