Southwest Airlines Co.
/ (LUV-NYSE) / $12.71

Note: More details to come; changes are highlighted. Except where highlighted, no other section of this report has been updated.

Reason for Report: Flash Update: Southwest, Dish in Free TV Deal

Prev. Ed.: Jun 7, 2013; Flash Update: Southwest Traffic Grows in May

Flash News Update

OnJul 2, 2013, Southwest Airlines announced a deal with Dish Network Corp. Per the agreement, Dish will provide the flyers of the airline free live television service on their own Internet devices including phones, tablets or laptops. This pact calls for Dish Network to pay for the services on over 400 Wi-Fi-equipped jets at the end of the year.

Passengers of Southwest planes can avail various television programs on Fox News Channel, MSNBC, CNBC, Bravo, NFL Network, Food Network, HGTV and Travel Channel, in addition to 75 on-demand shows. Earlier, the airline offered a similar service for $5 per day.

However, this service does not include the passengers’ access of Internet, for which the airline charges $8 per flight. Southwest provides Internet connection to over half of its fleet using Row 44 – a subsidiary of Global Eagle Entertainment Inc.

To make this offer more interesting, Dish will extend 12,500 frequent flier points to Southwest members who sign up for the Dish Hopper Whole Home DVR and home programming scheme. Along with this, Dish will also offer an iPad or a discount of $250 on Hopper subscription.

This initiative is part of Dish’s marketing and promotional strategy of exchanging the service – TV Flies Free – with its advertisements throughout Southwest’s air travel. The promotion would include confirmation emails, airport billboards and 30-second commercials on television.

MORE DETAILS WILL COME IN THE IMMINENT EDITIONS OF ZACKS RD REPORTS ON LUV.

Portfolio Manager Executive Summary[Note: Only highlighted material has been changed]

Southwest Airlines Co. (LUV or the company) provides primarily short-haul, high-frequency, point-to-point, low-cost, and low-fare service.

Of the 12firms covering the stock, 7provided positive ratings and 4assigned neutral ratings. One firm provided a negative rating. The price targets range from $9.00 to $17.00, with the average being $13.72.

The following is a summarized opinion of the diverse brokerage viewpoints:

Bullish: Buy or equivalent outlook (7/12firms): These brokerage firms remain bullishon Southwest’s solid balance sheet, lower cost structure, lowest and simplest fares, strong relative competitive positioning, and better labor relations. The firms expect revenue to continue to improve on product offerings like pet fees, EarlyBird check-in and unaccompanied minors, as well as the All-New Rapid Rewards program. The company is taking several initiatives to optimize its fleet and expand its network to new and unexplored markets that would further drive revenue growth. These strategies would deliver handsome returns by reducing costs and increasing profits. Further, the firms believe that the company’s acquisition of AirTran is a strong strategic fit and has been providing the much-expected healthy growth prospects from both the network extension and diversification perspective owing to minimal route overlap.

Cautious: Neutral or equivalent outlook (4/12firms): Although Southwest boasts a strong outlook based on improving profitability and free cash flow generation, the firms expect fuel price volatility and unstable economic conditions to restrict the company’s profitability going forward. The firms also expect non-fuel cost including salaries, wages and benefits, maintenance and airport costs to rise simultaneously. In addition, the new pricing rules laid by the government are expected to hurt profitability further.

The firms believe the following additional factors should also be taken into consideration for investing in the stock:

A)LUV is one of the largest domestic airlines serving the U.S. thatfocuses on short haul, high frequency, point-to-point service rather thantraditional hub and spoke operations.

B)The company faces competition from other low-cost carriers as well as from major airlines that cut fares in order to attract customers.The company competes with Delta Air Lines, American Airlines, Alaska Airlines, United Continental Holdings, and U.S. Airways.

C)AirTran’s integration with Southwest remains on track. The merger will boost LUV's growth over the next few years with relatively low risk, and provide its first international destinations in the Caribbean and Mexico.Southwest will also expand its presence in key markets such as New York LaGuardia, Boston Logan, and Baltimore/Washington.

D)Southwest Airlines is working on a number of initiatives to increase revenue and reduce costs over the next three years.

E)The company is optimizing and rightsizing its fleet in order to curtail non-fuel expenses for the upcoming period.

F)During 1Q13, the company replaced the previous $800 million credit facilities with a $1.0 billion five-year unsecured revolving credit facility.Southwest generated an 8% pre-tax return on invested capital as of Mar 31, 2012 and expects a 15% return (before tax) on its invested capital in 2013.

G)Southwest is the first low-cost carrier that paysdividend to its shareholders. The company doubled its shareholders return in the form of dividends and share buybacks.The company paid approximately $15 million in dividends in the quarter. The company also bought back 9 million shares or $100 million under its total stock repurchase program of $1 billion.

General Outlook

Southwest Airlines is working on a number of initiatives to increase revenue and reduce costs over the next three years. Coupled with these productive initiatives, the firms expect Southwest to report strong revenue and earnings growth in 2013 given the new reservation system, All-New Rapid Rewards program and increased ancillary product offerings such as EarlyBird check-in, unaccompanied minor travel and pet fees. The company is also including improved features to their services as well as introducing new productsto enhance its value and profitability. Moreover, AirTran acquisition is providing substantial opportunities for future revenue growth.

May 15, 2013

Overview [Note: Only highlighted material has been changed]

The firms identified the following factors for evaluating the investment merits of LUV:

Key Positive Arguments

/

Key Negative Arguments

  • Lowest Cost Structure: Southwest has the lowest operating cost structure in the domestic airline industry and consistently offers the lowest and simplest fares.
  • Growing Revenue Strategy: The company is focused on boosting revenue through various initiatives such as new reservation system, All-New Rapid Rewards program, new in-flight WiFi, EarlyBird check-in, unaccompanied minor travel and pet fees.
  • Strong Financial Position: Southwest boasts of strong financial position versus its peers that allows it the flexibility to expand amidst a high fuel cost environment. The company expects 15% return (before tax) on its invested capital over the next 40 years.
  • AirTran Acquisition: The acquisition of AirTran represents a unique opportunity for Southwest Airlines to expand its presence in key markets including Atlanta, Mexico and Caribbean. The transaction is expected to generate annual synergies of $400 million by 2013.
  • New Fleet Modernization Plan: The company isrightsizing its fleet to enhance fuel efficiency, thereby reducing costs. Additionally, Southwest is introducing Evolve: the New Southwest Experience, to its aircraft. These would lead to increased profitability going forward.
/
  • High Labor Costs: LUV negotiated tentative agreements with its labor groups. So, it is better positioned than the peer group, but its costs are increasing as provided by the new agreements.
  • Fuel Prices: As jet fuel prices fluctuate, shares of airlines are likely to fluctuate.
  • The U.S. Economy: The company is mostly dependent on the U.S. economy as it has a code share with Volaris, a Mexican airline, but does not serve the Mexican market itself.
  • Technology Investment: LUV is investing heavily in its technology to bring its systems into the 21st century.
  • Single Supplier: Southwest Airlines is dependent on Boeing as its sole supplier for aircraft. If the company is unable to acquire additional aircraft from Boeing or if Boeing is unable to provide adequate support to Southwest, then the company’s profitability will be hampered.
  • Regulations: Effective January 26, 2012, the U.S. Department of Transportation (DOT) has recently laid new pricing rules for the air carriers. The companies have to include all taxes and fees while advertising fares for their flights.As more and more passengers are switching to low fares, the new rules might hurt the travel demand, thereby leading to lower profits for the company.

Based in Dallas, Texas, Southwest Airlines Co. is a passenger airline that provides scheduled air transportation in the United States. It primarily provides short-haul, high frequency, point-to-point and low-fare services. Southwest is a leisure-oriented point-to-point carrier largely in Las Vegas, Chicago (Midway) and Phoenix. The company’s point-to-point route structure includes service to and from many secondary or downtown airports such as Dallas Love Field, Houston Hobby, Chicago Midway, Baltimore-Washington International, Burbank, Manchester, Oakland, SanJose, Providence, Ft.Lauderdale/Hollywood, and Long Island Islip airports.

Southwest Airlines is one of the world’s most profitable low cost airlines that consistently offers the lowest and simplest fares. The company sells frequent flyer credits and related services to companies participating in its Rapid Rewards frequent flyer program, including credit card companies, hotels, telecommunication companies and car rental agencies.

In May 2011, Southwest completed the acquisition of AirTran Holdings and now operates AirTran Airways as a wholly owned subsidiary. As of Dec 31, 2012, Southwest along with AirTran operated 694 Boeing aircraft, serving 97 cities in 41 states.

Further information on the company is available at its website:

NOTE: The company’s fiscal references coincide with the calendar year.

May 15, 2013

Long-Term Growth[Note: Only highlighted material has been changed]

The firms believe that Southwest is favorably positioned for long-term growth based on a number of initiatives that are directed toward revenue and earnings growth. The company is also adding novel features to its services as well as introducing products, which are enhancing its value and profitability. Southwest targets to introduce an international reservation system by 2014 and is working on a new revenue management program that will likely come online by 2013 end.

Though Southwest and AirTran are currently operating as separate entities, the single operating certificate obtained in Mar 2012, allows the company to combine their operations. The Southwest-AirTran integration is progressing well. Southwest converted 11 AirTran 737-700s aircraft into the Southwest livery by the end of 2012. Further, the company completed the integration of Finance and Human Resources systems (SAP) and brought in 26% of the AirTran workforce under its wings. The AirTran integration procedure is on track to be completed by the end of 2014.

Further, Southwest continues to optimize its combined networks with the introduction of new national and international services across various locations. The companytargets to introduce its services to new and unexplored domestic markets including Branson, Missouri; Charlotte, North Carolina; Flint, Michigan; Rochester, New York; Portland, Maine; Wichita, Kansas; and Grand Rapids, Michigan. Further, Southwest is looking to tap the opportunity in the international market with its debut in the Caribbean, Central America, Latin America and Mexican markets by 2015. In this regard, the company already won approval to add international travel out of the Houston Hobby airport. Additionally, Southwest will likely offer domestic services in and out of Dallas Love Field as flight restrictions (Wright Amendment) will be removed in 2014.

Moreover, the company is taking several efforts to enhance the quality of its fleet so as to generate increased profitability. The company upgraded 89 of its 737-700 fleet with the new Boeing Sky Interior, and renovated in-flight cabins and redesigned interiors (known as Evolve) for enhanced customer satisfaction and experience. The company is also offering Row 44 WiFi technology-based facilities including Live Television, satellite-based WiFi and on-demand movies to passengers on all Southwest Next Generation fleet (737-800s and 737-700s). This fleet replacement is expected to generate additional revenues over the next few quarters.

According to the firms, the ongoing fleet restructuringand several revenue-producing and cost-cutting measures will help Southwest to achieve high returns (before tax) on its invested capital over the next couple of years.

May 15, 2013

Target Price/Valuation[Note: Only highlighted material has been changed]

Provided below is a summary of target price/valuation:

Rating Distribution
Positive / 58.4%↓
Neutral / 33.3%↑
Negative / 8.3%↑
Avg. Target Price / $13.72↑
Max. Target Price / $17.00↑
Min. Target Price / $9.00↓
No. of Analysts with Target Price/Total / 9/12

Risks to target price include fuel price volatility, managing cost creep, maintaining good labor relations, economic weakness, government regulation, labor issues, taxation, airport constraints, and safety concerns.

Recent Events[Note: Only highlighted material has been changed]

On May 15, 2013, Southwest Airlines announced a 400% hike in quarterly dividend to $0.04 per share from $0.01 per share. On an annualized basis, the total amount of dividend payout is expected to reach over $100 million. The dividend will be paid on Jun 26, to stockholders of record on Jun 5. Additionally, the company also raised its stock repurchase plan to $1.5 billion from the existing program of $1 billion.

On May 7, 2013, Southwest Airlines announced traffic and capacity results for Apr 2013. The company’s traffic was 8.74 billion for the reported month, up 1.5% from 8.61 billion recorded a year ago. On a year-over-year basis, consolidated capacity moved up 4.1% to 11.23 billion. The load factor declined to 77.8% from 79.8% in Apr 2012.

On Apr 25, 2013, Southwest Airlines reported 1Q13 results. The company’s adjusted EPS(earnings per share) of $0.07 beat the Zacks Consensus Estimate of $0.03. The results improved considerably from 1Q12 of $0.02 per share.

Quarterly revenues moved up 2.3% year over year to $4.1 billion and were in-line with the Zacks Consensus Estimate.

Revenue[Note: Only highlighted material has been changed]

Revenues improved2.3% year over year to $4,084 million in 1Q13.

Airlines traffic, measured in billions of revenue passenger miles, increased just 0.3% year over year to 23.8 billion in 1Q13. Capacity or available seat miles increased 0.6% to 30.8 billion, while load factor (percentage of seats filled with passengers) dipped 20 basis points year over year to 77.1%.

On an annualized basis, Passenger, Freight and Other revenues increased 2.3%, 5.4% and 2.0%, respectively. Passenger revenue per available seat mile (PRASM) inched up 1.8% year over year.

Outlook

The bullish firms expect the company’s traffic to improve in the coming months based on gradual rebound in economic activities leading to more customers and higher business spending. Based on the current traffic trends, Southwest expects unit revenue to grow again in 2Q13. With regard to its AirTran merger, the company remains on track to generate net synergies of more than $400 million by 2013 on full integration.

With fuel prices hedged for 2013 and an increase in aircraft and employee productivity, Southwest is expected to register higher revenues in the quarters ahead. The company has introduced a number of initiatives to boost its profitability level in 2013 and revenue available per seat mile (RASM) to improve 4% to 5% year over year. The company plans to implement a Revenue Management system based on New Origin and Destination in 2Q13that is expected to lift the annual revenue run rate by $150 million to $175 million.

The bullish firms highlighted that several revenue growth measures will generate approximately $100 million of additional revenues in 2013. Faster integration of AirTran's international destinations along with various other strategic initiatives are expected to result in better network optimization, leading to higher revenues in 2H13.

Margins[Note: Only highlighted material has been changed]

For 1Q13, non-GAAP operating income was $112 million, up from $10 million in 1Q12.

Total operating expenses, excluding special items, decreased 0.2% year over year to $3.9 billion. Fuel price (economic) accounted for $3.29 per gallon, down from $3.44 in 1Q12.

Consolidated unit cost or cost per available seat mile (CASM), excluding fuel and special items, increased 3.4% to $0.0826.

Outlook

Based on current traffic trends, Southwest expects unit revenues to grow again in the coming months. Fuel price (economic) in 2Q13 is estimated at $3.00 to $3.05 per gallon.

The firms with a neutral view apprehend that the integration of AirTran aircraft with new engines and maintenance conversion program will likely raise the near-term expenses. Fuel hedge penalties along with fleet modernization costs are also expected to pull down margin levels.

Earnings per Share[Note: Only highlighted material has been changed]

Southwest Airlinesreported adjusted EPS of $0.07 that improved considerably from the 1Q12 loss of $0.02 per share. The quarter’s results wereinfluenced by fleet restructuring, introduction of various customer friendly programs and the effects of the AirTran integration.

Outlook

The bullish firms expect aggressive management of operations, technological upgrades and better pricing to drive earnings in the coming months. The fast optimization of the AirTran network, greater frequency of flights during the busy seasons, dropping flights in slack period and introduction of a new fee structure will likely lift the profitability level of the company.