Southwest Airlines Co. is resisting calls by some investors to pull back on planned expansion this year and raise fares, moves that could help stem declines in a key industry revenue gauge.
The conflict, which has contributed to an 18 percent drop in shares over the past three months, came to a head July 21, when Southwest said unit revenue would fall as much as 4 percent this quarter from a year earlier. That was double what some analysts were expecting and what the airline itself had forecast just a month earlier. The news sent the stock tumbling 11 percent that day, the most since 2009.
For more than a year, airline investors have fretted over sagging revenue from each seat flown per mile — a key measure of fares and demand. Ticket prices slid after carriers, enjoying low fuel prices and record profits, expanded faster than demand. That led to discounting, even on more expensive tickets purchased just before travel. The need to lower those last-minute fares for July and August caught Southwest by surprise. Its forecast looked particularly glum following the second quarter’s 0.6 percent increase in unit revenue.
“I’d like to see them boost their fares but also cut capacity,” said Chris Terry, a portfolio manager at Southwest shareholder Hodges Capital Management Inc. “That’s what the market wants. That’s what the market is telling everyone. Supply growth is exceeding demand growth, and I don’t think that’s healthy.”
Southwest won’t cut its growth plans for the rest of this year to help shore up unit revenue, Kelly told investors and analysts on a conference call last week. He also didn’t detail how much the Dallas-based carrier would expand in 2017, beyond noting that it would be less than the growth this year of 5 percent to 6 percent. The U.S. economy, a proxy for travel demand, is forecast to expand by about 2.2 percent next year.
“We were disappointed and we were very sure that some of our investors would share that disappointment,” Kelly said this week in an interview. “While the trends weren’t what we had hoped they would be for the third quarter, they’re still quite good comparatively. As to what we should do about it, we may just have a disagreement there.”
Rivals American Airlines Group Inc., Delta Air Lines Inc. and United Continental Holdings Inc. said this month they would trim capacity in the second half of the year to help better match demand, a step that generally enables carriers to increase prices. Kelly declined in the interview to comment on whether Southwest would raise fares. Those four U.S. carriers are part of a U.S. Justice Department investigation into price collusion.
Southwest has published its operating schedule through early March, and won’t drop flights that customers may have already booked, Kelly said. The carrier already reviewed that option and found that fixed costs associated with each flight meant trimming would increase unit costs and hurt profits, he said.
“There was no compelling reason to do that,” Kelly said. “What is far more important and a much better use of our time is to look at what we do with the next schedule for the balance of 2017. That’s where our focus is.”
Some analysts and investors like Terry disagree with an emphasis on profits over acting near-term to reverse unit-revenue trends. Southwest won’t have technological tools to boost revenue from scheduling flights differently and sources other than fares until next year, when a new reservation system is in place.
“Margins are really high, but are they really sustainable when you have fare degradation going on?” Terry said. “If you want a higher multiple, to have earnings valued more, you need to generate those with higher revenue. We’re just not there yet.”
Southwest’s 18 percent decline since April 27 is almost double the drop in the Bloomberg U.S. Airlines Index. Barry James, chief executive officer of James Investment Research, has been reducing its weighting of airline stocks as a share of equity holdings, although he favored Southwest until the recently.
“Southwest has done very, very well for our clients for a long period of time, up until this year,” James said. “This kind of surprising news definitely will put a damper on the stock. It’s not one we’re necessarily looking to add at this juncture.”
JPMorgan Chase & Co. cut its rating on Southwest to neutral from buy Wednesday, saying the carrier is “playing little if any role in trying to solve the industry’s domestic revenue challenge.” Analyst Jamie Baker also cited pending cost increases, estimating a 55 cent effect on earnings per share and 5 percentage-point boost in costs for each seat flown a mile next year from expected new employee contracts.
Argus Research Corp. also dropped the stock to hold from buy, and Credit Suisse pulled Southwest from its U.S. and global focus lists.
Not everyone is bearish on Southwest. Evercore ISI recommended July 26 that investors buy the shares, in part because of the company’s domestic focus, strong balance sheet and longer-term ability to improve revenue. The new reservation system will produce $200 million in earnings before interest and taxes at the start, growing to at least $500 million a year by 2020, Southwest has said.
“We should get more credit for how well the company is performing and has performed,” Kelly said. “Results matter, and the strongest answer is that results have been outstanding. We have a quarter coming up that is not meeting our goal. I don’t think that means you should throw the baby out with the bath water. ”
–With assistance from Dagney Pruner To contact the reporter on this story: Mary Schlangenstein in Dallas at firstname.lastname@example.org. To contact the editors responsible for this story: Brendan Case at email@example.com, Mark Schoifet, Bruce Rule
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