This Is Why Southwest Airlines Is No Longer an Investor Favorite

For decades, Southwest Airlines has been an investor darling.

That’s what happens when an airline reports 43 consecutive years of profitability, all while avoiding bankruptcy and keeping costs lower than the competition.

But that’s beginning to change. Yes, absolute profits remain high — Southwest made $388 million in the third quarter — but some investors are questioning whether the airline can continue exceeding competitors’ returns in the new airline world. The bigger legacy carriers, United, Delta, and American, are in stronger financial shape now, and ultra low cost carriers like Frontier and Spirit are increasingly nimble competitors in major markets.

Adding to investor fears, Southwest on Wednesday reported revenue per available seat mile — an industry metric measuring how money an airline earns for each seat it flies one mile — decreased 4.1 percent, year-over-year. That’s mainly a function of lower ticket-related revenues, and it’s an issue all U.S. airlines face. The problem: As airlines have made money and fuel costs have dropped, carriers have added flights, and Southwest executives say industry demand has not kept pace with the added seat supply. In the third quarter, Southwest’s average fare fell more than $7, year-over-year, to $146.96.

After Southwest reported earnings on Wednesday, its stock fell more than eight percent.

“There are more seats for the same number of passengers, and prices are going to soften,” CEO Gary Kelly told analysts on the airline’s third quarter earnings call. “A couple of things need to happen: Either demand needs to improve or supply needs to come in better alignment.”

Southwest is a strong business and in fine fiscal shape. There are no looming fears of bankruptcy, and it’s highly unlikely the airline will report an unprofitable quarter any time soon. But on the earnings call, executives acknowledged they must improve revenues, especially since the airline expects to have higher costs next year, due in part to new labor deals it could have with pilots and flight attendants. In the short term, Kelly said, Southwest’s earnings may continue to fall “in line” with other airlines, rather than ahead of them.

“Until we find another way for us to differentiate our revenue production, we are going to fall in with industry performance,” Kelly said.

Cutting capacity

Kelly promised Southwest will make “adjustments” to its model. Most importantly, he said, the airline will substantially curb its growth in 2017, adding less than 4 percent capacity, and possibly cutting some underperforming routes. In the first nine months of this year, Southwest grew by about six percent.

“We need to be more conservative with our growth,” Kelly said.

In a note published after Southwest reported earnings, Daniel McKenzie of Buckingham Research Group called Southwest’s capacity plan “encouraging,” saying the airline’s strategy could produce “revenue traction” at some point next year.

“Shares could get interesting again once consensus resets and if the stock corrects in the 10 to 15 percent range,” McKenzie said.

In recent months, Kelly said, airlines have added seats in Southwest’s markets, depressing fares. Southwest has calculated that ultra low cost carriers — mainly Frontier and Spirit —grew by 20 percent in Southwest’s markets in the third quarter, while other airlines added five to 10 percent more seats. Kelly called this development “very predictable,” noting that most other airlines have plenty of cash, and are paying far less for fuel than a couple of years ago.

Kelly promised Southwest would vigorously protect its core markets.

“We need to compete, and we need to compete by striving to have the best service at the lowest price,” Kelly said. “We will fight hard to maintain every single customer that we have fought hard to to win.”

No bag fees

One easy opportunity to increase revenues would be to charge for a first checked bag, as every other U.S. airline does. But Kelly reiterated Southwest does not plan to charge for bags. Southwest is also not planning to charge fees to passengers changing tickets, as others airlines do.

“We have a unique and beloved position in the industry with this approach, and we would be foolish to squander it,” Kelly said.

But J.P. Morgan analyst Jamie Baker suggested in a note Wednesday that Southwest is making a mistake by not levying bag fees.

“If shareholder demands that management revisit its aversion to self-help mechanisms like bag fees has already crescendoed to all-time highs, we suggest it’s time investors turn the volume knob up to eleven,’ he said.