Southwest Airlines: ‘Healthy’ Demand Alone Can’t Boost Profits

Southwest Airlines executives want investors to be clear about big thing: U.S. travel demand is “healthy.” Southwest leaders repeated the word several times during the third-quarter earnings call Thursday.

Healthy is OK in a normal market. It means airlines can fill their seats.

But in a market with rapidly growing supply — with many more airplane seats — steady demand is not enough to boost profits. Add in rising labor costs and the pressure gets worse.

That was clear in Southwest’s results. It was profitable, but barely. Its operating profit margin excluding items was just 3.4%. Capacity grew 12.5% from a year ago, but passenger traffic grew only about half as much. That contributed a 6.4% drop in passenger unit revenue.

“Travel patterns are changing,” said CEO Robert Jordan. “While it’s still strong, they’re changing for leisure, [and] they’re also changing for business — we’re seeing gains, but that last 10 to 15 points of business recovery is a little bit stubborn here.”

One change Jordan highlighted is that return-to-school dates for many Americans are moving earlier in August. That contributed to weak off-peak demand in August and September.

The business travel recovery, as Jordan noted, remains stalled at roughly 80-85% of 2019 volumes. And blended leisure and work trips have increased since the pandemic, which has shifted when and where people are flying.

This has U.S. domestic-focused airlines rethinking where and when they fly. Frontier Airlines, JetBlue Airways, and Spirit Airlines have all indicated that they are looking at making network changes.

For Southwest, that includes cutting growth to allow the many new markets it added during the pandemic to mature — Chief Operating Officer Andrew Watterson named Hawaii as one such market.

Orlando’s Gain is Fort Lauderdale’s Loss

Southwest unveiled its largest network change to date Thursday: Moving its southeastern international gateway to Orlando from Fort Lauderdale. The airline will add six new nonstops from the central Florida airport in June: Cancun, Grand Cayman, Nassau, Providenciales, Punta Cana, and San Jose (Costa Rica). It already serves Aruba and Montego Bay from Orlando.

“The international destinations … actually are modest-sized markets, that require a decent amount of connectivity to fill them up,” Watterson said. “Orlando being a little bit further north and having more flights for Southwest Airlines north of Orlando allows us to have the good complement of the local plus the flow.”

Southwest serves 22 U.S. cities from Fort Lauderdale, including Orlando and Tampa, in October, according to Cirium Diio schedules. It serves 47 cities from Orlando, excluding Fort Lauderdale and Fort Myers to the south.

Asked whether this marked a new focus on connecting traffic for Southwest, Watterson said: “Connectivity has always been the icing, not the cake, but we were very intentional about how we use it.”

The airline has long focused on travelers flying direct between cities, rather than connecting over a few hubs like at American Airlines, Delta Air Lines, and United Airlines. Roughly 25-30% of all Southwest passengers connect at airports across its network, Watterson said.

Southwest also has a crew base in Orlando, and not in Fort Lauderdale, that should help it lower costs on international routes.

The carrier will end flights between Fort Lauderdale and six international cities — Cancun, Grand Cayman, Havana, Nassau, Providenciales, and Punta Cana — at the beginning of June, a spokesperson said. Southwest will only serve Montego Bay on Saturdays from the South Florida airport. The airline will continue to serve Havana daily from Tampa.

Southwest’s Profit Margin Question

All of the talk of Southwest’s network changes was really about one thing: Profitability. The airline’s historic profitability eroded during the pandemic as costs rose. This year, supply of airline capacity outpaced the growth in demand.

Jordan reiterated to Wall Street analysts that the network changes next year would drive roughly $500 million in incremental pre-tax profit. This, coupled with other cost initiatives and slower growth aimed at boosting revenues, were all part of a “relentless” focus on boosting profit margins.

It “is absolutely the plan to improve margins in 2024, and we’re committed to getting back to our long term outperformance and operating margin,” Jordan said.

Southwest posted an 11.5% operating margin excluding special items in the June quarter, and negative 5% in the March quarter thanks to the overhang from its December 2022 holiday meltdown.

Evercore analyst Duane Pfennigwerth, however, pushed Jordan, asking if Southwest was unable to raise margins, if it would consider adding more ancillary fees that are standard at other airlines. For example, checked bag fees and or assigned seating — free items that Pfennigwerth described as “sacrosanct” for the airline.

“We are going to follow the lead of our customers,” Jordan said. “And if our customers ultimately tell us that, that is what they want, and that is what we will do. We’re not ready to — obviously not ready to say that today.”

Southwest did not provide margin guidance for the fourth quarter, or for 2024.

More Boeing Planes

Have airlines ordered too many new planes? Not according to Southwest. The airline unveiled a commitment for 216 more Boeing 737 Maxes on Thursday. It now has firm orders for 302 737-7s and 271 -8s — a 111 plane increase — with deliveries through 2031, plus 207 options, Southwest’s latest fleet plan shows.

“This orderbook supports our quarterly growth plan,” Southwest Chief Financial Officer Tammy Romo said. “And our fleet modernization initiative provides significant flexibility for us, and also gives us a great path to retire our [737]-700 fleet over the coming years.”

Romo and other executives spoke of having the ability to adjust the timing of new 737s — for example, 80 are now due next year even as the airline slows growth — to meet future travel demand.

Southwest plans to grow capacity 6-8% year-over-year in 2024. That compares to a 14-15% increase this year.

The airline is far from alone in bulwarking its orderbook into the 2030s. Air France-KLM, EasyJet, Ryanair, and United Airlines have placed orders recently with an eye on guaranteeing deliveries in the latter half of the decade amid lack of availability at planemakers Airbus and Boeing. EasyJet, in its rationale to investors for ordering another 147 Airbus A321neos, said: “Delivery slots for narrowbody aircraft … are very limited until at least 2029. EasyJet anticipates that this limitation will extend into 2030 and beyond.”

And the Numbers

One metric closely watched by analysts are Southwest’s unit costs excluding fuel and special items, which measures how much it costs the airline to transport a passenger one mile. This rose 3.7% year-over-year in the third quarter even as passenger unit revenues fell.

Unit costs excluding fuel and special items are forecast to fall 15-16% in the fourth quarter but a large part of that is the comparison to last year when Southwest’s December meltdown added significant costs. For all of 2023, Southwest expects the metric will fall 1-2%.

Speaking of the fourth quarter, Southwest anticipates a “nominal increase” in revenues compared to last year during the period, Chief Commercial Officer Ryan Green said. Passenger unit revenues will continue to be weighed down by the carrier’s — and others — accelerated capacity growth. Southwest plans a roughly 21% year-over-year capacity increase.

December quarter bookings, Green said, are “strong” for October and the Thanksgiving and year-end holidays.