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Southwest Airlines has a more upbeat view on the domestic market than its US rivals

Southwest Airlines is beginning to see some positive trends in the US domestic market place even as its competitors are indicating that domestic yields should remain soft during the summer high season for travel in the US.

Southwest has arguably been a contributor to the soft domestic yields through its massive expansion from Dallas Love Field that started in late 2014. Since that time the airline’s competitors have cited the challenges created by the capacity additions and diluted pricing in the market.

But Southwest is maintaining a relatively positive outlook, driven by gains from a new credit card agreement that is helping to buoy its unit revenue performance. Aside from that boost, the airline believes yield trends overall have stabilised, and expects some slight improvement in 3Q2015.

Southwest's 2Q2015 passenger unit revenues fall at a similar rate to Delta

Southwest posted a 4.6% decline in passenger unit revenue year-on-year for 2Q2015, which was a similar drop to Delta and a better performance than American and United.

American, Delta, Southwest and United 2Q2015 passenger unit revenue performance

Airline PRASM increase/decrease
American 6.9%
Delta 4.6%
Southwest 4.6%
United 5.6%

The airline’s yields dropped 5.4% as its average fare decreased 3.4% to USD157.51. For 1H2015 Southwest’s average fare fell 1.5% to USD157.74.

Southwest has much less exposure to international markets than American, Delta or United. The passenger unit revenue performance of those three airlines has been dragged down by negative effects of the appreciation of the USD against most major global currencies and lower fuel surcharges as energy prices remain below historical highs.

For the week of 20-Jul-2015 to 26-Jul-2015, only 4% of Southwest’s ASMs and 2% of its seats are deployed to international markets.

US major airline % of ASMs and seats deployed to international markets: 20-Jul-2015 to 26-Jul-2015

Airline International ASMs International seats
American 45% 24%
Delta 41% 17%
Southwest 4.1% 2%
United 49% 24%
US Airways 27%

11%

However, all three of Southwest’s large network airline rivals have cited soft domestic yields, naming Dallas as one of the major markets driving the weakness. With the lifting of the Wright Amendment in late 2014 that limited certain long haul flights from Love, Southwest undertook a massive expansion from the airport that resulted in prices falling in the market.

Other domestic regions that Southwest’s rivals have cited as weak are Chicago and Orlando. American and United have hubs at Chicago O’Hare and Southwest is Chicago Midway’s largest operator.

See related report: Delta Air Lines is not immune from soft domestic pricing. Will domestic capacity shrink? Can it?

Southwest seems more upbeat on the domestic market that its US peers

Breaking out the drivers of its 2Q2015 unit revenue decline, Southwest estimated 1ppt of the decline was driven by a year-ago USD47 million favourable accounting change, and 2.6ppt of the drop was driven by an increased in average stage length, which increased 4.6% year-on-year to 756 miles.

“So if you take all that into account, it really leaves a year-over-year decline of only about a little over 1%, due to the softer demand or softer economy,” Southwest CEO Gary Kelly recently concluded.

He also highlighted Southwest’s favourable performance in Dallas despite the added capacity and pricing dilution, noting the market’s load factors, profit margins and return on invested capital all exceeded the system average.

Southwest’s overall commentary regarding the domestic market seems more upbeat than its larger network rivals. CFO Tammy Romo concluded that while US economic indicators have been mixed, the economy overall seems solid and “our revenue trends appear to be stabilising and improving”. She remarked that Jul-2015 is trending better than average, even without the benefit of the revamped Chase credit card agreement, and that overall 3Q2015 is looking sequentially more favourable than 2Q2015.

A new credit card agreement will buoy Southwest's unit revenues in 2H2015

Southwest is forecasting a unit revenue decline of only 1% in 3Q2015 driven in part by favourable effects from a new branded credit card agreement it has reached with Chase. Ms Romo stated that the new agreement would distort year-on-year PRASM comparisons for roughly a year, and as a result the airline would focus on reporting revenue per available (RASM) performance.

Essentially, the new agreement produces a USD400 million benefit to Southwest for 2H2015, of which USD150 million will be recorded as a special revenue item. The remaining USD250 million will be reported in Southwest’s RASM, and should produce roughly two to three points of unit revenue benefit in 3Q2015 and 4Q2015.

The timing of the Chase agreement was certainly positive for Southwest given the tenuous domestic pricing environment, and it certainly could ease some investor anxiety over domestic unit revenue trends.

But the airline stresses that “it was our feeling before the deal that things were beginning to improve just a little bit,” said Mr Kelly. However, he acknowledged that improvement was modest, “and the majority of improvements that we are reporting to you sequentially is the Chase deal”.

American Airlines concludes pressure in Dallas will remain the status quo

It seems as if Southwest through the Chase agreement has orchestrated some positive noise in its unit revenue results going forward, which on a quick glance will show a markedly better performance than its competitors. United for 3Q2015 is forecasting a 5% to 7% drop in passenger unit revenues and Delta is projecting a 4.5% to 6.5% drop. American, which has borne the brunt of Southwest’s pricing actions in Dallas, is forecasting a 6% to 8% decline in passenger unit revenues during 3Q2015. The airline estimated that its passenger unit revenues in Dallas were down 5% year-on-year in 2Q2015, and concluded that competitive capacity growth will remain in the market during 3Q2015.

American Airlines president Scott Kirby observed that the environment in the US domestic market remains largely unchanged, and in Dallas in particular Southwest is preparing to introduce eight more new routes from Love Field in Aug-2015.

The new markets are Boston, Detroit, Omaha, Philadelphia, Pittsburgh, Charlotte, Raleigh-Durham and Salt Lake City.

American operates in all of those markets from DFW, and has a monopoly on three routes – Pittsburgh, Omaha and Raleigh-Durham. It essentially also has a monopoly on Charlotte since it serves the route alongside merger partner US Airways. Spirit and Delta serve Detroit, and Spirit and US Airways operate to Philadelphia. American and Delta service Salt Lake City and JetBlue and Spirit offer service to Boston.

American does not expect positive unit revenues until 2016; Southwest plans lower 2016 ASMs

Queried about a return to positive unit revenue growth, Mr Kirby ticked off the list of factors driving down American’s performance in that metric – capacity outstripping demand, currency headwinds and weak economies in certain regions. He concluded that capacity trends for 3Q2015, 4Q2015 and 1H2016 look similar to 2Q2015, and that unit revenues may not trend positive until 2H2016.

Overall, Southwest has a slightly more positive view, no doubt aided by the Chase agreement that will inflate its unit revenue growth in 2H2015. Southwest plans slightly lower capacity growth in 2016 of 5% to 6% after growing 7% in 2015. The airline stresses that most of the planned 2016 increase is driven by the expansion it is undertaking in 2015.

Unit revenue weakness lingers. Should investors be concerned?

Southwest’s expansion from Love Field has no doubt demonstrated that competition is vibrant in certain regions of the US domestic market, and passengers are benefitting from the lower fares in Dallas.

Similar to American, Delta and United, Southwest is also producing top-line financial results, which include a return on invested capital of 28% for the 12M ending 30-Jun-2015. Southwest through the Chase agreement has initiated a move to boost its unit revenues at a time when investors are attempting to discern if they should be overly concerned about unit revenue deterioration alongside record financial results that are largely due to lower oil prices.

Based on assessments by the major US airlines, unit revenues will not recover in 2H2015, and it could be at least a year before the general industry metric among most of the largest US domestic airlines returns to positive territory.

That’s one point of certainty that is becoming more clear to investors attempting to discern the health of the US airline industry.

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