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LUV Is in the Air, but Southwest Airlines Co. May Need More Thrust

In an industry where major US commercial airlines have experienced near-constant flirtation with bankruptcy, Southwest Airlines Co. ( LUV ) has defied the odds by achieving a four-decade streak of profits. As America's iconic low-cost carrier, Southwest continues to spread its wings to become a behemoth in the industry and to carry on its deep-rooted legacy of success.

The airliner operates with a "point-to-point" strategy instead of a conventional "hub-and-spoke" system, which allows for more direct nonstop routing, and thus enables the carrier to control delays and total trip time. The "point-to-point" structure helps the company offer cheap flights to passengers who just want to get from point A to point B with no bells and whistles.

While justly famous for its productivity, the low-cost carrier has seen its cost base edge up over the years as it has matured and gained in scale. In response Southwest has adapted its business model , and has started to fly from crowded markets, such as New York's LaGuardia.

Additionally, the 2011 AirTran acquisition , the biggest in Southwest's history, further accelerated the process of expansion, bringing the company a large position in the Atlanta domestic market and also short-haul international destinations in the Caribbean and Mexico.

The integration with AirTran supports management's plan to achieve $400 million of net synergies in 2013. Higher fares and synergy benefits from the AirTran integration have supported Southwest's revenue growth by 2.3% year over year to $4.1 billion in Q1 2013. The carrier's passenger traffic has also increased marginally due to support from the AirTran integration.

For Q1 2013, Southwest reported earnings and revenue that exceeded Wall Street expectations (EPS: $0.07 per share, Revenue: $4.08 billion vs. EPS: $0.02 per share, Revenue: 4.07 billion). Additionally, average passenger revenue per available seat mile rose 1.8% along with an increase in passenger traffic by 0.3%.

Keeping the strong numbers in mind from the last quarter, analysts are optimistic about Q2 2013 earnings ($0.39 a share, up from $0.36 during Q2 2012).

Q2 2013 covers the early part of the summer vacation season, so it's expected that Southwest will earn higher revenue. Southwest Airlines is also expected to benefit from lower jet fuel prices witnessed during the quarter: Jet fuel prices declined from $3.22 per gallon in February 2013 to $2.77 per gallon in June 2013, driven in part by the weak global economic growth outlook. As fuel costs constitute nearly 37% of the company's operating expenses, the decline in jet fuel prices will improve the carrier's operating profits. However, hedging losses will likely offset some gains from lower fuel prices.

Investors will be closely eyeing Southwest's expectations for travel demand, including whether there might be a chance to push fares higher. Since Southwest has an oversized influence on prices charged by rivals, a decision to increase fares would help increase revenues across the industry.

Market IQ proprietary Fundamental metrics give Southwest Airlines a Neutral rating. Market IQ characterizes Southwest Airlines as an average quality but low value stock (see below).

The company's qualitative strengths can be seen in multiple areas such as revenue growth, return on equity (ROE), and financial strength.

  • Over the trailing 12 months, revenues have increased by 3.84%. Growth in revenue appears to have helped boost the earnings per share. Additionally, revenue growth surpasses the industry average of 3.75%.

  • ROE increased to 5.47% in Q1 2013 vs. 3.8% in Q1 2012.

  • Southwest Airlines has an equity to debt ratio of 0.86, which is higher than the industry average of 0.42, indicating strong financial strength relative to its peers.

Based on Market IQ's valuation metrics, Southwest is trading at a premium relative to its peers (see below).

Going forward, favorable macroeconomic conditions and improving industry conditions will likely aid growth for the company. Southwest Airlines has also adopted a number of strategies to increase revenues and reduce costs in the upcoming quarters. These include fleet restructuring, network expansion, capacity management and various customer friendly programs such as Wi-Fi on board. These initiatives will attract customers and strengthen the company's position in the industry. A healthy financial profile will further support its endeavors.

However, a highly competitive environment and technological failures may adversely impact the performance of the company. Moreover, increased regulations and higher taxes may pose major impediments to growth in the near-term: In May 2013, the Obama administration announced a proposal for a $14 tax on all airline passengers in an effort to boost revenue for airport maintenance. This might unnerve some of Southwest's clients since the charge may be more prominent for those looking for cheap flying options.

Southwest is at a pivotal point in its life. From being what was once a mere domestic carrier, it has now reached beyond to transport its fliers internationally - spreading some love from its domestic hubs into the outskirts of the US and, perhaps soon, into the rest of the world.

This article was written by Selena Ing, an analyst atMarket IQ .

An integrated solution to help you understand your investment's strengths and weaknesses quickly and effectively, the Market IQ Terminal offers investment analysis and portfolio optimization based on proprietary fundamentals, market sentiment, analyst sentiment, and technical parameters.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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