Southwest Airlines' Recovery Begins in Earnest

Southwest Airlines (NYSE: LUV) disappointed shareholders in 2021. While the low-fare airline giant rapidly expanded its route network to new cities to capture incremental demand that it could not serve previously, it didn't see the financial benefits that bullish investors had expected.

For the full year, Southwest lost about $1.3 billion, excluding grants received from the federal airline payroll support programs. And whereas Southwest Airlines stock rallied to a multiyear high of nearly $65 last April, the shares have since shed about a third of their value, ending last week at $42.93.

LUV Chart

Southwest Airlines stock performance, data by YCharts.

Fortunately, Southwest Airlines finally returned to profitability last quarter. Furthermore, the company's results should improve significantly over the next few years as air travel patterns normalize.

A solid end to the year

In October, Southwest projected that its fourth-quarter revenue would fall 15% to 25% compared to 2019. Combined with rising fuel prices and nonfuel unit cost inflation, this implied that it would post yet another quarterly loss.

However, at the carrier's investor day in early December, management revealed that demand had recovered rapidly in the preceding weeks, with particular strength around the Thanksgiving holiday. Additionally, Southwest Airlines signed a new co-branded credit card agreement with Chase in early December, featuring improved economic terms. That put the company on track to record a profit in the fourth quarter.

Ultimately, Southwest booked $5.05 billion of revenue for the fourth quarter: down 11.8% from 2019 on an 8.3% capacity reduction. This allowed the company to withstand higher fuel prices and a 10.6% increase in adjusted nonfuel unit costs compared to two years earlier and earn a profit of $0.14 per share. That beat the analyst consensus of $0.07.

Expecting a quick rebound from the omicron variant

At the time of Southwest Airlines' investor day, management anticipated that the company would earn a profit in every quarter of 2022. Unfortunately, the severe impact of the omicron variant on demand and staffing has thrown a wrench into those plans.

Southwest estimates that it will miss out on $330 million of revenue in January and February combined because of this short-term drop in demand. As a result, first quarter revenue is set to decline 10% to 15% compared to Q1 2019 on approximately 9% less capacity.

Southwest Airlines planes in an airport gate area.

Image source: Southwest Airlines.

Meanwhile, the impact of capacity cuts and an incentive program to keep planes flying despite a surge in sick calls will drive a 20% to 24% increase in nonfuel unit costs over the same period. Fuel costs have moved higher, too. This will cause Southwest to book a loss for the first quarter.

However, with COVID-19 case counts starting to decline again in the U.S., demand is already recovering. By the month of March, Southwest expects to be back in the black, and profitability should continue to strengthen over the course of 2022 as demand improves and cost pressures ease.

Finally worth a look again

For most of 2021, investor euphoria about the potential post-pandemic recovery had Southwest Airlines stock trading at levels that didn't leave much room for error. Not surprisingly, that led to poor share price performance as the airline experienced various setbacks in the second half of the year.

By contrast, Southwest Airlines stock now trades at an attractive valuation of 10 times its 2019 adjusted earnings per share (EPS) of $4.27. Southwest has numerous initiatives to boost EPS beyond that level, including fleet upgrades and efforts to boost fares by appealing to more business travelers. Additionally, the company has a substantial amount of excess cash that it will likely return to shareholders once restrictions on dividends and buybacks expire later this year.

To be fair, I remain concerned about Southwest's rising costs. Management projects that adjusted nonfuel unit costs will rise 12% to 16% this year compared to 2019 before easing somewhat in 2023. Other airlines did a better job of finding permanent cost savings over the past two years. Higher costs could offset much of the benefit from Southwest's revenue initiatives.

Yet the risk of rising costs pressuring profitability appears to be baked into Southwest Airlines' stock price today. That makes this stock worth a look for investors who want to bet on an airline industry recovery.

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Adam Levine-Weinberg has no position in any of the stocks mentioned. The Motley Fool recommends Southwest Airlines. The Motley Fool has a disclosure policy.

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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