MIAMI — Southwest Airlines churned out yet another record quarter of profitability, reporting a $190 million net profit for the fourth quarter of 2015 on January 22. The Dallas-based carrier’s fourth quarter net income was $404 million net of special items, and for full year 2014, it reported a record $1.4 billion net profit ($1.1 billion including special items).

Unlike its major airline peers Delta and United, Southwest did not record substantial losses due to fuel hedges during the quarter. It does, however, have a net liability of $234 million for its outstanding fuel hedges moving forward.

Southwest Airlines at Phoenix Sky Harbor International Airport.
Southwest Airlines at Phoenix Sky Harbor International Airport.

Unlike several of its peers, Southwest’s earnings were powered by surging revenues, which grew 5.1 percent year-over-year (YOY). Capacity growth as measured by available seat miles (ASMs) finally slowed down after years of outpacing GDP, rising 0.5 percent YOY for the full year and 2.4 percent in Q4. Operating margin for the full year came in at 11.9 percent, driving a record full year return on invested capital (ROIC) of 21.2 percent for the first time in 14 years.

All in all, it was a relatively eventless quarter for Southwest, at least outwardly, though there were several notable non-financial items (most notably growth at Dallas Love Field and Washington Reagan National Airport). But those growth gains were offset by capacity “smoothing” across the remainder of the network, allowing PRASM to rise a healthy 5.1 percent YOY for the full year and 2.6 percent in Q4 (mostly in line with peers given Southwest’s domestic heavy passenger mix). That being said, there were some interesting items in the earnings call, which I will summarize below.

  • Rapid Rewards generated $400 million, fleet modernization $500 million, and AirTran synergies $500 million in 2015.
  • Dallas Love ASMs are up 80 percent YOY while Reagan ASMs are up 180 percent. The majority of Dallas markets are above 90 percent load factor.
  • No change to Southwest’s growth plans for 2016 and 2017 due to lower oil prices.
  • PRASM expected to be flat in Q1 2015, despite 3.5 percent increase in stage length and 2.4 percent increase in seats/trip.
  • Early Bird revenues were $56 million in Q4.
  • Q4 hedging loss was $0.03 per gallon or $15 million.
  • 2015 fuel is effectively unhedged, and Southwest projects $1.7 billion in YOY fuel cost savings.
  • Much of the growth in Dallas, International, and Washington Reagan has been redeployed from AirTran.
  • Southwest expects demand weakness in Texas due to energy sector weakness.
  • Southwest believes ROIC is the best measure of profitability for airlines.
  • Cuba is on Southwest’s radar but not a priority.

So overall it’s business as usual from Southwest. But behind the superb figures and ever-present profitability, there are issues, primarily with labor. For a very long time, Southwest enjoyed excellent management-labor relations, part of the airline’s large corporate culture. As an analyst, I am usually skeptical of grand pronouncements about the value of corporate culture, but I am willing to concede that, at least for Southwest, the whole package adds tens of millions of dollars to the bottom line, at least at present.

Southwest Airlines at Dallas Love Field.
Southwest Airlines at Dallas Love Field.

But Southwest’s labor relations have suddenly, and dramatically taken a turn for the worse. The situation between pilots and management is tenser than it has been in a decade and a half. On one side, management sees its labor costs rising steadily (8.3 on a per-ASM basis in 2014) year-over-year, even as Southwest’s once-robust productivity advantage has evaporated. On the other, labor has been conditioned to expect raises and stasis on work rules year after year. Something has to give between these two mindsets (reining in labor costs and steady raises).

Southwest Airlines employees in training
Southwest Airlines employees in training

Unfortunately for Southwest’s shareholders, external conditions might dictate that labor gets its way. Unlike past decades, United, Delta, and American are taking steps to boost compensation for their employees, so Southwest’s are no longer the best-paid. These new contracts put pressure on Southwest to raise pay accordingly, even though Southwest lacks the global network capable of delivering Delta-, United-, or American-sized revenues.

And fuel prices are going to leave Southwest with a whole bunch of cash, at least $1.7 billion annually. While Gary Kelly and his management team can go to the table with pilots and talk about the necessity to keep cost inflation down, his words are going to sound hollow when Southwest is reporting quarter after quarter of record profitability. Even if the pay rates management eventually agrees to aren’t sustainable under (inevitably) higher oil prices down the line, they may have no choice to acquiesce. And that would have a substantial and detrimental effect on Southwest’s long-term finances.

On the surface, things are fantastic at Southwest. But for the first time in ages, the airline faces the prospect of a battle with labor, one that threatens to roil the present hegemony in an irreversible manner.