MIAMI — Southwest Airlines reported a record net profit of $820 million for the second quarter (Q2) of 2016 Thursday, even as it canceled about 1,150 flights in the wake of a computer systems failure the previous day.

The record net profit figure was up 34.9% year-over-year (YOY) from the same period in 2015, but Southwest’s shares were pummeled, down 11.2% to $37.32 in the wake of a 3.5% drop in PRASM and a miss on revenue expectations.

Southwest Earnings Highlights

  • Operating Revenue of $5.38 billion, up 5.3% YOY
    • Passenger revenue up 1,1% YOY to $4.91 billion
  • Operating Expenses of $4.11 billion, up 2.0% YOY
    • Labor expenses up 2.0% YOY to $1.64 billion
    • Fuel expenses down 10.1% YOY to $903 million
    • Maintenance up 16.7% YOY to $543 million
  • Operating Profit of $1.28 billion; operating margin of 23.7% vs. 21.2% in Q2 2015
  • GAAP Net Income of $820 million
  • Capacity up 4.8% in available seat miles (ASMs), demand up 6.0% in revenue passenger miles (RPMs)
    • Load factor flat at 84.9%
  • Unit revenue per ASM (PRASM) down 3.5% to 12.83 cents, cost per ASM (CASM) down 2.6% to 10.75 cents, CASM excluding fuel up 1.1% to 8.38 cents

Notes and Observations from Southwest’s Quarterly Earnings Call

The vicious (at least for Southwest) irony in its financial results was that another measure of unit revenue, RASM, which takes into account all revenue (including ancillary, secondary service, and the like) was actually up YOY, 0.6% to be exact.

Like Delta, Southwest saw softening in corporate yields (albeit with robust demand) according to CFO Tammy Romo, which helped drive down PRASM. But ancillary revenue performance pushed overall PRASM up, along with a net benefit of approximately $135 million related to the amendment of Southwest’s credit card agreement with Chase.

We were happy to see a moderation in Southwest’s labor expenses, an increase of just 2.0% in absolute terms and a decrease of 2.7% in per ASM terms is a true moderation, and after sounding the alarm in previous quarters about the long run run-up (no pun intended) in Southwest’s labor expenses we were happy to see an abatement in that trend.

Of course with Southwest’s pilots agitating for a massive raise and an uneasy relationship between labor and management, this may well prove to be a temporary respite.

Looking forward into the back half of 2016 and 2017, projected YOY capacity growth for 2016 remains unchanged in the 5-6% range on average net fleet growth of 2% per year for 2016-2018. Romo reiterated that figure several times on the call, though she did note that looking forward into February of 2017 (Southwest’s schedule is currently published through February 2017), that figure starts to dip down to “a couple” of percentage points.

Southwest CEO Gary Kelly also provided some interesting color on the nature of Southwest’s changing customer base. There’s a perception amongst analysts and industry observers (including this column) that Southwest is a carrier that’s moving to handle more of a business traveler clientele.

Kelly actually rejected this notion, framing Southwest’s pull-down of high frequency short haul flying as driving away some business travelers and offsetting growth in business customers on longer routes. Our view is that business travel represents about the same percent of total enplaned passengers as it did in the 1990s but a higher share of revenue.

Kelly categorized also Southwest as a “low-cost producer” and a “low-fare brand” in his comments. That’s just not supported by the data — Southwest’s all-in travel costs are middle of the pack for the U.S. industry, and its cost structure, particularly excluding fuel, is actually on the higher side. To be clear this is not a bad thing – Southwest’s profits more than attest to that. But Southwest is fundamentally a different carrier than its ULCC roots.

Here are some additional observations from the call:
  • International market revenue results are above system averages
  • Southwest forecasts a RASM decline of 3-4% overall
  • The expected net loss due to Southwest’s fuel hedges is about $550 million in 2017
  • The cause of Wednesday’s outage was a router failure in Southwest’s network, and it was fixed in about 12 hours.

Another PRASM Rant

That wraps up our sober analysis of Southwest’s Q2 earnings. And with more than half of the U.S. carriers completing their report of Q2 earnings, it’s time for what is fast becoming a quarterly tradition in this space. Yep, it’s time for another rant about PRASM.

That this segment is placed in the Southwest analysis is mainly an artifact of the massive drop in its share price today. At time of writing (Thursday night U.S. Eastern Standard Time) American’s earnings haven’t been released yet, and I may well reiterate some of these themes in covering those earnings on Monday.

In the meantime, Wall Street’s idiocy and lunacy on the subject of positive PRASM for U.S. airlines and fetishizing of capacity cuts continues unabated. By pretty much every possible mode of financial assessment, Southwest had an excellent quarter. I’ll let Romo describe it in her own words from the conference call:

“This was another quarter of record profits, outstanding margins and strong cash flows. Demand for low fares is strong and we continue to produce record load factors… [S]econd quarter earnings would’ve improved with or without the benefit of lower fuel prices. Our balance sheet is strong as ever… and pre-tax return on invested capital was just phenomenal at 33.5%. As we look ahead to third quarter, we are expecting another quarter of strong margins.”

Yet with the tone of questioning from the Wall Street analysts on the call, it would have appeared as though Southwest were suffering massive losses. Several analysts asked pointedly when Southwest would bring its (already muted) capacity growth “below that of GDP.”

Meanwhile, one analyst openly spoke of “industry dysfunction on pricing,” while another pontificated seriously on “the industry’s revenue crisis.”

We keep wondering if the fine folks down in New York are caught in some weird alternate reality, where up is down and record profits are actually record losses. To recap yet again, in an environment of sub $60/barrel oil PRASM growth is simply not a good indicator of present or future airline profitability.

We know that we’ve stated variations on this theme in numerous pieces this year, and we will continue to do so again and again until someone listens. Frankly if anything, U.S. carriers should be adding more capacity not less. As Kelly noted on the earnings call, “The final point is, as we have discussed this in recent weeks about the opportunity to reduce the schedule primarily in the fourth quarter, we’ve not been able to model a scenario where it was profit positive for us to do that.”

U.S. airlines should be adding capacity, not moderating it. And the fact that Kelly called it an “opportunity” to reduce capacity is a sign that Southwest’s management has to some extent given in to Wall Street’s mindset on this point.

That’s too bad, as Southwest’s shareholders will miss out on hundreds of millions of dollars in cash flow. But at least we can call the present mood for capacity reduction by a moniker that more befits the reality of the situation. It’s not an “opportunity” but rather a ransom paid by U.S. airline management to the myopic focus on positive PRASM at the expense of profits.