MIAMI — Southwest Airlines reported a first quarter 2014 net profit of $126 million, or 18 cents per diluted share, on Thursday excluding special items. The earnings more than doubled year-over-year (YOY) from Q1 2013, when the Dallas-based carrier made $59 million.

The carrier said it would have done even better had winter weather in January and February not forced the cancellation of over 7,500 flights. The estimated hit to profit of the cancellations was $50 million.

Operating revenues grew 2.0% YOY $4.16 billion, led by a 2.5% YOY increase in passenger revenues to $3.93 billion, reflecting a 3.1% rise in per-passenger revenue, to $156.96. In contrast to trends at other network carriers, other operating revenues actually declined 6.8% to $193 million. A 0.7% increase in yields to 16.28 cents helped drive up passenger revenue per available seat mile (PRASM) 3.5% YOY to 12.90 cents on a 1.1% decline in capacity as measured in available seat miles (ASMs). First quarter business travel trends were strong, with a double-digit increase in corporate sales.

On the expense side, labor costs continued to rise despite a 1.4% reduction in full time employees, expanding 7.8% YOY to $1.27 billion. Labor cost per available seat mile rose an alarming 9.3% to 4.18 cents, and continues to be the most important cost pressure for Southwest. The more increase was offset by fuel costs, which dropped to $3.14 per gallon, diving 9.8% YOY in aggregate to $1.31 billion. Maintenance and rental costs also decreased, 14.1% to $250 million and 12.9% to $81 million respectively, partially reflecting a decrease in overall fleet size to 676 from 699 at the end of Q1 2013. In total, the carrier’s operating expenses decreased 1.6% to $3.95 billion YOY. Operating cost per available seat mile (CASM) dropped 0.5% YOY to 12.96 cents, though CASM excluding fuel rose 4.2% to 8.65 cents, primarily due to labor costs.

In terms of managing CASM, Southwest now has the full benefit of 54 737-800s in the fleet, the completion of the Evolve seating retrofits, and the replacement of AirTran’s 717 fleet. These figures will help to tamp down Southwest’s CASM over the remaining three quarters of the year. The introduction of Scimitar Winglets on the 737-800 fleet is expected to save 5-5.5% in fuel burn annually, which should help further manage CASM.

Southwest’s pre-tax ROIC came in at 14.2% slightly below the carrier’s target of 15% (though it would have hit the mark if not for the weather effects). For the quarter, Southwest recorded an operating profit of $215 million for an operating margin of 5.2%, up from 1.7% the year prior. While the operating margin improvement was strong at about 3.5 percentage points YOY, it trailed behind Delta’s 7.0% and 7.3% figures.


Looking forward into Q2, April PRASM is expected to improve 6 – 7% thanks to the shift of Easter. Second quarter fuel price is expected to be around $3.06 percent, with CASM excluding fuel expected to rise 2 – 3% YOY. Accordingly, we expect Southwest to record its 42nd straight year of profitability in 2014.

Still, the more interesting questions with Southwest are tied to their future. Starting with costs, Southwest expects to keep overall fleet size flat in 2015 at 695 aircraft, but grow capacity 2 – 3% due to the effect of the 737-800’s larger seat count and up-gauging from the 717 to the 737-700. This will help CASM to some degree, but of course the primary challenge remains labor costs. Southwest employees, for what it’s worth, have come to expect annual raises consistently thanks to Southwest’s labor relations strategy. Admittedly affected by other factors, labor productivity as measured in terms of ASMs produced per dollar of employee compensation continue to fall, reaching 23.92 in Q1, down from 29.24 in 2008.

Southwest has no choice but to focus on raising revenues. This is where checked baggage fees come into play. After discussing baggage fees more candidly in past conference calls, CEO Gary Kelly pulled back a little from those comments during this quarter’s conference call, but the long term incentives are just too strong. Even a $10 bag fee would have generated $306.57 million in additional revenues for Southwest this quarter, and a $25 bag fee in the vein of its network peers would have generated $766.41 million. In moments of candor, Kelly has admitted in the past that one of the primary reasons for not introducing a bag fee is in fact lack of capability, something that will be completely fixed with Southwest’s new reservations system. It is still our view that Southwest will introduce a first checked bag fee within the next three to four years.

But the more interesting revenue play is turning to international flying. CEO Gary Kelly had interesting comments about that on the earnings call:

Well, over the long term, I think it’s a large opportunity. We’re thinking about it as North America. I would throw in Hawaii and Alaska, just because it is so different than flying in the 48 states, into that whole growth opportunity. We serve 96 cities today with Southwest and AirTran and have a potential to add 50 new destinations over some period of time, and that would be several hundred airplanes worth of flying. So it’s a very material opportunity. And as I mentioned earlier, growing the airline is, in many ways, tactical. We’ve made the strategic investment to create the capability at Southwest to fly beyond the borders and to fly longer distances….. And again, this all assumes 737 service. The geographic footprint is all of North America, including the Caribbean and actually, the northern reaches of South America. So it’s a very exciting opportunity, 200 airplanes. I didn’t do the math in my head, but that would be about not quite 1/3 increase in the fleet. So it’s longer-haul flying, which takes longer, and it is higher revenue.

Kelly’s comments are extremely interesting on several levels. For starters, talking about 200 airplanes and 50 destinations represents a major expansion into international service, covering pretty much every major international destination in the Caribbean, Central America, and Northern South America. This represents a massive opportunity to grow margins for Southwest, and an unexpectedly aggressive one. And Southwest has the hub structure to do it, pairing Fort Lauderdale with Houston and Phoenix to bracket Southbound hub traffic.

Notable in its exclusion was Canada, where taxes might simply be too large for Southwest to fully compete. Southwest does has decent brand recognition in Canada thanks to passengers who drive down into the US to fly, and a Canadian gateway at Chicago Midway could make some sense. Still, it’s nice to finally get some numbers on what Southwest is planning with regards to international expansion.