MIAMI — Dallas-based low cost- network hybrid carrier Southwest Airlines reported an annual net profit for the 41st straight year in what is rapidly approaching a “death and taxes” level of certainty. Southwest reported a net profit of $236 million for the fourth quarter of 2013, or $0.33 per diluted share, an increase of 263.1% year-over-year (YOY). For the full year, the airline reported a robust net profit of $805 million excluding special items ($1.12/share), for calendar 2013, up 93% YOY, setting a new annual record.

A combination of increased operating revenues and declining fuel prices were the primary contributors to the improved profitability. Operating revenues increased 3.6% YOY to $17.69 billion, led largely by a 3.9% increase in passenger revenues to $16.72 billion.

Passenger yield grew 2.4% YOY to 16.02 cents, while PRASM increased a more modest 2.1% to 12.83 cents on capacity growth (as measured in available seat miles (ASMs) of 1.7% system wide. The increase in ASMs despite a decrease in revenue passengers carried of 1.2% reflect both the integration of longer haul markets from the AirTran network, and Southwest’s reduction of short haul capacity (especially on either coast) due to a rising cost base.

Operating expenses decreased 0.3% YOY to $16.42 billion from $16.46 billion. Individual line items show a mixed bag of results. Employee costs, including salaries, went up 6% to $5.03 billion despite the company shedding 1,030 full time equivalent (FTE) positions.

The increase in labor costs is not an isolated result, but just the latest step in the steady upwards march of Southwest’s labor costs. Since the middle part of this decade, when the so-called low hanging fruit for explosive domestic growth evaporated, Southwest has seen a steady rise in labor costs and declines in productivity, as the chart below shows.

The productivity decline is due to the restructuring of the business model; Southwest operates flight schedules that are more oriented towards facilitating connections at its “hubs” like Chicago Midway and Baltimore/Washington and also operates into congested and delay prone airports such as Newark, Boston, and Washington Reagan in the Northeast.

The rise in labor costs has more to do with Southwest’s founding philosophy, which espoused a belief that taking care of one’s employees would naturally lead to better customer service and repeat business.

There’s certainly an element of truth to that. Southwest’s customer satisfaction scores are extremely strong (though there has been some blowback over operational difficulties in recent months), and even as the airline expanded its customer base to include business travelers, that group too named Southwest as one of its top two US airlines in a recent survey.

But the rise in labor costs has necessitated the evolution of the business model, leading Southwest to focus on expanding its revenue base by entering higher yield congested markets on the east coast, going international, and redesigning the product offering to appeal not only to leisure travelers, but to business ones as well.


Offsetting the rise in labor costs was a decline in fuel and acquisition/integration costs. Fuel, reflecting an average 2013 gallon price of $3.10 including hedges, dove 5.8% YOY to $5.76 billion, 7.4% on a per-ASM basis. Acquisition and integration costs fell 53% YOY, down to $86 million from $183 million the year prior as the airline continues to make progress on integrating AirTran. This decline should reverse itself temporarily in 2014 as Southwest takes on the more challenging process of integrating international destinations into the network (as opposed to domestic + San Juan), and tries to manage three separate reservations systems: Sabre Cowboy (pre-merger Southwest), Navitaire (pre-merger AirTran), and a beta version of the new Amadeus system that will allow the carrier to fly as a single carrier abroad.

Southwest is taking a very measured approach to IT and technology integration, but as United’s experience during the disastrous IT issues of 2012 proves, that is probably the right approach.

Cost per available seat mile (CASM) dropped 1.9% YOY to 12.60 cents, while CASM excluding fuel increased 1.4% to 8.18 cents. The CASM decline was helped by the completion of Southwest’s Evolve fleet refurbishment program (for 372 Southwest 737-700s, 78 Southwest 737-300s, and 6 of 52 AirTran 737-700s), which added 4.4% more seats while keeping trip costs the same, as well as the transition of 13 out of 88 pre-merger AirTran 717-200s to Delta.

In 2014, CASM figures should continue to decline as the remaining 717s exit the fleet, the remaining AirTran 737-700s are retrofitted with Evolve, and the delivery of 33 more 175-seat Boeing 737-800 aircraft.

Turning to the balance sheet, Southwest reduced long term debt and capital lease obligations by an additional $313 million over the course of 2013, solidifying the company’s position as the US carrier with the strongest balance sheet, with total debt of just $3.15 billion against $3.1 billion in cash and short term investments. Southwest will continue to aggressively reduce debt to the tune of $550 million in 2014.

With regards to cash flow, Southwest’s healthy operating margin of 7.22% led to operating cash flow of $2.49 billion. An aggressive capital expenditures program in 2013 of $1.45 billion (which will likely be matched in 2014) resulted in free cash flow of $1.04 billion. However, Southwest was particularly aggressive in returning this cash to shareholders, close to 58.8%, via share repurchases of $540 million and $71 million in dividends paid out. Return on invested capital (ROIC) more than doubled YOY to 13.1%.

Overall, Southwest recorded yet another year of strong profitability as it has begun to saturate the revenue-generation capacity of its network. Looking forward to 2014, the year will be perhaps more challenging, especially on the cash flow side given required capital expenditures for IT upgrades. And the carrier will have a difficult decision to make on the future of its highly successful “Bags Fly Free” policy with regards to the tradeoff between the marketing boost and lost revenue.