Southwest Airlines: New Labor Contracts Will Drive Unit Cost Growth

By Markets Fool.com

When it rains, it pours. A month ago, Southwest Airlines (NYSE: LUV) had a slew of unresolved labor contracts that were the source of growing discontent within its workforce. However, in a span of just two weeks between late August and early September, Southwest announced that it had reached tentative agreements for new contracts covering three labor groups: pilots, flight attendants, and facilities maintenance technicians.

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Reaching these tentative contracts was critically important for Southwest Airlines. Without happy employees, service standards could have eventually suffered. Nevertheless, if all three new contracts are ratified, it could drive a steep increase in Southwest's unit costs next year.

Southwest pilots finally get their big raise

Last year, Southwest Airlines pilots rejected a contract offer that would have given them substantial pay increases. Now, they are on track to get even bigger raises.

Pilots are about to get big raises at Southwest Airlines. Image source: The Motley Fool.

Under the terms of a tentative agreement reached in late August, Southwest's pilots would get a 15% raise on Oct. 1. They would then get 3% annual raises in each of the next four years. The tentative agreement also includes a significant signing bonus -- worth up to 11% of a pilot's annual pay -- to compensate the pilots for not getting a raise since 2011.

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This tentative pilot contract doesn't quite measure up to the union's bargaining position, but it comes close. Thus, there is a good chance that a majority of Southwest's pilots will endorse it. The ratification process won't conclude until early November, though.

New contracts for flight attendants and facilities technicians, too

In the past few weeks, Southwest Airlines has also reached new tentative contract agreements covering its flight attendants and facilities maintenance technicians. Both of these work groups have also been stuck in negotiations with the company for several years.

If these deals are also ratified, Southwest will suddenly be close to having all of its unionized employees covered by current contracts. That would mark a big change from the beginning of the year, when half a dozen work groups were operating on outdated contracts. (Union contracts never formally expire in the airline industry -- they merely become amendable at some point.)

Nonfuel unit costs will rise

For a long time, Southwest Airlines aimed to reach new labor agreements without increasing its cost structure. However, it's inevitable that Southwest's new labor contracts will drive up its nonfuel unit costs.

Southwest already spends a little more than 30% of its revenue on labor costs, including the cost of benefits. Furthermore, labor costs represent more than half of its nonfuel costs, with pilots being by far the highest-paid work group.

As a result, if the new pilot agreement is ratified, it will have a particularly large impact on Southwest's cost structure. The pilot union estimated that its contract proposal would increase the company's nonfuel unit costs by 3.44% in 2017. While the tentative agreement calls for slightly smaller raises than what the union had asked for, the impact on Southwest's unit costs will still be noticeable.

Of course, the other new tentative agreements will also put upward pressure on labor costs. The net result is that nonfuel unit costs could easily rise by 4% or more next year, compared to an expected 1% increase in 2016.

There will be offsetting savings

The good news for Southwest Airlines is that it will see meaningful savings on some other line items in the next two years. First, the company is on pace to lose about $1 billion on fuel hedges this year. That amount should drop by roughly half in 2017 and then fade to almost zero in 2018. This will reduce Southwest's fuel costs significantly -- or at least mitigate any increase in oil prices.

Second, Southwest Airlines is currently incurring accelerated depreciation costs for its oldest 737 jets, due to its decision to retire them by Labor Day of 2017. That expense will come off the books a year from now. Meanwhile, Southwest will be replacing its oldest 737s with brand-new, fuel-efficient 737 MAX aircraft.

As a result, while Southwest's profitability is likely to decline in 2017, lower fuel hedging losses will partially offset rising labor costs. Moreover, profitability could rebound in 2018 as hedging losses decline again, labor cost increases start to moderate, and accelerated depreciation for the oldest 737s ends.

There may be some bumps in the road for Southwest Airlines during the next year, but patient investors could be rewarded for their perseverance.

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Adam Levine-Weinberg has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.