Southwest Airlines' Profit Is Set to Soar in 2018

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Last week, Southwest Airlines (NYSE: LUV) reported a solid profit for the final quarter of 2017. Adjusted net income was roughly flat year over year (slipping from $463 million to $459 million) as a solid 1.9% uptick in revenue per available seat mile (RASM) mostly offset a 3% increase in adjusted unit costs. Share buybacks helped Southwest achieve modest growth in earnings per share: EPS reached $0.77, up from $0.75 a year earlier.

While these results were solid -- and matched analysts' expectations -- Southwest Airlines is positioned for much stronger EPS growth this year. Benefits from a new reservation system, the retirement of its oldest Boeing (NYSE: BA) 737s, better fuel hedging positions, and a lower tax rate will all contribute to making 2018 another year of record earnings at Southwest Airlines.

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Southwest Airlines' hedge losses come to an end

Since late 2014, low oil prices have helped airlines boost their earnings. However, Southwest Airlines didn't see nearly as much savings as most of its rivals. Unfortunately, the company had locked in higher fuel prices with fuel hedges a few years earlier.

The last of those "legacy" hedging losses came during 2017. If fuel prices remain near recent levels, Southwest will reap modest fuel hedging gains this year. The carrier also has meaningful protection in case oil prices continue to move higher. Most importantly, Southwest has revamped its fuel hedging strategy to prevent a repeat of its 2015-17 hedging losses.

The net result is that Southwest Airlines currently expects its average economic fuel price to inch up just 2% year over year in 2018. That compares to increases of 20% or more for most other airlines. In other words, the biggest profit headwind for the airline industry this year will barely impact Southwest at all. That will support the company's profit growth.

Recent profit improvement initiatives are set to pay off

Southwest Airlines is also poised to capture the benefits from some recent profit improvement strategies during 2018. First, the carrier switched to a new reservation system last May. So far, it has been incurring costs related to this new technology -- as well as occasional disruptions as it irons out the kinks in the system -- without getting much in return.

However, as the year progresses, the new system's improved revenue management capabilities should start to pay off in a big way. Southwest has estimated that this will boost operating income by about $200 million in 2018 -- with further gains in the future as extra features are turned on. This will help Southwest Airlines keep unit revenue growing.

Second, Southwest Airlines retired its last Boeing 737 Classic airplanes in September. These airplanes were built in the 1990s and had 1980s-era engine technology. The new 737-800 and 737 MAX 8 planes that are replacing these older Boeing 737s are much more fuel efficient, which will help reduce unit costs. Southwest will also benefit from lower depreciation expense in 2018, now that the 737 Classic fleet has been retired.

In total, Southwest expects fuel efficiency to improve by 2% to 3% this year, while nonfuel unit costs are expected to decline by as much as 1% (excluding profit sharing and special items). As a result, Southwest Airlines is on track to increase its pre-tax margin in 2018, as long as fuel prices stay near current levels and unit revenue remains positive.

Tax reform is a huge added bonus

The recent reduction of the statutory federal corporate tax rate to 21% will add to Southwest Airlines' earnings momentum this year. Last year, the company's effective tax rate (excluding the impact of tax reform) was about 36%. In the previous two years, its effective tax rate was roughly 37%.

By contrast, Southwest expects its effective tax rate to fall to 23% to 23.5% this year. That will provide a roughly 20% lift to net income for any given level of pre-tax profit.

Another provision of the tax reform law will allow companies to fully deduct the cost of capital expenditures from their taxable income for the next five years. This could encourage Southwest Airlines to increase its growth rate during that period. It will also free up extra cash that the company could use for share buybacks, providing an incremental EPS boost.

Southwest Airlines stock isn't especially cheap. It currently trades for around 17 times trailing earnings. However, between the big step-up in EPS that is likely in 2018 and Southwest's longer-term growth opportunities, the stock still has plenty of upside.

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Adam Levine-Weinberg has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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