In early September, JetBlue Airways and United Continental tweaked their Q3 unit revenue forecasts higher, reflecting strong demand. Last week, low-fare airline giant Southwest Airlines (NYSE: LUV) followed suit.
Over the past year, Southwest's revenue performance has been undermined by suboptimal fleet scheduling caused by a temporary aircraft shortage. A fatal accident in April created further pressure on unit revenue. That said, the recent guidance increase is an encouraging sign that Southwest Airlines is on track for better unit revenue trends in the quarters ahead.
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Revenue guidance rises
Back in July, Southwest Airlines projected that revenue per available seat mile (RASM) would be roughly flat year over year in the third quarter. Management noted that strong demand was being offset by three factors: continuing to run a suboptimal schedule; an aggressive fare sale launched in May to counter a slowdown in bookings following the April accident; and the implementation of new accounting rules. Together, these factors were expected to reduce RASM by about 2 percentage points.
On Wednesday, Southwest raised its RASM growth outlook to a range of 1% to 1.5%. The carrier said that flight cancellations related to severe storms in July and August reduced capacity in the quarter by about 1 percentage point, boosting unit revenue by between 0.5 percentage points and 1 percentage point.
However, the rest of the guidance increase was driven by strong demand. This led to higher fares for last-minute bookings, more than making up for a modest decline in Southwest Airlines' load factor (the percentage of seats filled with paying customers) in July and August.
Cost pressure continues
While weather-related flight cancellations have positively impacted Southwest's third-quarter unit revenue performance, the resulting reduction in capacity growth has put further pressure on unit costs.
Entering the quarter, management was already expecting non-fuel unit costs (excluding profit sharing) to rise 2% to 3% year over year, driven in part by the timing of expenses within the year. Including the impact of the July and August cancellations, Southwest Airlines is now on track to report a 3% to 3.5% increase in non-fuel unit costs (again excluding profit sharing) for the third quarter.
On balance, Southwest's guidance update implies that Q3 earnings will be slightly better than what was indicated by its initial forecast. The carrier's adjusted pre-tax margin will likely decline between 2.0 percentage points and 2.5 percentage points year over year. This points to earnings per share slightly above the current average analyst estimate of $1.04.
Good news for the future
While the change to Southwest's third-quarter unit cost guidance offset most of the increase in its RASM forecast, the strong demand environment should lead to better results in the fourth quarter and beyond.
Importantly, Southwest Airlines will lap the September 2017 retirement of its 737 Classic fleet at the end of this month. That means the headwind from suboptimal scheduling -- which has hurt unit revenue over the past year -- will turn into a tailwind next quarter. Additionally, demand appears to have fully recovered from the dip experienced after the accident in April. A recent move to increase the price of EarlyBird check-in for most flights should also boost RASM going forward.
In short, Southwest Airlines could be reaching an inflection point for unit revenue. While RASM came in worse than expected during the first half of 2018, the combination of stronger demand, increased ancillary revenue, and a more optimal schedule should drive solid RASM growth in the fourth quarter. Easy year-over-year comparisons in the first half of 2019 could enable another step up for unit revenue.
This improving RASM trend puts Southwest in good position to increase its profit margin, despite continuing to face high fuel costs. Shareholders are counting on this margin expansion to keep Southwest Airlines stock on an upward trajectory.
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Adam Levine-Weinberg owns shares of JetBlue Airways and Southwest Airlines and is long January 2019 $10 calls on JetBlue Airways. The Motley Fool recommends JetBlue Airways and Southwest Airlines. The Motley Fool has a disclosure policy.