Between 2011 and 2014, Southwest Airlines (NYSE: LUV) took a hiatus from growth. It increased its capacity less than 2% over that three-year period as it struggled with high fuel prices and focused on integrating its AirTran acquisition.
Having more or less completed the AirTran acquisition by the end of 2014, Southwest has returned to growth in 2015. Fortuitously, Southwest is doing so just as it is reaping a big tailwind from lower fuel costs. In other words, Southwest couldn't have picked a better time to start growing again.
Return to growth
Last fall, Southwest revealed plans to accelerate its capacity growth rate to 6% in 2015. To some extent, this growth plan was driven by the company's ability to return to a more normal aircraft usage pattern after having many planes out of service due to the AirTran integration. But it also reflected attractive growth opportunities.
The biggest of these -- representing about half of Southwest's projected 2015 growth -- was the opening of Dallas Love Field to long-haul flights, which occurred last October. American Airlines (NASDAQ: AAL) has absolutely dominated the Dallas-Fort Worth air travel market for the past decade because of restrictions that sharply limited long-haul flights at Love Field, Southwest's home airport.
However, Southwest was convinced that there was massive pent-up demand for long-haul flights out of Love Field. The new routes performed so well in their first few months that Southwest acquired two more Love Field gates in late January in order to expand further. In a classic version of the "Southwest Effect," lower prices have also stimulated traffic for American Airlines in the Dallas-Fort Worth market.
As a result of getting the extra gates in Dallas, Southwest now expects its full-year capacity to rise about 7% year over year. It also expects to grow capacity by at least 5% next year because of the impact of annualizing the new routes added during 2015.
Rising profitability
Growth usually puts pressure on an airline's profitability in the short run. It can take a couple of years for demand to fully ramp up as customers discover the new flights and change their travel patterns.
However, thanks to the massive drop in fuel prices -- and to a lesser extent, improved efficiency -- Southwest reported a stellar 17.4% operating margin last quarter. This was up by more than 10 percentage points year over year despite Southwest increasing its capacity by 6.0%.
A great time to grow
Southwest's stellar Q1 results show the wisdom of targeted growth in the current domestic airline market. Costs are falling because of the sharp drop in oil prices since last summer, while domestic travel demand remains robust.
Southwest hopes to hold unit revenue flat this year. Even if it falls short of this ambitious target, it will still be better off than if it had adopted a modest growth rate. After all, it is earning a very high 25.6% return on invested capital. When a company is earning a very strong return on invested capital like that, investing in growth is clearly in shareholders' best interests.
There are still plenty of doubters
Not all Wall Street analysts see it that way, though. Southwest Airlines CEO Gary Kelly still had to fend off a couple of questions during the earnings call about why the company was growing so quickly.
What really seems to be happening is that American Airlines and its legacy peers have reduced their capacity plans recently in order to bolster their unit revenue, and some analysts were hoping Southwest would follow suit.
Southwest isn't facing the same pressures as the legacy carriers, though. For example, passenger unit revenue declined 1.7% last quarter at American Airlines, whereas it was flat at Southwest. For Q2, American expects its passenger unit revenue to decline 4%-6%, while Southwest expects a more modest decline of perhaps 2%.
American Airlines has been fairly up-front about the fact that Southwest's rapid growth in Dallas (and elsewhere, to a lesser extent) is one of the factors depressing its unit revenue right now. But from Southwest's perspective, this is very profitable growth. As long as it is earning a better than 20% return on invested capital, Southwest should keep pushing the pace on expansion -- regardless of the impact on its competitors.
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Adam Levine-Weinberg has no position in any stocks mentioned.
Source: southwest - Google News http://ift.tt/1zdaVuZ
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