LUV Fuel Hedges Dwindle

[AA767AV8TOR]

April 19, 2007 Wall Street Journal

Southwest Airlines: Losing Its Fuel Hedge Competitive Advantages

Southwest Airlines (LUV-NYSE) is one to watch as its fuel hedge advantages are becoming less and less compared to other legacy and discount air carriers. The company reported $0.04 EPS on an 8.9% revenue rise to $2.2 Billion. The headline number is $0.12 EPS, but the company says its "economic net income" was $0.04 and goes further to compare it directly to the First Call mean estimate of $0.04 (Revenue estimates were $2.21 Billion, too).

We previously ran a story comparing this company to legacy carriers, because this one is not just a pure-play discount airline anymore if you do your own price comparisons to other airlines. It still has its loyalists that would fly it over any others, so it isn't like the company is doing the wrong thing. Sometimes the competitive advantages are taken away by the market, and that is what is happening. The single most important factor ahead is that Southwest is no longer at 'as large' of a competitive advantage based on old fuel costs being hedged, and that is dwindling further in the coming year.

It noted $65 million in favorable cash settlements from derivative contracts for Q1 2007, BUT fuel costs per gallon increased 11.6 percent to $1.63; and has derivative contracts for over 95% of estimated Q2 2007 fuel consumption capped at an average crude-equivalent price of approximately $50 per barrel (compared to over 75% at approximately $36 per barrel for Q2 2006). Southwest says it is "hopeful" that Q2 2007 fuel costs will not exceed $1.70 per gallon. it also maintains that it has derivative contracts for approximately 90% of estimated fuel consumption for the Second Half of 2007 at an average crude-equivalent price of approximately $50 per barrel.

Its forward fuel hedges are dwindling, which means this gets to visit the same barrel session as the other airlines on fuel costs. In 2005 they were sitting pretty with an average cost per gallon of only $1.03, but we are almost in the middle of 2007 and those hedges could only be purchased for so long into the future. Its 2006 total fuel costs rose 48.5% to $1.53 because so many hedges ratcheted higher. According to its last annual report here is the company's fuel hedge for forward years ("approximate" per barrel basis, as of mid-January):

2007 is 95% hedged at $50/barrel;
2008 is 65% hedged at $49/barrel;
2009 is over 50% hedged at $51/barrel;
2010 is over 25% hedged at $63/barrel;
2011 is over is 15% hedged at $64/barrel;
2012 is 15% hedged at $63/barrel.

So if you look at current prices with crude at $62.21, the company is much closer to coming online to current fuel prices than it has been in any recent year. Other airlines have managed to hedge a portion of their fuel costs as well. The truth is that Southwest STILL has what is probably the best fuel hedges for 2007 and 2008, but after that the relative advantages to the legacy and discount air carriers comes down drastically.

Southwest also noted that Q1 2007 unit costs, excluding fuel, rose 1.7% over last year (as expected). It has also disclosed upcoming labor contract risks, although that is the case in the entire airline sector.

Shares are down about 2% at $15.30 today after the earnings report, and its 52-week trading range is $14.50 to $18.20. On a longer term basis the average trading band is really $13 to $18 per share over 90% of the last 5+ years.

Jon C. Ogg
April 19, 2007

Jon Ogg can be reached at [email protected]; he does not own securities in the companies he covers.

 

[Dude]

we're screwed..................

 

[Dude]

I'm sure once every other airline emerges from BK and their employees are rewarded for keeping them in business, we'll be on a level playing field again. I don't know how our mgt team would have done it without those hedges. I give us a year or two before we are providing feed for AA, DAL, UAL, and whomever else will pay to help keep us in business.

 

[Bavarian Chef]

I don't think that was the point of the article nor was it probably the point of the poster (sic).

Sometimes it just makes sense to show every side of the issue. Wait 'till tomorrow -- JB D DAY. No one will even remember this article.

 

[AA767AV8TOR]

we're screwed..................

Far from it, but you’ll have to start raising prices which is good for all of us.

AA767AV8TOR

 

[AlbieF15]

Off the subject...

You know..a B-1 dropping a huge stick of iron bombs really doesn't do much in todays war plans....like plinking JDAM after JDAM.

However--it sure is impressive....

 

[desolo]

Time to send out the resumes again....SWA is history.

 

[canyonblue]

Far from it, but you’ll have to start raising prices which is good for all of us.

AA767AV8TOR

You first! Go to AA.com and it will make you puke. On the other hand, you'll get to see where your paycut has been going.

 

[Ex737Driver]

I'm sure once every other airline emerges from BK and their employees are rewarded for keeping them in business, we'll be on a level playing field again. I don't know how our mgt team would have done it without those hedges. I give us a year or two before we are providing feed for AA, DAL, UAL, and whomever else will pay to help keep us in business.

I don't think anybody is knocking your mgmt team. SWA mgmt has done an outstanding job in keeping costs at a minimum but I think most folks are VERY interested in what they are going to do next to generate revenue since the fuel hedges are running out. Granted fuel is not the only cost but it is an extremely large one. Facetiousness is often unbecoming.

 

[Bavarian Chef]

You first! Go to AA.com and it will make you puke. On the other hand, you'll get to see where your paycut has been going.

Hey Albie -- is the harmony you were jonesin' for?

 

[HighSpeedClimb]

Those hedging numbers are still pretty impressive considering what's up in Iran and the continued fiasco in Iraq. Still, why are the SWA guys so quick to attack an article written by someone not even affiliated with SWA? Of course, it is from the WSJ.....The sky is falling!!!!! If SWA ever has anything to worry about, we're many many years from it. Cheers

 

[Jonny Sacko]

Hmmmm

 

[Whataburger]

Far from it, but you’ll have to start raising prices which is good for all of us.

AA767AV8TOR

like we did 6 times last years.

 

[RJAA]

I think the problem may exist where SWA has started to charge more than some of the legacy carriers, and often their iteneraries do consist of a stop or two somewhere along the way. For example, Houston-Washington DC market. Continental has tons of non-stop options to BWI/DCA/IAD thoughout the day and some of SWA flights from Hobby make one or even two stops. Just recently I purchased a revenue ticket between LAS-LAX and I was shocked to find AA was charging just half of what SWA was offering two weeks out. So, why fly SWA if not the cheapest and/or not the most convenient?

 

[YourPilotFriend]

It has been reflected in the last quarterly report, that SWA has the highest average fares among the major airlines. The other airlines are slowly creeping up to match SW fares. This is why they don't sell tickets on the comparative websites like orbitz. Instead SW relies on the perceived notion that it has the lowest fares. It's an old fashion technique but still brilliant.

 

[firstthird]

part of the fare differential has to do with the underlying philosphy of selling tickets. the book Hard Landing covers it pretty well. American pioneered the standard legacy technique with their sabre system.

Basically, legacies sell expensive tickets to business travellers and first class flyers which covers the cost of flying the plane point a to b (fuel, salaries, leases) and then you sell the leftover seats at whatever you can get for them (pure profit). the problem developed when businesses were no longer willing to pay the premium for the last minute tickets, etc.

Planes have the same problem as hotel rooms, a perishable product. once a hotel room is empty for a night you can never recapture that revenue. same with a plane that pushes with empty seats. So, legacies decided that any amount is better than letting seats go empty, so you can find great deals on the travel websites as the legacies try to fill up those last few seats at any price they can get.

SWA, on the other hand, tends to sell a certain percentage of tickets at each of the 3 fare levels. lets say 1/3 each for simplicity. you get there first/early, you get the cheap ones. you get there late on a full flight you pay 'full fare' on SWA. This is one reason our load factors are so low compared to almost any other airline. we are 'saving' seats to be sold at full fare. we'd rather fly at 75% full than 'give' the last 25% away at very low fares.

this is also why SWA doesn't allow standby travel on earlier flights (you can if you pay the fare difference but most leisure travellers ar not). this is a real sore point for our customers who are used to flying standby on other airlines since almost all other airlines will let you move up.

short answer - swa knows we let seats go that could've been sold at lower prices but we choose to do that to that the seat is available if daddy warbucks walks up 1 min before push willing to pay full fare (right now never higher than $319). (oh, and for the SWA is more expensive crowd, what is your highest one way fare as a last minute walkup?)

you really want to talk about damaging the industry, why are the legacies selling for so low? joke.

assigned seat or not, I'd rather be on a plane with a 70% load factor than a 90% load factor. you've got a better chance of that on SWA than any other carrier.

 

[AA767AV8TOR]

part of the fare differential has to do with the underlying philosphy of selling tickets. the book Hard Landing covers it pretty well. American pioneered the standard legacy technique with their sabre system.

you really want to talk about damaging the industry, why are the legacies selling for so low? joke.

assigned seat or not, I'd rather be on a plane with a 70% load factor than a 90% load factor. you've got a better chance of that on SWA than any other carrier.

Firstthird,

Nice discussion of LUV ticketing strategies. The book “Hard Landing” is a must read for anyone in the industry.

Don’t get me wrong, LUV is an excellent company and I’m sure it will do fine, but it does face challenges in the future like the rest of us. Our union plans on making some major improvements this contract which will probably take some of the sting out of your declining fuel hedges. Most of the pilots here are through subsidizing our management’s million dollar bonuses. Our contact fight will probably turn ugly next year since our esteemed management wants to lock in our 2003 pay cuts and we want to do exactly the opposite.

It is truly a crazy industry when a SWA guy says that the legacies prices are too low.

AA767AV8TOR

 

[YourPilotFriend]

(oh, and for the SWA is more expensive crowd, what is your highest one way fare as a last minute walkup?)

On NWA, first class walk up is thousands of dollars i've seen as high as $18,000, a coach walk-up fare doesn't change anymore. Right now we have some $27 fares that are walk up.

 

[canyonblue]

It has been reflected in the last quarterly report, that SWA has the highest average fares among the major airlines.

And that is a big problem that Legacy pilots won't address.

 

[canyonblue]

Our union plans on making some major improvements this contract which will probably take some of the sting out of your declining fuel hedges. Most of the pilots here are through subsidizing our management’s million dollar bonuses.

AA767AV8TOR

I hope that others will follow your lead. Remember, our hourly rate is high just by default. There is no reason why a Legacy pilot can't earn more than a SWA pilot on an hourly basis. It never seemed to bother them before to look at SWA pay as a comparison.

 

[Big Slick]

Legacy Carriers Fly High Despite High Fuel Costs, Demand Fears
Friday April 20, 7:00 pm ET
Marilyn Alva
While the airline industry faces higher fuel costs and warnings of slowing passenger demand, a subtle shift in fortune has begun: L ow-cost carriers are struggling, and legacy airlines aren't.
On Wednesday, No. 1 American (NYSE:AMR - News) reported first-quarter profit of $81 million, or 30 cents a share, despite $60 million lost to weather-related problems. It lost 49 cents the prior year.
Continental (NYSE:CAL - News) on Thursday said earnings more than doubled to 25 cents a share -- its first first-quarter profit in six years.
Meantime, first-quarter profit at Southwest (NYSE:LUV - News) fell 50% to 4 cents a share, excluding special fuel hedging items. What's more, the low-cost leader warned Thursday that advanced domestic business looks to be weakening.
Low-cost JetBlue (NasdaqGS:JBLU - News), which canceled hundreds of flights when it couldn't cope with winter storms, earlier reported a 19-cent loss.
The playing field seems to be evening. "Low-cost carriers don't have as much of an edge as they have had historically," said Stuart Klaskin, partner with KKC Aviation Consulting.
Airline Stocks Descending
Shares of airlines of all kinds have struggled this year as energy costs climbed after shares surged late last year on lower oil costs.
Airline stocks sold off Friday as crude prices rose. Continental lost 5.5%, United Air (NasdaqGS:UAUA - News) slid 4.5% and American slid 3.5%.
That followed sizeable losses on Thursday. Despite a strong earnings report that day, Continental's shares fell 6% "on confusion over demand outlook," analyst Daniel McKenzie of Credit Suisse wrote in a report. He contends Southwest's demand warnings "are specific to Southwest."
Carriers have been able to pass on higher fuel costs by raising fares. But if domestic demand weakens -- and not all analysts are sure it will -- that might not be an option.
Overseas Liftoff
Analysts say weaker domestic demand would hurt Southwest more than other airlines since it has the most U.S. flights. Also, Southwest's large fuel hedges are wearing off.
Meantime, it's boom time on the international front, where demand, load factors and pricing remain strong. Most low-cost carriers don't fly these lucrative routes, but the legacy carriers are adding new flights, buoyed in part by an "open skies" deal that will free up European airports such as London's Heathrow to more U.S. carriers.
Even if domestic yields slow, many of those flights feed into higher-yielding international connections. "Those new international routes make domestic routes stronger," said Michael Boyd of the Boyd Group.
In a stunning turnabout, Southwest execs said they might look to join the global party. The airline, which shrugged off talk of a leveraged buyout, also is looking into charging for new services such as Internet access.
Analyst Ray Neidl of Calyon Securities favors the legacy sector since it "can better take advantage of the upside cycle" with its vast hub systems, broad yield management systems and lowered cost structure.
Thanks in large part to their ability to balance supply with demand, legacy carriers have reported record-high load factors.
Better Shape
Years of cost cutting and fleet resizing have put mainline carriers in better shape to battle head winds such as volatile fuel costs and a slowing economy -- two of the industry's biggest risks.
The industry lost $35 billion from 2001 to 2006, though it turned profitable at some point 12ast year.
This year is looking stronger, even with forecasts that analysts revised downward.
Most legacy carriers restructured their business under Chapter 11. Delta expects to exit bankruptcy by April 30, with Northwest to follow.
American avoided bankruptcy in 2003 by securing millions in labor concessions and other cuts. All told, the industry gave up a third of its labor force.
But labor is angling to take back some of its concessions. Labor's anger over big executive payouts at American could make upcoming negotiations tough.
The latest round of bankruptcies haven't solved all the industry's problems. The majors continue to look for more savings.
Barring a major economic downturn, huge spikes in oil or terrorist attacks, the current upcycle "is about two-thirds the way toward a modest peak," Klaskin said. He puts the peak 18 months to two years away.
Looking ahead to better times, major carriers are starting to step up fleet renewal programs.
American on Wednesday said it would take delivery of 47 Boeing 737s on order. New planes at legacy carriers would replace older, less fuel-efficient ones.
At low-cost airlines such as Southwest, new planes would add to their relatively new fleets.
Overcapacity could become a problem. Southwest, Air Tran and Jet Blue "all have a lot of new airplanes on order and they are running out of places to fly them," Boyd said.

 

[Captain X]

And that is a big problem that Legacy pilots won't address.

Yeah, basically. Because we all keep capitulating to our managements and walk away hypnotized and mumbling "You can't pass fuels costs along to the customer. We'll lose all our salary-paying passengers. Must give concessions...."