Cost Issues Haunt Southwest Air - TheStreet

Cost Issues Haunt Southwest Air

Earnings rise 40%, but the company is taking steps to keep its expenses under control.
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Updated from 8:48 a.m. EDT

Third-quarter earnings jumped about 40% at

Southwest Airlines

(LUV) - Get Report

, but rising costs have the company scrambling to take steps to protect its role as the low-cost leader.

Dallas-based Southwest earned $106 million, or 13 cents a share, on revenue of $1.55 billion, compared with earnings of $75 million, or 9 cents a share, on revenue of $1.39 billion last year. The results matched Wall Street expectations of a profit of 13 cents a share on revenue of $1.53 billion.

The company added more ticketed passengers than capacity in the quarter, as revenue passenger miles, or traffic, jumped 7.7%, while available seat miles, or capacity, rose just 3.4%. This boosted third-quarter load factor, or the percentage of seats filled, to 70.5% from 67.7% a year ago.

Yields were up, with the company taking in 11.71 cents of revenue for every passenger mile flown in the quarter compared with 11.28 cents a year ago. Revenue per available seat mile, or RASM, jumped 8% to 8.53 cents in the quarter.

"Summer demand for vacation travel was strong, resulting in a record July and very solid August load factor performance," the company said. "Thankfully, post-Labor Day travel also held up reasonably well, although our September traffic was impacted by Hurricane Isabel."

The company is "encouraged" by its recent revenue per available seat mile performance and booking trends, and expects year-over-year unit revenue growth in the fourth quarter, although RASM will decline sequentially from the third quarter, something that usually happens because of seasonality. On a conference call, company management said that bookings for the upcoming holiday season were trending well and that full-fare flight purchases were up 4% to 5% in the quarter.

Cost Controls

On the expense side, third-quarter unit costs rose just 2.4%, thanks partly to a relatively tame 3.7% increase in jet-fuel costs. But with pilots due for a raise after a five-year wage freeze and fuel prices rising, the company sees "more year-over-year cost pressure in the fourth quarter of 2003 and higher unit cost levels than in the third quarter of 2003."

Indeed, these rising costs have forced Southwest to take action to help combat them. On Monday, along with earnings, Southwest announced that it would be eliminating the 5% commission paid to travel agents, a cost-cutting move that other carriers took in March 2002. The carrier said the policy, which will be enacted on Dec. 15, will save $40 million annually.

"With the kinds of cost pressures we're seeing here in the third quarter and what we're telling you about the fourth quarter, what would the wisdom be to continue to pay a 5% commission in an industry that pays none?" said Gary Kelly, Southwest's chief financial officer, in a conference call. "You add that up and it's pretty big money for Southwest airlines. It was time to make that change."

Analysts warned that Southwest's cost advantage over rivals may narrow in the coming years, as labor wage increases take hold and competitors work through massive restructuring plans. But with Southwest planning to grow capacity by more than 7% in 2004 and 10% in 2005, rapid revenue growth should outpace rising costs.

"Contractual wage hikes, including a double-digit pilot increase next fall, put pressure on Southwest's unit costs," said Glenn Engel, Goldman Sachs analyst, in a note reacting to the conference call, "but distribution costs decline as Southwest stops paying commissions. Faster growth neutralizes some of Southwest's cost pressures, but its large cost advantage may narrow."

Pullback Time?

Because costs were higher than many expected, and given Southwest's high valuation relative to peers, analysts said the stock may be in line for a pullback.

"Against a backdrop where revenues were driven higher by third-quarter leisure travel, and costs came in above expectations, we see these pricey shares as being vulnerable to a pullback," said Jim Higgins, analyst for Credit Suisse First Boston, in a note.

On Monday afternoon, Southwest shares experienced no such pullback, gaining 45 cents, or 2.5%, to $18.85, which is about 30 times the 2004 First Call earnings estimate of 63 cents a share.