Southwest Beats on Record Revenue

Before the opening bell, the largest U.S. low-cost carrier Southwest Airlines Co. ( LUV - Analyst Report ) reported its second quarter 2012 adjusted earnings of 36 cents per share that surpassed the Zacks Consensus Estimate by 3 cents. The quarter’s earnings were more than double the year-ago earnings of 15 cents.

Despite the prevailing depressed economic conditions, the company’s outstanding performance was credited robust revenue growth, driven by strategic initiatives including cost-cutting measures, network optimization and All-New Rapid Reward program as well as synergies from the AirTran acquisition. Southwest recorded $40 million pre-tax synergies from the AirTran acquisition in the quarter. The company also benefited from the falling fuel prices of late.

Revenue

Revenue climbed 11.6% year over year to a record $4.62 billion, outpacing the Zacks Consensus Estimate of $4.6. Airlines traffic, measured in billions of revenue passenger miles, increased 5.1% year over year. Capacity or available seat miles rose 5.6% while load factor (percentage of seats filled with passengers) fell 40 basis points year over year to 81.9%.

On an annualized basis, Passenger, Freight and Other revenues increased 11.5%, 16.7% and 13.5%, respectively, in the reported quarter. Passenger revenue per available seat mile (PRASM) grew 5.5% year over year.

Operating Expenses & Operating Income

Total operating expenses, excluding special items, increased 7% year over year to $4.1 billion due to higher maintenance and airport costs. Fuel price (economic) accounted for $3.22 per gallon, down from $3.28 in the year-ago quarter.

Consolidated unit cost or cost per available seat mile (CASM), excluding fuel and special items, grew 3.8% and CASM, including fuel and special items, crept up 0.2% year over year.

Despite the higher operating cost, operating income spiked 75.7% to $485 million from the year-ago quarter.

Liquidity

At the end of the second quarter, the company had $3.7 billion in cash and short-term investments and $800 million in undrawn revolving credit facilities. Long-term debt reduced to $3.02 billion from $3.05 billion at the end of first quarter.

Southwest generated operating cash flow of $145 million, down from $235 million in the year-ago quarter. Capital expenditures were $416 million compared to $215 million in the year-ago quarter.

Further, Southwest repurchased 59 million shares for approximately $500 million as of June 30 since the initial $500 million share buyback plan announced on August 5, 2011. The company recently increased its share repurchase authorization to $1 billion from $500 million.

Guidance

Based on robust traffic trends, the company expects unit revenue to grow again in third quarter.

Southwest expects third quarter unit costs, excluding fuel and special items, to increase from the year-ago level. Fuel price (economic), including taxes, is estimated to be in the range of $3.05–$3.10 per gallon.

With regard to its AirTran merger, the company remains on track to generate net synergies of more than $400 million by 2013 on full integration. The merger will also result in a one-time charge of $500 million, of which $165 million has been exhausted until the second quarter of 2012.

Our Take

Fuel price, the major threat to the company’s profitability, has dropped to a certain extent, which has made airline operations less expensive. This lower cost along with the cost-cutting measures is offsetting higher maintenance costs associated with the fleet modernization program amidst the ongoing market turmoil.

Additionally, Southwest is expected to generate strong profitability from fleet rightsizing, Evolve retrofit program, steady capacity growth, All-New Rapid Rewards, several ancillary revenues and AirTran merger synergies. These initiatives would also provide the company a competitive edge over its major rivals - United Continental Holdings Inc. ( UAL - Analyst Report ) and Delta Air Lines Inc. ( DAL - Analyst Report ) .

Based on falling fuel prices and strong growth opportunities, we recently upgraded our recommendation on Southwest to Outperform. For the short term (1-3 months), the stock holds a Zacks # 2(Buy) Rank.