Southwest and American Report Q2 Results

Southwest and American, the two Texas-based major airlines, reported 2nd quarter earnings. The picture is somewhat mixed, despite the industry's resilience during the Iran War and rising fuel prices over the last few months. Both carriers reported record operating revenues, $16.7 billion for American and $8.4 billion for Southwest. But things diverged from there. Southwest, which is roughly 1/2 of American’s size, reported pre-tax income three times higher than its larger competitor. While the second quarter was slightly profitable for American, it is typically the second most profitable, with the spring shoulder and peak summer travel season beginning. American’s operating margin was 2.7% during the quarter, with Southwest clocking in at 3.4%. But both pale in comparison to the 9.4% from Delta and 6.2% from United, which reported their results last week and are projecting double-digit growth. [caption id="attachment_196047" align="aligncenter" width="580"] Source: SEC filings[/caption] American’s Weak Performance and Balance Sheet At American, passenger load factors fell year-over-year in the quarter from 84.7% to 83.2%. While TRASM climbed 10.3% from 18.54 to 20.45 cents year over year, operating expenses grew 16.5% from 17.08 to 19.90. The average fuel price climbed to $4.05 per gallon, up from $2.29 per gallon last year, accounting for most of the cost increase. American was able to eke out a small net profit of $71 million on $16.7 billion of revenue. When compared with last year’s second quarter loss of $311 million, the turnaround is welcome. The transcript for American’s earnings call can be found here, and the Form 10-Q for the quarter here. [caption id="attachment_196048" align="aligncenter" width="580"] image: Boeing[/caption] American’s Strategy American’s four-pillar strategy focuses on elevating the customer experience, growing the global network, driving premium revenue, and leading in loyalty. American, while behind its major competitors Delta and United in financial performance, has adopted similar strategies focusing on product, premium traffic, network, and loyalty that its competitors have already implemented. While the carrier is behind its competitors, CEO Bob Isom believes it has the most upside potential as its strategic initiatives mature. The question we have is whether it is too late, or whether the hubs and loyalty for American can pull out a significant win. With premium revenue up 19% in the quarter and non-premium up 15%, premium traffic provides nearly half of ticketed revenue on roughly 30% of seats. 60% of American revenue comes from households earning $150,000 or more, indicating a more stable base for continued demand. Plus, the AAdvantage loyalty program was the first in the industry and remains the largest in terms of membership. The question is how well the airline can leverage that asset and how well its new credit card deal with Citi will perform. American Needs to Focus on Both Strategy and the Balance Sheet A fundamental issue at American is the continued weakness of its balance sheet, and the negative shareholder value from more liabilities than assets. This does not bode well compared with its competitors, each of which is in the 20-25% shareholder value-to-assets range. America simply has too much debt for its size and will need to focus on debt repayment rather than dividends and shareholder returns in the short- to intermediate-term. The current level of profitability will not support strong debt pay-down and will continue to place American at a competitive disadvantage until it is addressed. Southwest Airlines Southwest Airlines reported its first full quarter since the major changes in strategy, including seat assignments, have been implemented. Initial results, discussed on their earnings call, indicate that the carrier’s new strategy is working, as shown by a 35% year-over-year growth in Rapid Rewards loyalty program enrollments. That program now has nearly 100 million members. Co-branded Chase credit card programs grew 28% year-over-year, as new customers have engaged with the airline. [caption id="attachment_196049" align="aligncenter" width="580"] image: Boeing[/caption] Successful New Product Introduction Customer response to Southwest’s new product has been effective, and Southwest continues to win awards as the leader in customer satisfaction among economy passengers. Southwest’s core competencies are focused on hospitality, reliability, operational execution, and value. New Starlink connectivity is expected to reinforce the economy-class preference. Southwest now charges for baggage, gaining 1-2% in revenue, and advanced seat assignment is driving economy-class business travel on their flights. That also enables Southwest passengers to connect from one flight to another without risking being forced into a poorly located middle seat if the initial connecting flight runs late. With Southwest awaiting the 737 MAX 7 initially scheduled for 2019 and Boeing trying to complete certification paperwork this quarter, the availability of new planes will reduce dependence on the increasingly unreliable 737-700 airplanes in its fleet. Right-sizing equipment to markets is something Southwest has been unable to do without the new aircraft, which are expected to begin deliveries by year-end. Operating cash flow generation of $500 million enabled the carriers to end the quarter with liquidity of $5.3 billion, above their $4 billion target. With the success of the new programs, the company plans to generate stronger cash flow for the full year. Southwest’s investment-grade balance sheet provides a sharp contrast to American. The Bottom Line Southwest is actively demonstrating that a change in strategy can work in the carrier’s favor when well executed within a core culture of customer service. American, in following its competitor strategies for premium traffic, has shown that with a weaker balance sheet, it is more difficult to implement those changes. Southwest has a strong balance sheet and can withstand short-term shocks, such as higher fuel prices. American, with a weaker balance sheet, remains in a more tenuous financial position and needs to focus on two conflicting objectives - investing in product while rebuilding its balance sheet. The latter is a much more difficult task. Of the four major airlines, Delta, United, and Southwest appear well positioned for the future, while American has a long road to recovery. If one is to be sunny-side up, American has the greatest potential for growth, given how far it has fallen.

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