Southwest Airlines: Losing Its Fuel Hedge Competitive Advantages

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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;
2010 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 jonogg@247wallst.com; he does not own securities in the companies he covers.