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Morningstar | Market Shows Southwest LUV After Flying Through Challenging 1Q

We expect to raise our fair value estimate by no more than 2% after hearing details around Southwest’s MAX-related contingency plans and recalibrating our model for a six-month grounding. We previously modeled a three-month MAX suspension, but Boeing’s slow rollout suggests they could easily slip into peak travel months toward a nine-month period. We use six months as our midpoint and adjust supply and demand accordingly. Our changes incorporate limited spare capacity at Southwest and a lack of interline agreements that could relieve capacity shortages. Because first-quarter results suggest Southwest can match supply with demand during this challenging period, we’re mostly keeping our passenger yield assumptions and forecast demand growth within 100 basis points of supply growth. Aircraft supply disruptions are mostly limited to 2019, as we expect Southwest will revert to growth in 2020 with newly launched Hawaii capacity and MAX aircraft returning to service.

During the first quarter, Southwest battled through several challenges, including the U.S. government shutdown, mechanic disputes, and MAX groundings. In total, these developments canceled 10,000 flights. Southwest should see marginal improvements in the coming quarter with a new mechanic’s labor agreement and the government shutdown now resolved. However, we estimate that MAX groundings lasting through August, forcing nearly a dozen expected MAX deliveries out of service, could bring total MAX cancellations closer to 20,000 for the full year and cost about $500 million.

Top-line revenue rose 4% over the March quarter last year, while margins slipped on discount campaigns over the last three months. We still model incrementally higher margins over 2018 (70 basis points higher) thanks to expectedly lower fuel costs. That said, our assumptions are lowered by mechanic disruptions that drove maintenance costs 14% above the same quarter last year and added $42 million in labor costs.

We chose to marginally increase our fair value because of Southwest's ability to compensate for MAX disruptions during the first quarter. We remain confident in our long-term forecasts that capture benefits from adding larger and more fuel-efficient planes but by also expanding into higher-revenue markets. MAX groundings will pause cost savings, but nearly a dozen deliveries at the tail end of 2019 and another 38 in 2020 will ultimately help drive operating margin expansion toward 16% in the middle of our Stage I period.