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Morningstar | Southwest Remains in Holding Pattern With Hawaiian Expansion, but 2019 Guidance Is Encouraging. See Updated Analyst Note from 25 Jan 2019

Our $59 fair value estimate and no-moat rating are unchanged after Southwest reported fourth-quarter results. The market reacted positively to the carrier's updated unit revenue growth guidance for the first quarter of 2019, which calls for at least 4% growth versus 2018. Management also clarified unit cost inflation estimates for the first three months of 2019, placing these at 3% year over year. We raised our expectations for available seat mile growth, but our model still falls short of the 5% ASM growth management expects during 2019. Our long-term thesis remains in place, but we think the second half of 2019 remains important since it will prove whether the carrier can bring unit cost growth in line with inflation while also meeting capacity targets, including 2.5% growth from its Hawaii routes.

Management plans to reach its lofty first-quarter unit revenue growth target via its new revenue management system, schedule optimization thanks to Boeing 737-700s retirements, and robust booking yields. We expect full-year 2019 yields will rise 2% versus flattish yield evolution during 2018 due to fleet enhancement initiatives and new routes to Hawaiian markets, which traditionally produce yields above domestic routes with similar stage lengths. In subsequent years, we model yields flat to down mostly due to slowing travel demand and oil price weakness, which usually gives way to declining fares.

While management didn’t step back from its forecast calling for 3% unit cost growth excluding fuel, or CASM-ex, it did specify that 2019 cost growth would be driven by one-time startup costs and fleet underutilization, which are both derivatives of its Hawaiian expansion. Our model shows 3% CASM-ex in 2019, but we assume costs will fall slightly in each successive year of our forecast thanks in large part to softer oil costs. Pairing this evolution in costs with our unit revenue forecast, we expect operating margins will settle around 15% by our 2023 midcycle year.

Although the government shutdown has delayed Southwest’s Hawaiian expansion efforts, the carrier has a few hurdles (for example, gaining ETOPS certification for its narrow body 737s) to clear once the FAA is fully operational again. At the latest, Southwest plans to begin flying in the second quarter, assuming the shutdown is resolved, and tests are held in the coming months. We raised our capacity growth for 2019 to about 4.5% from 4%, after management mentioned that its Hawaii flights would contribute two and a half points of its total 5% capacity expansion in 2019, without much leakage into 2020.