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Morningstar | Southwest Reveals Impact of 1Q Cancellations; Lowering FVE Slightly

We are planning to lower our fair value estimate for Southwest by about 2% after it revealed the impact of several first-quarter headwinds. We expect Southwest’s challenges will spill into subsequent quarters and alter the carrier's approach to the rest of 2019. Southwest previously said that the government shutdown took $60 million off its top line for the first quarter of 2019. Management said it expects another $150 million impact to revenue this quarter because of a mechanics dispute, MAX groundings, and, to our surprise, soft demand on leisure routes. We lowered 2019 capacity, demand, and unit revenue growth in our model after absorbing the full scale of Southwest’s first-quarter impediments. We also include higher CASM-ex (costs per available seat mile excluding fuel, profit sharing, and special items) on management’s new first-quarter cost guidance, which is 3% above its guidance at the end of 2018.

Southwest’s last update projected first-quarter CASM-ex inflation 6% higher than last year, with most cost inflation front-half loaded before flattening in the second half of 2019. On management’s revised CASM-ex growth for the first quarter (10%), we raised our 2019 CASM-ex forecast slightly above the top end of management’s previous guidance of 3% to 3.5%. We expect lower full-year capacity growth (3% versus 3.7%) will drive unit costs higher, but not unit revenue. Southwest lowered its expectations for first-quarter RASM, or revenue per available seat miles, by 1 percentage point to 2%-3% on mechanic-induced flight cancellations and softness in leisure-oriented passenger demand. RASM growth averages 1.6% in 2019 in our model, above Southwest’s flattish growth in 2018. That said, we don’t expect Southwest will match last year’s RASM growth between the second and fourth quarter. Unless the MAX aircraft return to operation quickly, discounts may be used to encourage growth later in the year.

We believe capacity growth will finish above 3.5% for the last three quarters of 2019, unchanged from our last model, as Southwest attempts to soak up elevated spending from early 2019. We also expect the carrier will look to defend its market share in key leisure markets where competitors fly narrow bodies unaffected by FAA groundings. Southwest’s current issues shouldn’t affect its newly launched Hawaiian routes, but if the carrier elects to siphon seats from those markets, we have higher confidence full year capacity growth will fall further away from 5% and its Hawaii expansion will make up most of its growth in 2019 rather than half.

We believe domestic U.S. MAX groundings could last 1.5 to 3 months due to the time required to roll out a fix on the MCAS software, certify the aircraft, and train pilots. In this scenario, we think May or June MAX reactivations could offset benefits from Easter and Spring break seasons and dampen RASM benefits for the second quarter. This makes the third quarter and fourth quarter holiday seasons important to whether Southwest meets its 2019 targets. Separately, we were somewhat surprised to hear soft leisure demand surfaced in the first quarter since January results and commentary suggested demand was still robust. If in fact leisure demand is weakening, Southwest unit revenues and load factors could slide more than we initially expected and add to the carrier’s challenges in the coming quarters.