(LUV) Southwest Airlines Analyst Rating Slips to Underperform

We are downgrading our long-term recommendation on Southwest Airlines Co. (LUV) to Underperform owing to feeble macro data points in the entire airline industry and the company’s weak outlook for the first quarter.

Theentire airline industry is struggling with higher fuel prices and a slow moving U.S. economy. We expect conditions to worsen further over the year, due to the weak outlook for Europe, stemming from its financial problems, which is dragging down the global airline profits to half from the 2010 peak.

In the worst-case scenario of a full-blown Euro-zone crisis, Europe will likely drag the U.S. into a recession, pulling down growth in China and other emerging economies. Ensuing losses in the global airline industry would then be massive, perhaps the worst since the 2008 financial crisis.

Coming to Southwest, it expects fuel costs of about $3.50 per gallon for the first quarter. This is higher than its previous expectation of $3.35 per gallon. In addition, the company saw weaker-than-expected passenger revenue per available seat miles growth of 4% in February compared with 7% in January. This represents the smallest increase since last July.

As a result, Southwest is not expected to report profits in the first quarter. The Zacks Consensus estimates a loss of 3 cents for the first quarter, representing a substantial 215.15% decline on an annual basis.

Although Southwest is poised to benefit from fleet rightsizing, the Evolve retrofit program, steady capacity growth, All-New Rapid Rewards, AirTran merger synergies and several ancillary revenues, we are mainly concerned about high maintenance and operating costs associated with fleet rightsizing and modernization. Additionally, the successful integration of AirTran would result in a one-time charge of $500 million, of which $134 million was expended last year.

Further, coupled with surging fuel prices, Southwest also expects non-fuel costs to grow modestly this year primarily due to higher salaries, wages and benefits, maintenance and airport costs.

Moreover, new advertising rules and stiff competition from United Continental Holdings Inc. (UAL) and Delta Air Lines Inc. (DAL) keep us cautious on the stock. Besides, Southwest is dependent on Boeing Co. (BA) as its sole supplier for aircraft. If Southwest is unable to acquire additional aircraft from Boeing or if the latter is unable to provide adequate support, the company’s profitability will inevitably be hampered.

The largest U.S. low-cost carrier also launches fare sales from time-to-time, with discounted ticket prices in order to boost sales. These actions, however, hurt overall revenues.

Consequently, the stock also holds a short-term Strong Sell rating with the Zacks # 5 Rank.

DELTA AIR LINES (DAL): Free Stock Analysis Report

SOUTHWEST AIR (LUV): Free Stock Analysis Report

UNITED CONT HLD (UAL): Free Stock Analysis Report

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