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Will Southwest Airlines’ Margin Continue to Contract in 2017?

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1Q17 performance

Southwest Airlines (LUV) reported a significant earnings decline for the first quarter of 2017 though it continued to maintain its position as one of America’s most profitable airlines. For 1Q17, Southwest’s EBITDA fell 23.3% year-over-year (or YoY) to $998 million, while earnings per share fell by a significant 30% to $0.61.

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Non-fuel costs rise

Southwest ratified its pilot contract at the end of 2016, which has resulted in huge expenses for the quarter. Cost per available seat mile excluding fuel and profit sharing expenses (or CASM ex-fuel) has risen 4.5% YoY to nine cents, which led to operating expenses increasing by almost 11.3% YoY.

Fuel costs rise too

As Southwest had significant fuel hedging losses in 1Q16, the company’s fuel cost rise wasn’t as pronounced as it has been for other airlines. Southwest’s fuel cost has risen 10.1% YoY to $1.96 per gallon.

As a result, EBITDA margin fell to 20.4% as compared to 27% in 1Q16. Net margin also fell to 7.6% as compared to 11.7% in 1Q16.

Expectations

Southwest Airlines expects CASM ex-fuel to rise 6% YoY in 2Q17. For the full year 2017, CASM ex-fuel is expected to rise 3% YoY.

However, investors should keep in mind that these are short-term troubles. Most of the effect from labor cost increases will be over by the end of 2017, and Southwest Airlines can then return its focus to improving margins in 2018.

Southwest’s peers JetBlue Airways (JBLU), American Airlines (AAL), United Continental (UAL), and Delta Airlines (DAL) are facing similar problems of rising fuel and labor costs.

Investors can gain exposure to Southwest Airlines by investing in the Dynamic Leisure & Entertainment Portfolio (PEJ), which holds 4.5% of its portfolio in the stock.

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