Southwest Airlines’ & Fuel Hedging Assignment

Southwest Airlines’ & Fuel Hedging Assignment Words: 3395

A “Hedge” of the Pack: A Review of Southwest Airlines Innovative Fuel Strategy While many airlines suffer from rising fuel costs, Southwest Airlines continues to emerge victorious in the aeronautical landscape. Other carriers now forced to increase prices to compensate for fuel costs, are now subject to the new mindsets of consumers who are opting for longer bus and car rides, or simply not traveling at all. The woes of the airlines industry have many posing the question if airline travel is fast becoming a travel method for the affluent (Stoller, 2008).

In the midst of the situation, Southwest Airlines is able to capitalize on rising costs and maintain its low-price position because of an innovative fuel acquisition strategy known as fuel hedging (Pae, 2008). The following activities will be reviewed in this document as an analysis of this organization. The activities to be addressed are: 1. Organizational History of Southwest Airlines 2. Overview of the Airlines Industry 3. SWOTT (Strengths, Weaknesses, Opportunities, Threats and Trends) Analysis of Southwest Airlines 4. An Analysis of the Impact of varied economic concepts on the CPI 5.

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An Analysis of varied Economic Indicators This document focuses on the impact of a volatile environment of consumer demand has impacted this organization, and how its “hedging” strategy has allowed it to maintain its competitive advantage in an ever-changing economic climate. Organizational History of Southwest Airlines Southwest Airlines is an organization that has remained true to its operational roots, and continues to expand and to offer a product as well as service that its passengers can consistently depend on. Southwest Airlines was started in 1966 as Air Southwest Co in Texas.

Since its inception, its company philosophy and perspective has been “dedication to the highest quality of Customer Service delivered with a sense of warmth, friendliness, individual pride, and Company Spirit. ” The company has undergone few changes in leadership and operations, occurrences which have allowed it remain competitive and comparable in the airline industry. For the last 30 years of its corporate existence, Southwest Airlines, also known as “Southwest” or “SWA”, has been a shining example of how low fares and great service culminate in great returns.

The company has experienced consistent growth and flies more passengers than any other U. S. airline. At its 30-year operational anniversary, its fleet consisted 417 planes were making 2,900 hops a day to 59 destinations. Revenues continued to increase at a 10 percent, reaching $6. 5 billion in 2004. Even in the post-September 11th environment, when other airlines were fearing shutdowns due to decreased consumer demand and travel fears worldwide, Southwest reported earnings of $313 million???a handsome number compared to other airlines at that time.

One secret to the success of Southwest is their consistency. In terms of their equipment, Southwest only flies only Boeing 737s, to simplify maintenance and training. In terms of their product, this means low fares and distinct travel locales. For these reason, Southwest has long been considered a maverick. As Southwest began doing business in 2005, it faced many familiar challenges: rising oil prices, intense competition, cumbersome regulations.

In the uncertain times that had legacy (traditional) carriers reeling, Southwest was still winging ahead with its ever-popular low-fare formula. One reason for their ability to stay ahead despite the fuel costs that plagued other air carriers is an innovative strategy known as “fuel hedging. ” This strategy is another secret of the success that Southwest enjoys to this very day. Overview of the Airlines Industry The US Airline industry continues to experience growth and to look optimistically towards the future.

A key milestone of the US Airline industry is its deregulation in 1978. While deregulation presented a wealth of opportunity to this industry in the form of expansion for most airlines, it should be noted that even in the 30-year span following deregulation that the U. S. airline industry has never matched the profitability of even the average U. S. corporation (ATA Report, 2007). In its “”FAA Aerospace Forecast Fiscal Years 2008???2025,” the Federal Aviation Administration (FAA) reported on the industry’s 36 mainline air carriers that use large passenger ets (over 90 seats) and 84 regional carriers that use smaller piston, turboprop, and regional jet aircraft (up to 90 seats) to provide connecting passengers to the larger carriers (FAA, FAA Aerospace Forecast Fiscal Years 2008???2025, A Review of 2007), stating that “three distinct trends have occurred over the past several years that have helped shape today’s U. S. commercial air carrier industry: (1) major restructuring and shrinking by the mainline network carriers; (2) rapid growth by low-cost carriers, particularly in nontraditional long-distance transcontinental markets; and (3) exceptional growth among regional carriers. Within the last decade, the industry has fallen on difficult times due to the effects of the September 11, 2001 terrorist attacks, and the extenuating weather circumstances in August 2005, which resulted in the back-to-back onslaught of Hurricanes Katrina and Rita. The effects of these hurricanes in addition to implausible losses of life and property, would soon include reduced fuel production in the gulf, and begin a period of rising fuel costs which affected both consumers and carriers, and now in 2008, as an OPEC production standoff creates an even greater increase in fuel costs.

However, in spite of the volatile environment in which the airlines now operate, the FAA Forecast stated that 2007 was a year of increase. Specifically, it stated that, “U. S. commercial air carriers in 2007 posted modest gains in capacity (the sum of domestic plus international) capacity rose by 2. 6 percent to demand, despite higher fares and growing concerns about the economy. Additionally, and despite continued high fuel prices, the turnaround in airline industry finances continued, with the industry posting a $5. 8 billion net profit in 2007, the first since 2000.

The performance of the network carriers was the most visible demonstration of the financial turnaround. Both Delta and Northwest came out from bankruptcy protection, and after losing $3. 2 billion in 2006, network carriers recorded their first annual net profit since 2000, earning $4. 4 billion in 2007. However continued high fuel prices and concerns about the economy are altering the carrier plans, as carriers have deferred deliveries of new aircraft and trimmed growth plans to sustain profitability. ” (Graphic representation from FAA. gov) In summation, the U. S.

Airlines industry isn’t the strongest, but it continues to evolve and to grow even though the conditions of the global marketplace pose numerous challenges on a continuous basis. Increasing fuel prices have taken their indubitable toll on the airlines; however, the US airline industry seems to make changes when necessary and can be counted on to demonstrate economic gains- even if they are minimal. SWOTT (Strengths, Weaknesses, Opportunities, Threats and Trends) Analysis of Southwest Airlines Southwest Airlines is the pioneer of the low-cost business model, but high oil prices are a growing threat.

Southwest is a low-cost leader of the airline industry because it uses assets more efficiently than competitors and employs a highly productive workforce. Excluding fuel costs and adjusting for the average length of flights, Southwest’s cost per available seat mile is one of the lowest in the industry, second only to AirTran (Morning Star Analysts, 2008). Southwest’s culture emphasizes thrift, and all employees are rewarded for cost-reduction efforts in the form of potential stock appreciation and profit sharing.

At the same time, Southwest has rationalized its workforce by consolidating its back office and offering early retirement plans to qualified employees. The result: The number of employees per aircraft is below 70, one of the lowest in the industry. Southwest is also known for its streamlined gate procedures, which allow employees to turn around planes faster and fly aircraft more often per day than the competition. Southwest offers frequent, short-haul flights to less-crowded airports, enabling the airline to save on airport fees and avoid congestion that would otherwise slow down its operations.

Southwest saves on pilot training and maintenance costs by using just one aircraft type, the Boeing 737. The company has extensively invested in technology across the spectrum to streamline its operations, from revenue management to maintenance procedures. Though the firm possesses several cost advantages over its competitors, all airlines are feeling the pinch from escalating fuel prices. Crude oil now tops more than $100 per barrel, and Southwest’s fuel costs are fast approaching labor as the largest expense item. Yet, the firm has difficulty in passing along much more than 50% of every unit increase in fuel prices ince rapid price increases would snuff out demand in the fragile domestic economy. The low-cost carrier business model is particularly vulnerable to higher oil prices since it depends on expanding the airline by stimulating demand with low fares that attract customers who could not otherwise afford to travel by plane. The price elasticity of demand for air travel is high, and the low-cost airlines are particularly at risk of destroying demand if they raise prices too much. For the time being, Southwest is better protected due to its below market fuel hedges.

During 2008 alone, the firm has 70% of its fuel requirements hedged at around $50 per barrel. However, as these hedges expire, Southwest’s cost structure will converge with its competitors. Strengths- The strengths of Southwest Airline is obvious because she can boasts to be one of the lowest unit cost structures in the industry along with the most productive workforce. The majority of growth over the past several years has been internally financed. This conservative approach gives the company a strong financial position to weather industry downturns. Southwest benefits from fuel hedges that diminish its exposure to volatile oil prices.

The airline has more than 70% of its fuel needs hedged at a price of $50 per barrel in 2008, 55% hedged at $51 in 2009, 30% at $63 in 2010, and 15% at $64 in 2011, based on expected capacity. Southwest has a nearly $3 billion war chest and hundreds of millions in available credit lines. A war of attrition waged by other low-cost carriers, which are leveraged to the hilt, would lead to their own demise (Corridore, J. et al. , 2008). Weaknesses-Weaknesses will be obvious should profit-sharing and stock compensation growth stall, employees might use their union muscle to demand higher wage increases and diminish Southwest’s cost advantage.

The growth of other legitimate low-cost carriers is making it harder for Southwest to pluck attractive routes from the hub-and-spoke carriers, thereby making profitable growth a greater challenge. As the average tenure of employees at Southwest has grown, labor costs per available seat mile have risen, and eventually productivity improvements may not keep pace. Opportunities- Southwest Airlines plans to expand to new cities when economically feasible, while adding flights in existing cities when gates become available. The company focuses on markets where it can maintain its low-cost structure hile undercutting higher-fare competitors. The airline is also readying itself to offer international flights, which will probably focus on leisure routes proximate to the U. S. mainland. Threats- Despite fuel hedges, oil prices remain a wild card that could hurt the airline’s bottom line. Southwest is exposed to cyclical risk in the economy, since air travel is highly correlated to economic conditions. Eventually, the quest for growth (as demanded by many investors) may necessitate head-to-head battles between the best low-cost carriers: Southwest, JetBlue, and AirTran. Such a clash of titans could result in devastating price wars.

Trends- In examining Southwest’s financial trends, one finds that over the five years through 2007, Southwest Airline exhibited a compound annual growth rate (CAGR) for revenues of about 10. 7%, while net income grew at a CAGR of about 7. 9%. Despite the growth in net income over the past five years, net income in 2007 of $645 million was less than the company recorded in 2001. This reflects, the industry downturn that took place after the terrorist attacks of 9/11, which hurt average airfares and operating margins, while higher debt levels and fuel costs led to lower net income.

However, the airline has outperformed the rest of the industry in profitability, and has maintained balance sheet health. The company’s debt to total capitalization ratio stood at 17. 8% as of the end of 2007, which reflects a highly conservative capital structure. Even including the present value of operating leases, it is believe that the company’s adjusted debt-to-cap ratio is about 42% (Corridore, J. et al. , 2008).. An Analysis of the Impact of varied economic concepts on the CPI The airline sub-industry fundamental outlook was recently reduced to negative, from neutral.

The reason for this is as a result of worried about the impact of high oil prices, which continue to make new highs. Capacity cuts in the industry are likely to drive fare increases, but this may not be enough to offset rising jet fuel costs. A continued weakening of the U. S. economy into 2009 could start to hurt air travel demand, though bookings through the summer of 2008 still remain strong (Southwest Airlines 2007 Annual Report, 2008).. The high oil prices are likely to drive an industry-wide loss in 2008, despite major cost and revenue progress over the past few years.

Many of the shares warrant an added risk premium, in the analysts view. It is forecast that the top 10 U. S. carriers earned about $3. 1 billion in 2007, following a $7. 6 billion loss in 2006 (including bankruptcy-related reorganization charges at Northwest and Delta). Excluding reorganization items, analysts estimate that the 10 largest carriers earned $1. 3 billion in 2006. For 2008, there exists a loss of $5. 0 billion, largely due to higher jet fuel costs. Airlines are continuing to attempt to raise fares, aided by what is seen as rational domestic supply.

However, a weakening economy could make further price increases difficult. Total revenue passenger miles (RPMs) increased 1. 8% in 2007 to 665. 2 billion, after rising 1. 3% in 2006, 5. 2% in 2005 and 10. 4% in 2004. This is now well above the RPM levels attained in 2000, the last year of relative airline industry health, although yields have declined sharply since. Analysts estimate that RPMs will increase about 2% in 2008. UAL Corp. , the parent company of United Airlines, emerged from bankruptcy in February 2006; Delta and Northwest both emerged from bankruptcy in the first half of 2007.

Low-cost carriers have been growing rapidly, a trend that is expected to continue. Year to date through June 30, the S&P Airlines Index fell 12. 8%, versus a 12. 0% drop in the S&P 1500. The airlines index performance would have been even worse excluding Southwest Airlines, which dominates the index. In 2007, the industry index declined 26. 3%, versus a 3. 6% rise for the S&P 1500. At December 31, 2007, Southwest had 34,378 active full-time equivalent Employees, consisting of 13,885 flight, 2,079 maintenance, 13,921 ground, Customer, and fleet service, and 4,493 management, accounting, marketing, and clerical personnel.

Southwest has ten collective bargaining agreements, which covered approximately 82 percent of Southwest’s Employees as of December 31, 2007. Southwest’s relations with labor unions are governed by the Railway Labor Act (the “RLA”), which establishes the right of airline employees to organize and bargain collectively. Under the RLA, a collective bargaining agreement between an airline and a labor union generally does not expire, but instead becomes amendable as of a stated date. During 2007, as part of its efforts to improve future profitability, the Company offered an early retirement program to certain of its Employees.

A total of 608 of approximately 8,500 eligible Employees elected to participate in the program. Also in March 2008, Southwest Airlines grounded 43 planes to carry out inspections that had been neglected by maintenance personnel. The lapse was discovered by the Federal Aviation Administration, which slapped Southwest with a $10. 2 million fine, the largest single fine imposed on an airline. While Southwest is protesting the fine, management finally acted to take the planes in question out of service to perform inspections.

Routine in nature, the inspections will take about 90 minutes each and are not likely to have a lasting effect on operations. However, the revelation is a black eye on Southwest’s usually impeccable safety record. Additionally, the firm has suspended three employees who were implicated in the lapses. Selected Financial Data The following financial information for the five years ended December 31, 2007, has been derived from the Company’s Consolidated Financial Statements: Company Financials Fiscal Year Ended Dec. 31 Per Share Data ($) 2007 2006 2005 2004 2003 Tangible Book Value 10. 49 8. 23 8. 38 7. 04 6. 40 Cash Flow 1. 56 1. 3 1. 25 0. 91 1. 00 Earnings 0. 84 0. 61 0. 67 0. 38 0. 54 S&P Core Earnings 0. 83 0. 60 0. 62 0. 30 0. 48 Dividends 0. 02 0. 02 0. 02 0. 02 0. 02 Payout Ratio 2% 3% 3% 5% 3% Prices: High 16. 96 18. 20 16. 95 17. 06 19. 69 Prices: Low 12. 12 14. 61 13. 05 12. 88 11. 72 P/E Ratio: High 20 30 25 45 36 P/E Ratio: Low 14 24 19 34 22 Income Statement Analysis (Million $) Revenue 9,861 9,086 7,584 6,530 5,937 Operating Income 1,371 1,449 1,289 985 867 Depreciation 555 515 469 431 384 Interest Expense 119 77. 0 83. 0 49. 0 58. 0 Pretax Income 1,058 790 874 489 708 Effective Tax Rate 39. 0% 36. 8% 37. 3% 36. 0% 37. 6% Net Income 45 499 548 313 442 S&P Core Earnings 635 489 504 236 385 Balance Sheet & Other Financial Data (Million $) Cash 2,779 1,390 2,280 1,305 1,865 Current Assets 4,443 2,601 3,620 2,172 2,313 Total Assets 16,772 13,460 14,218 11,337 9,878 Current Liabilities 4,838 2,887 3,848 2,142 172 Long Term Debt 2,050 1,567 1,394 1,700 1,332 Common Equity 6,941 6,449 6,675 5,524 5,052 Total Capital 11,526 10,120 9,965 8,834 7,804 Capital Expenditures 1,331 1,399 1,210 1,775 1,238 Cash Flow 1,200 1,014 1,017 744 826 Current Ratio 0. 9 0. 9 0. 9 1. 0 13. 4 % Long Term Debt of Cap 17. 8 15. 5 14. 0 19. 2 17. 1 % Net Income of Revenue6. 5. 5 7. 2 4. 8 7. 4 % Return on Assets 4. 3 3. 6 4. 3 3. 0 4. 7 % Return on Equity 9. 6 7. 6 9. 0 5. 9 9. 3 Stock Report | August 2, 2008 | NYS Symbol: LUV Southwest Airlines Co. An Analysis of varied Economic Indicators Capacity Utilization- Southwest Airlines has carried more customers than any other U. S. airline since August 2006 for combined domestic and international passengers according to the U. S. Department of Transportation’s Bureau of Transportation Statistics. Southwest Airlines is one of the world’s most profitable airlines and in January 2008, posted a profit for the 35th consecutive year.

Southwest has shown there selves to be efficient, accident free and affordable. (Wikipedia. org) Interest Rate (discount rates)- Southwest is listed as number one when it comes to discounted rates for there air fare. As most major companies sale their tickets on web sites such as Cheap Tickets. com, Orbitz, and Priceline, Southwest uses there own personal website and still manages to remain the cheaper carrier. A minority of there tickets are sold through travel agents but their web site has a distinct offer feature that no other major airlines have called “web nly” fare discounts. This is where the tickets can be purchased at a price cheaper than southwest is already providing, just for purchasing online. Customers of Southwest are also offered other benefits such as the ability to change reservations with no additional cost, no assigned seating, and a frequent flyers program called “Rapid Rewards” which offers the customer the ability to earn credits off of each flight and once a certain amount is obtained free flights are offered to the customer for there dedication and loyalty to the company. Wikipedia. org) Retail Sales- Southwest currently serves 64 cities in 32 states with more than 3,300 flights a day. Southwest turned its first annual profit in 1973 and has done so every year since. Southwest uses a financial technique called “fuel hedging” to increase the company’s profitability and to counteract many of the fiscal disadvantages of operating an airline. In order to “hedge fuel” the company must purchase fuel options years in advance to smooth out fluctuations in fuel costs.

Southwest felt in order to lock in historical low prices they are able to use a mixture of “swaps” called “options” to secure fuel in future years while paying prices they believe are low at the time of purchase. According to an annual report of 2007 the company’s fuel hedge for forward years was on an “approximate” per barrel basis. Mid-January: 2007 was 95% hedged at $50/barrel; 2008 is 65% hedged at $49/barrel; 2009 is over 50% hedged at $51/barrel; 2010 is over 25% hedged at $63/barrel; 2011 is over 15% hedged at $64/barrel; 2012 is 15% hedged at $63/barrel (Pae, 2008).

It has been speculated that Southwest has been simply speculating on energy prices, without a formal rationale for doing so, but it appears whatever the rationale is there method has enabled this airline to remain successful and continue to earn profit so that they may be able to sale the most tickets at the lowest fares. (Wikipedia. org) In conclusion, Southwest Airlines has benefited greatly from its fuel hedging strategy. The benefits of this strategy have included the ability to maintain its competitive position as a low-cost carrier, and to generate profits while its competitors post a loss.

In the end, it seems that Southwest definitively, as Southwest Chief Executive Gary Kelly says has “We’ve got, I think, the best fuel price protection in the industry. ” References Corridore, J. , Standard & Poor’s Industry Reports, & Independent Analysts (2008), Retrieve August 2, 2008 from http://www. standardandpoors. com Federal Aviation Administration (2007). Aerospace Forecast Fiscal Years 2008???2025, A Review of 2007). Retrieved August 18, 2008 from http://www. faa. gov/data_statistics/aviation/aerospace_forecasts/2008-2025/media/Review%20of%202007. df Independent Analysts and Industry Reports (2008), Morning Star Stock Report. Retrieved August 2, 2008 from http://www. morningstar. com. Pae, P. Southwest Airlines reaps benefits of fuel hedging strategy. (2008, May). Los Angeles Times Southwest Airlines 2007 Annual Report (2008), Southwest Airlines 2007 Annual Report, Retrieve August 2, 2007 from http://www. southwest. com Stoller, G. (2008, August). Will fares go so high that only the rich can fly? Retrieved August 19, 2008 from USAToday. com Wikipedia. org (2008) Southwest Airlines.

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