To Hedge or Not to Hedge

03/10/2009 1:00 pm EST

Focus: STOCKS

Vahan Janjigian

Editor, Bottom Line's Money Masters Stock Report

Vahan Janjigian, editor of Forbes Growth Investor, explains how Southwest Airlines successfully hedged against higher fuel costs, then got caught when oil prices fell.

Southwest Airlines (NYSE: LUV) is a low-cost carrier serving 64 cities across the US. It keeps costs down by employing a point-to-point strategy, meaning flights are usually booked as direct nonstop routes, as opposed to the hub-and-spoke model, which typically includes at least one stop.

The point-to-point model tends to result in fewer delays, faster trips, and reduced fuel consumption. Furthermore, because LUV relies on only one kind of aircraft (the Boeing 737), it can keep maintenance and training costs low.

The company benefited from prudent fuel hedges in recent years. Hedges were critical to the company’s financial health in 2008, when crude oil prices soared to almost $150 per barrel. Even though they saved LUV $1.1 billion in 2008, fuel costs still rose to $3.7 billion or 35% of operating expenses.

Many of LUV’s competitors were not as fortunate with their hedging programs. Soaring fuel costs crushed profit margins for many airlines. Some resorted to charging fees for standard services. Some added fuel surcharges to ticket prices. By maintaining complimentary services, LUV succeeded in differentiating itself from the competition.

Fourth-quarter net revenues grew 9.7% year over year to $2.73 billion. Operating revenue per available seat mile climbed 8.8%. However, fuel hedges backfired. Because it was hedged, LUV was unable to fully benefit from the sudden decline in energy prices.

Total fuel and oil costs increased 23.4% in the fourth quarter to $918 million. The cost would have been $870 million if LUV was not hedged. Operating income declined 44.4% to $70 million. LUV also had $117 million in noncash mark-to-market charges related to its derivatives portfolio. Pro forma net income was $61 million, or eight cents per share. Net loss on a GAAP basis was $56 million, or 56 cents per share.

[Ironically,] the decline in energy prices is benefiting competitors that did not rely as much on hedges. It is giving them greater flexibility in pricing fares and providing complimentary services. LUV has reduced fuel hedges to just 10% of expected consumption through 2013. Management expects 2009 fuel costs to be $1 billion less than it had projected a year ago.

The cost of fuel is one investment concern, but the recession represents a greater risk. Revenue passenger miles declined 6.4% in January from a year earlier, to 5.1 billion miles. Available seat miles declined 4.4% to 8.2 billion. The load factor fell 140 basis points to 62.8%. Deteriorating demand could lead to intensifying price competition.

Thanks to its low-cost structure, LUV should come out a winner. While profits may be pressured, the company should be able to increase market share. LUV already plans to expand service to Minneapolis-St. Paul this month [and] to initiate service to Boston this fall. Furthermore, LUV made a bid for 14 slots in New York’s LaGuardia Airport, [which] could close as early as this month.

(The stock closed above $5 Monday—Editor.)

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