Here's What Makes Southwest a Buy

Not surprisingly, discount-carrier Southwest Airlines' (NYS: LUV) first-quarter profits were in the red. Weeks before the announcement, the company predicted an unprofitable quarter because of rising fuel costs.

Even so, the company's shares surged as much as 4% after the results were announced, as its losses turned out to be lower than Street expectations. Let's take a closer look at what worked and what didn't for Southwest during the quarter.

Quick round-up of the quarter
Southwest earned $4 billion in revenue, an impressive 29% surge compared with the same period last year. This was mainly due to the dual effect of increased passenger revenue and synergies derived out of its AirTran acquisition.

On the flip side, however, the company posted a loss of $18 million, or $0.02 per share, after adjusting for special items, as fuel prices continued to bite into profits. Analysts had expected the company to lose $0.05 per share.

The AirTran trump card
AirTran, an airline company that Southwest acquired last May, enabled the latter to earn $40 million in net pre-tax synergies during the quarter. The acquisition has also resulted in the addition of prime hubs such as Atlanta -- whose airport is the busiest in the world by passenger traffic -- to Southwest's network portfolio.

But that's not all. AirTran's slightly different business model is also working well for this discount-carrier. Unlike Southwest, AirTran levies extra charges on its customers for services such as baggage fees, change fees, cancellation fees, and phone-booking facilities. In fact, during the first three quarters of the previous year, Air Tran collected $166.6 million from baggage and change fees alone. And Southwest plans to retain these charges in the near future, as it knows this will add to its revenue.

More passengers + price increases = higher revenue
Passenger revenue has been gradually improving as the company raises prices to combat high fuel costs. In fact, last year, Southwest increased its fares as many as 10 times. Average passenger fare improved by 5% during the quarter, with the help of better passenger traffic and higher charges.

Pricey liquid
However, this surge in passenger fare looks weak when compared with a 17% rise in fuel prices per gallon during the quarter. A $472 million increase in jet-fuel costs during the quarter translated into an alarming 45.5% growth in such costs last year.

With spiking jet-fuel costs continuing to be an industrywide concern, different airline companies are adopting customized strategies to combat these costs, and Southwest is no exception. The company has outlined massive plans to incorporate fuel-efficient aircraft made by Boeing (NYS: BA) . Southwest has already taken delivery of bigger 737 aircraft during the quarter and is awaiting the fuel-efficient 737 MAX, which will come to the market by 2017. Further, it expects delivery of 33 737-800 jets this year.

The competition is also developing unique ways to counter this problem. Industry peer United Continental Airlines (NYS: UAL) faces the same rising fuel costs and is cutting capacity to be able to demand higher fares. And Delta Air Lines (NYS: DAL) is even going to the extent of buying an entire oil refinery to curb fuel costs.

The Foolish takeaway
The airline industry is very competitive, and margins are slim. At the same time, fuel costs remain its biggest headache, which Southwest plans to counter by acquiring more fuel-efficient aircraft. Investors, however, also need to keep a close watch on its competitors and their strategies for cutting down on costs.

Airlines have struggled to turn profits consistently, but other industries have thrived even during economic downturns. One particular example is highlighted in our free report, "The Motley Fool's Top Stock for 2012." The report features a company that's revolutionizing commerce in Latin America, and you can get instant access to the name by downloading the report here.

At the time thisarticle was published Fool contributor Navjot Kaur owns no shares of any of the companies mentioned in this article.Motley Fool newsletter serviceshave recommended buying shares of Southwest Airlines. The Motley Fool has adisclosure policy. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

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