Southwest Airlines

Southwest reported second-quarter results very close to our expectations overall, earning $285 million in operating profit on $8.4 billion in revenue. As in last quarter, its new seating and pricing plan resulted in more empty seats but higher revenue per seat than we had foreseen.

Why it matters: Southwest's revamped seating and pricing offerings seem successful so far, and the company is still refining and experimenting with its new pricing mechanisms. The quarter's dramatic fuel price spike that rattled the airline industry does not seem to have shaken consumer demand for travel, even at higher ticket prices. While we see a lot of moving parts in Southwest's new merchandising initiatives and the volatile macroeconomic environment, the primary effect of these changes that we have incorporated into our forecast is an increase in Southwest's revenue per passenger seat mile.

The bottom line: Based on persistent travel demand, we forecast higher yields for no-moat Southwest, resulting in a slight increase to our fair value estimate, along with the time value of money since our last update, to $35.20 per share from $32.70.

Bulls say: The shares trade almost 27% above our revised fair value, which we interpret as investors anticipating Southwest's new recipe may boost its yield indefinitely. Our view is that competition will eventually erode yield closer to industry averages and drag industry profitability with it.

Our fair value estimate is $35.20 per share, representing an enterprise value of 4.8 times our 2026 EBITDA estimate and 11 times our 2026 GAAP earnings estimate. In January 2026, the airline introduced seats with extra legroom and started assigning seats with ticket purchases and pricing them based on their desirability in the cabin. In late 2025, it also introduced a basic economy ticket, which will not include its customary allowance for two checked bags, thus matching the industry standard for bargain air travel. We believe that matching industry practice will restore Southwest's ability to compete with its full-service rivals as well as other no-frills carriers using its distinct route network.

Over the near term, we still expect strong domestic leisure travel and strengthening business travel as workers return to offices. We anticipate Southwest's load factors will eventually return from recent lows below 80% to historic norms closer to 83%, and its passenger revenue yields are likely to approach $0.20 per mile as its pricing segmentation takes effect.

Our operating margin forecast averages 8.4%, compared with the 2015-19 average of 16.4%. We no longer see evidence that pandemic-related restructuring has generated labor efficiencies at Southwest. We observe airlines adding unit costs as they rehire necessary crew and renegotiate labor agreements. We forecast 4 more cents in structural costs per available seat mile in Southwest's midterm future than it experienced in 2015-19, which is largely a reflection of the simple reality that Southwest's unit costs more closely resemble those of a "normal" airline than they did a decade ago.

We expect capital expenditures around $3 billion in 2026, as Southwest is awaiting delivery of dozens of 737 MAX aircraft during the year, and average around $3.0 billion per year over our explicit forecast period (compared with the 2015-19 average of $1.8 billion), though the airline has announced plans to offset some of these outlays with opportunistic sales of its existing jets and even new ones from its Boeing order book.

We think Southwest deserves a cost of equity on par with the best US-based airline peers, and a lower cost of debt given its conservative balance sheet. Southwest continues to fund its business with more equity than debt, which results in an 8.2% weighted average cost of capital.

We assign Southwest Airlines a Morningstar Economic Moat Rating of none.

Airlines rent seats by the hour on aircraft that fly for decades, their operations and financial results subject to fluctuations beyond their control including volatile fuel costs, growth in labor costs, weather, seasonal variation in travel demand, and ticket prices in most markets. The airline business remains price-competitive, capital-intensive, and labor-intensive, all of which make it difficult for an airline to generate any profit beyond its cost of capital. IATA, an industry group, published estimates in 2020 and 2026 that return on invested capital had only approached the industry's cost of capital once in 30 years, never exceeding it. Our own modeling reflects the same reality for Southwest: over the last decade it showed volatile annual ROICs ranging from 25% to negative 29%, averaging 8.5%, consistent with our 8.2% cost of capital estimate and our midcycle forecast.

What's more, the industry was pummeled by severe macroeconomic shocks over the last two decades: Sept. 11, 2001, two global pandemics (SARS and covid-19), and the global financial crisis. Airlines experienced drastic and systemic disruptions to their operations, staffing, and financial viability, resulting in much higher leverage and many bankruptcies. Similar shocks are likely to recur at any time, which no airline can defend itself from, leaving investors persistently at risk of permanent capital loss.

Although the amount of fuel needed to power every flight is known to the gallon by weight at takeoff, the price the airline will pay for it can vary widely over a week, seasonally, and regionally. Most important about fuel prices is that each airline experiences them in more or less the same way: they are a commodity. Most of the time, airlines can pass this cost on to customers by charging more per mile when fuel prices are high. Over the long term, airline CPI, a component of consumer CPI, has been remarkably stable (notwithstanding bumps since 2022 that reflected transitory spikes in fuel prices), implying that aggregate airline fares operate similarly to a commodity, as well.

Major US carriers have partnered with a credit card issuing bank to promote loyalty programs that feature their frequent flyer points. For some, these programs, in which the bank pays the airline more for the points up front than they are technically worth to redeem, represent the lion's share of ongoing operating profit. We do not see these programs as changing the competitive dynamics or structural profitability of the airline. Rather, the airlines have time-shifted when they experience any profit from serving a loyal segment of customers, in many cases redeeming points for perks such as premium seating and lounge access that add incremental cost to provide and maintain.

Through persistent price competition, basic advertised airfares now only include transportation for a passenger (and a small personal item) in an unassigned seat. Labor and other cost inflation have narrowed the historical gap in structural unit costs between discount and full-service carriers. Instead, by charging higher fares to include baggage allowance, seat assignments, and a widening array of other perks, and by exchanging them for collected loyalty points, airlines have tried to establish switching costs among certain segments of their customers. If they represented a large enough and loyal enough portion of customers to deliver economic profits to an airline over an entire cycle, we might ascribe it a narrow moat, though we suspect that industry fundamentals and price competition will outweigh segmentation through the next downturn.

The most-costly competition airlines engage in is for aircraft. Every other decade or so, Boeing and Airbus offer new models powered by new engines that can fly farther, carry more passengers, and consume less fuel. We observe a steady increase in available seat miles (ASMs) flown per gallon of fuel consumed across all airlines, as they consistently upgrade their fleets. Delta, United, and American were able to fly an average airplane seat about 60 miles on a gallon of fuel in 2012 and approached 70 in 2023. Southwest went from 70 ASMs per gallon a decade ago to over 80 in 2023. Southwest has a mileage advantage versus the Big Three because it flies only variants of the narrow-body 737 on point-to-point routes, while the others fly hub-and-spoke routes with regional and wide-body jets that burn more fuel per seat mile. The structural unit cost (cents per ASM) advantage Southwest enjoyed versus legacy carriers in the 2000s has all but eroded while budget leisure airlines like Spirit, Frontier, and Allegiant emerged with even-lower unit costs than Southwest’s. The mileage trend reflects improvements in engine efficiency, wing design, and fuselage materials, and it represents a competitive ratchet that no airline can afford to ignore: multiplied over many hundreds of millions of seat miles per year, even a small difference in fleet efficiency would represent a structural disadvantage for an airline competing on similar routes. Thus, airlines constantly refresh their fleet to stay competitive (new seats, bigger luggage trays, and the like are a side benefit of new planes that also may augment an airline's brand perception for a short time).

Airlines provide invaluable service to their customers and communities, often stimulating the economies of those destinations they connect to the global travel network. However, investors in airlines are literally flying on a wing and a prayer, as we see no prospect for durable economic profit in this industry. Instead, we observe that the duopoly airframe suppliers Airbus and Boeing and the oligopoly engine manufacturers GE, Safran, Pratt & Whitney, MTU, and Rolls-Royce reap the economic reward from providing successively more efficient, powerful aircraft that airlines line up to buy or rent so their service and cost profile can keep up with competing carriers.

Southwest is adapting to customer preferences for premium seats, which could increase revenue yield and profitability, which has suffered for the airline recently.

Southwest's lean operating model and discipline leave it with the cleanest airline balance sheet in North America, lowering its risk profile for equity investors.

Southwest’s (belated) investments in yield management and operational technology should allow it to attract new customers through bulk ticketing agencies and mitigate future scheduling disruptions from weather.

As the largest passenger carrier in the US, Southwest faces competition from legacy carriers as well as lower-cost airlines.

Southwest's growth plans have been hampered by Boeing's delayed deliveries of 737s, leaving the airline with more staff on payroll than it really needs.

Southwest's plan to assign seats and offer extra legroom in the cabin may expose it to more direct price competition on some routes, as its offering will more closely resemble other airlines.