Southwest Airlines reports a profit

While other airlines are losing money, Southwest Airlines Co. yesterday reported a $321 million second-quarter profit, beating Wall Street expectations, largely by hedging fuel costs.

But even Southwest is feeling the pinch of surging fuel prices and said it would trim back growth and raise fares.

Philadelphia's second-largest airline, which transports 12 percent of passengers here and has 71 daily nonstop departures, said it spent 35.2 percent more on fuel in the latest quarter, compared with a year earlier.

But chairman and CEO Gary C. Kelly said he was concerned about a "boiling cauldron of issues" facing the industry: a weak economy, soaring operating costs, huge jet-fuel price increases, and higher fares dampening passenger demand.

Southwest's revenues were up 11.1 percent to $2.9 billion in the quarter ended June 30. The Dallas-based carrier earned $321 million, or 44 cents a share, up 15.5 percent from a year ago, when it earned $278 million, or 36 cents a share.

Excluding special items, Southwest said it would have earned $121 million, or 16 cents a share. That compares with earnings of $195 million, or 25 cents per share, on revenue of $2.6 billion a year ago. Analysts polled by Thomson Reuters had expected 12 cents a share.

How has Southwest maintained profitability while other airlines bleed red ink?

Since the 1990s, Southwest has hedged against rising fuel prices, using complicated financial strategies, such as buying "call options." Southwest's hedging program generated $511 million in cash in the second quarter. The value of such contracts through 2012 is about $4.3 billion.

Southwest has hedged 80 percent of its third-quarter fuel at the crude oil equivalent of $61 per barrel, 80 percent of its fourth-quarter fuel at $58 a barrel, and 70 percent of its 2009 fuel at $66 a barrel.

By 2012 Southwest's hedges will decline to cover only 20 percent of its fuel. Airlines pay expensive premiums to hedge.

"As fuel continues to rise in price, it gets harder to lock into hedges," Southwest spokeswoman Brandy King said.

"We've locked in a certain percentage for now. We could potentially increase our hedges as we move closer to those dates."

Southwest will grow no more than 4 percent in 2008 and may not grow at all next year, Kelly said. From July through the end of the year "our flying is essentially flat," he said.

"We've had no choice but to push through fare increases, four since April," Kelly said on a conference call. "Over the next 18 months we're going to do everything we can to get our average fares up substantially."

He said Southwest will not nickel and dime customers with fees. Southwest does not charge for checking a first or second bag, soft drinks, curbside check-in, buying a ticket over the telephone, or changing a reservation.

Southwest is looking for other ways to increase revenues and recently announced a code-share agreement with Canadian airline WestJet to begin international flights. Kelly said he hopes to announce code-share flight deals to Hawaii, Mexico and the Caribbean next year.

According to Fitch Ratings, Southwest by virtue of its strong balance sheet "has ensured its position as the 'last airline standing' in any far-reaching industry shake-out linked to a prolonged and extreme fuel shock scenario."

Southwest's strong financial position is primarily because of its fuel hedges. Other airlines hedge some fuel, but do not have the cash or creditworthiness to hedge more. After the 2001 terror attacks, airlines suffered big losses, and several filed for bankruptcy protection.

Southwest - with a lower fare structure, point-to-point flying instead of a hub-and-spoke system, and higher labor productivity - stayed profitable after 2001 and hedged when oil was cheap.

Southwest is the only U.S. airline with an investment-grade credit rating. It ended the June quarter with $5.8 billion in cash and short-term investments, $2.7 billion more than at the end of March.

Southwest shares closed down 98 cents, or 6 percent, to $14.90.