We are downgrading our recommendation on Southwest Airlines (LUV) to Underperform as the company is not expected to report profits in the first quarter this year. The company reported lower year-over-year earnings in the fourth quarter but outpaced the Zacks Consensus Estimate.
Although Southwest is poised to benefit from fleet rightsizing, its Evolve retrofit program, steady capacity growth, All-New Rapid Rewards, AirTran merger synergies and several ancillary revenues, fuel prices continue to drag down the profits. The entire airline industry is currently struggling with higher fuel prices and a slow-moving U.S. economy.
Additionally, high maintenance costs associated with fleet modernization, new advertising rules, risks pertaining to the AirTran integration, heavy investments and reliance on a single fleet keep us cautious on the stock. Hence, we rate the stock Underperform with a target price of $7.50, based on 11x our earnings estimate for 2012.
