The Good, Bad & Ugly Of UBS's Latest Visit With Southwest

In a report published Friday, UBS analyst Darryl Genovesi maintained a Buy rating on Southwest Airlines Co LUV, while reducing the price target from $47 to $42.

The good: capacity guide appears downward-biased
The company has acknowledged that demand growth is trending short of its expectation for the past few months. It had earlier guided to 7 percent y/y growth in capacity in 2015. Although currently supply seems to be outpacing demand, Southwest Airlines indicated that it has "significant flexibility to scale back capacity if demand growth doesn't re-accelerate like it did in 2H'13."

The bad: "not an oligopoly"
Southwest Airlines views the US airline industry as extremely competitive. "Unsurprisingly, LUV doesn't believe 30% pre-tax ROIC can be sustained as it sees new and existing competitors as likely to grow and steal share from it lest it grow too," analyst Darryl Genovesi said. Moreover, the company indicated that there was limited scope for cost cutting in the near term, in view of its commercial activity and ongoing labor contract negotiations.

The ugly: big labor ask coming
"SWAPA (pilots union) leadership sees its members as ~12% underpaid relative to current DAL/AAL contracts, and ~20% underpaid relative to tentative agreement (TA) with DAL pilots that (if ratified) would raise base wage rates but scale back profit sharing. SWAPA leadership sees a 15% base wage increase with modestly higher profit-sharing as minimum to get a deal done, and believes management's expectation for an overall cost-neutral labor deal is unrealistic," the UBS report noted.

The EPS estimates for 2015, 2016 and 2017 have been reduced from $3.35 to $3.20, from $3.85 to $3.40 and from $4.65 to $3.90, respectively.