When Southwest Airlines reported its traffic results for December earlier this month, the results once again reflected a recurrent paradox in the US airline industry. Southwest Airlines, which was once the industry’s low-fare leader, recorded unit revenue gains of 7%-8%, its 15th straight month with a unit revenue increase of more than 5%. The carrier achieved these revenue gains despite a 1.8% higher capacity and a 0.3% drop in traffic as measured by available seat miles (ASMs) and revenue passenger miles (RPMs), respectively. For the full-year 2011, traffic grew 6.4% at Southwest while capacity was up 4.9%.

Alongside the announcement of their December traffic results, Southwest also announced that the low-cost carrier (LCC) would be adding a third daily flight between their hubs in Atlanta and Los Angeles, supplementing the two daily flights currently operated by subsidiary AirTran. The additions will bring Southwest’s Atlanta operation to 18 flights a day on Southwest metal, alongside the 200 plus daily flights operated by AirTran.

When Southwest announced its consolidated financial results for the fourth quarter of and full-year 2011 on January 19th, 2012, industry analysts and the carrier were pleasantly surprised, as the results reversed the disturbing trend revealed in Southwest’s 2011 third quarter financial results. In the third-quarter of 2011, Southwest recorded a US$226 million pre-tax loss as opposed to the US$332 million net profit recorded in the same quarter of 2010. Net income swung to a US$140 million loss from a US$205 million profit in the corresponding period a year ago, with the largest chunk of the loss was driven by a US$262 million special charge to settle unfavourable fuel hedging contracts. However, there were other more troubling signs, total expenses jumped 43% to US$4 billion while operating profit dropped from US$355 million to US$225 million year-over-year. Rising costs created a 10% increase in unit costs, driven by the combination of 34% higher per-gallon fuel costs and rises in employee pay.

However, Southwest’s 2011 fourth-quarter results marked a return to profitability for the carrier, and ensured their 39th straight year of net profits. Fourth quarter net income was US$152 million, or US$0.20 per diluted share, up from US$132 million in the same period a year earlier, and beating consensus analyst estimates by around 10%. This profitability also comprised the largest part of Southwest’s full-year 2011 profit of US$178 million, down sharply from the US$459 million net profit recorded in 2010. Southwest Airlines chief executive Gary Kelly said, “Fourth quarter passenger revenues were strong, driven by record yields and continued high load factors. Compared to the prior year, our fourth quarter passenger unit revenues increased 8.2% on a combined basis. Based on current traffic and booking trends, we expect another strong passenger revenue performance in first quarter of 2012.”

Once again, fuel prices were the most significant drags on profitability, with economic fuel costs per gallon increasing 34.7% year over year. This was partially offset by a 9.3% increase in the fourth quarter combined revenues to US$4.1 billion, and a 7.0% increase in unit revenues. Revenue growth managed to make up for the 8.3% rise in unit costs, or a 0.5% increase in non-fuel costs. For the year, capacity was up 26.3%, though a large chunk of that growth came due to the acquisition of AirTran Airways, which was completed in May. Employee costs grew at a relatively slower 19.9% pace, but with former AirTran employees scheduled to receive significant pay raises under their new contracts with Southwest, the overall trend for employee costs is constant increases. For the full year, unit revenues were up just 2.6%. However, Southwest has noticed this trend and committed to stringent capacity discipline in 2012, the carrier’s recently released schedule extension for late August and early September 2012 contains a net reduction of 172 daily flights, even as Southwest takes on many of AirTran’s flights.

Image Courtesy of Southwest Airlines

Not your mother’s Southwest Airlines
Both the financial results and the revenue trends for December are indicative of a paradigm shift that has occurred within Southwest Airlines over the past 5 years. For the longest time, Southwest Airlines had simply grown its way to profitability with a combination of low fares, a no-frills but exciting product, and continuous expansion into secondary US markets. SWA’s business model utilised point-to-point flights between un-congested airports, and relied on quick turnarounds to drive productivity and profitability. In the early 2000s, an additional factor, the carrier’s smart fuel hedging contracts, allowed it to maintain profitability in the face of rising fuel prices that caused significant volatility amongst the other carriers in the US airline industry.

Southwest’s trouble came right around 2007 or 2008, when its history of consistently rising costs finally caught up with growth, implying it had extinguished all of its easy growth opportunities or the so-called “low hanging fruit” by saturating the vast majority of secondary US airports. At the very same time, its fuel hedges, which had allowed them to survive the slow run-up in oil prices between 2001 and 2007, began to run out, thereby bringing Southwest’s fuel costs to parity with the rest of the industry. Meanwhile, the carrier’s famously strong relationship with its heavily unionised workforce precluded concessionary contracts, and employee-driven unit costs continued to rise. Both wage and benefit costs leapt as management sacrificed cost cuts for peaceful labour relations, and the workforce slowly began to age. Meanwhile, a traditional advantage of Southwest’s costs: the defined-benefit pension plans that burdened its full-service competitors, were wiped out by Chapter 11 bankruptcy reorganisations similar to the process started by American Airlines and its parent company AMR Corporation in November 2011.

As Southwest was grappling with its rising costs, a host of new nimble low-cost competitors emerged, eager to steal market share from Southwest. Carriers like JetBlue, Allegiant, Spirit Airlines, and Frontier Airlines all utilised unique business models and lower costs to attract Southwest’s typical constituency of leisure travellers. Thus it was inevitable that Southwest’s business model would have to change.

In early 2007, Southwest began to take notice of these troubling trends and took action, it rebuilt its entire business model to cater to the business travellers. Revenue generation became their greatest priority, ostensibly to offset rising costs. Slowly but surely, the carrier began to soften its rigid focus on running efficient operations through secondary airports.

The first step change occurred in Southwest’s network strategy. For the longest time, Southwest had avoided many of the larger airports in the Northeast, such as New York John F. Kennedy International Airport, New York LaGuardia, Newark Liberty, Philadelphia, Boston, Washington Reagan Airport in favour of alternatives: Islip, Manchester, and BaltimoreWashington. But recognising that these are among the most powerful business destinations in the country, Southwest swallowed its typical derision for business airports and began actively targeting expansion into the congested Northeastern airports. Southwest rapidly built up a quasi-hub in Philadelphia, challenging incumbent leader US Airways with up to 80 daily flights at operational peak. Moreover, it expanded into slot-restricted airports like New York LaGuardi through a purchase of slots from the now-defunct American Trans Air (ATA) and Washington Reagan National Airport through the merger with AirTran. Electing to sacrifice some of its industry-leading productivity, Southwest also moved into congested legacy airline strongholds like Boston and Minneapolis St. Paul. These efforts resulted in significant revenue appreciation and additional corporate traffic and contracts. But it also caused a significant drop in the airline’s vaunted productivity, with productivity in a variety of measures dropping 6-8% between 2007 and 2011. Increased delays at congested airports, as well as at Southwest’s new hubs, also cutbacks on Southwest’s once stellar on-time performance (OTP), with Southwest finishing dead last in OTP amongst major US carriers in 2011 according to Flightstats.com, an independent firm measuring airline operational performance.

Southwest’s business model also shifted at existing airports. Whereas Southwest had once solely operated point-to-point flights, it began to offer more and more connections in its large existing airports like Chicago Midway and Baltimore-Washington. Indeed, according to a 2010 report from aviation consultancy Boyd Group International, 9 large Southwest Airline operations: Chicago Midway, Baltimore-Washington, Houston-Hobby, Nashville, Dallas-Love, Denver, St. Louis, Phoenix, and Las Vegas, saw more than 25% of their traffic bases composed of flow, or connecting traffic. The largest percentage of connections occurs at Chicago Midway, where a full 43.2% of passengers were connecting to separate flight. On a network-wide basis, according to Southwest spokeswoman Brandy King, between 70%-75% of customers fly non-stop on Southwest, meaning that connections number 25%-30% of Southwest’s passengers. Southwest’s largest operations actually look very similar to legacy hub operations in smaller airports such as Delta Air Lines in Cincinnati or United Airlines in Cleveland. Southwest’s commitment to a changing model was seemingly validated by their merger with Atlanta-based AirTran Airways, whose central hub in Atlanta serves 67.3% flow traffic, with smaller but still significant totals at its other hub operations in Baltimore and Milwaukee.

Airport Daily flights Destinations Served

Chicago (Midway)

236

55

Las Vegas

228

55

Baltimore/Washington

189

46

Phoenix

185

49

Denver

148

42

Houston Hobby

133

33

Dallas (Love Field)

130

15

Los Angeles (LAX)

114

21

Oakland

107

19

Orlando

101

33

Air Tran integration poses network challenges & opportunities
Despite the subtle long-term shift from point-to-point to connecting traffic, Southwest’s business model still operates on the other end of the spectrum from AirTran. Southwest’s outstations typically require a minimum of 8-10 daily flights for viability in order to spread airport costs over enough flights, whereas AirTran sometimes operates just 1 or 2 daily flights per destination. According to Southwest Airlines spokeswoman Brady King, “We plan to integrate the AirTran network into Southwest over the next few years, and plan to evolve the AirTran market into a Southwest point-to-point model. We don’t have a percentage that we are working to reach, just a natural integration of the two carriers that transitions AirTran over to Southwest’s style of operating”. This plan was directly illustrated in Southwest’s recent schedule announcements, including its plan for further 2012 integration between AirTran and Southwest.

As part of Southwest’s continued merger integration, Southwest has worked to eliminate service to small and/or marginally profitable airports, many of which rely on connections over the carrier’s hubs. “Effective August 12, 2012, AirTran Airways will cease operations at the following airports: Allentown, Pa. (ABE); Lexington, Ky. (LEX); Harrisburg, Pa. (MDT); Sarasota, Fla. (SRQ); Huntsville, Ala. (HSV); and White Plains, N.Y. (HPN). AirTran currently operates six daily non-stop flights at Sarasota with 16 employees. Its Allentown (one daily non-stop flight), Lexington (two daily non-stop flights), Harrisburg (one daily non-stop flight), Huntsville (two daily non-stop flights), and White Plains (three daily non-stop flights) operations are all supported by AirTran’s contracted vendor partners.” These airports, with the exception of White Plains which is slot restricted, possess primarily leisure travel bases, and provide limited ability for Southwest to upscale with more flights on larger aircraft. The last factor is especially important because much of Southwest’s fleet of smaller Boeing 717 aircraft inherited from the AirTran merger comes off lease over the next 5 years, with some analysts predicting that Southwest will eliminate the relatively inefficient fleet entirely before that point.

Meanwhile, 22 AirTran markets will retain their service for the time being, and are planned to convert to Southwest services in the near future. The fate of the balance of AirTran’s destinations has for the most part been determined, with 53 of the carrier’s 69 destinations planned for conversion to Southwest operations. Under this plan, the first joint destination to be solely converted into a Southwest operation is Seattle, where the carrier will offer up to 41 peak-day flights.

The commitment also involved several international destinations including, “Punta Cana, Dominican Republic (PUJ), Cancun, Mexico (CUN), Montego Bay, Jamaica (MBJ), Aruba (AUA),  Bermuda (BDA), and Nassau, Bahamas (NAS).” Mexico City and San Jose Cabo will also be getting Southwest service, with the carrier announcing a slew of routes to those destinations in late 2011, as well as applying to serve Cancun from Denver and Austin in early 2012. This expanded international flying marks a departure from the traditional Southwest model of domestic flights only, and will require Southwest to alter its reservations system substantially to include such flying.

Potentially more lucrative are the new opportunities brought to Southwest by AirTran, as well as the shift in business model the merger has caused. AirTran holds a valuable slot portfolio at both Washington-Reagan and La Guardia, which Southwest can utilise to improve its standing with business travellers. Southwest has already begun to transition these operations to more profitable airports like St. Louis and Denver from New York LaGuardia. International business also looks set to grow, with Southwest recently indicating that it wants to start international operations from quasi-hub Houston-Hobby. Hobby currently lacks FIS facilities with Houston’s international flights being handled by further away George Bush Intercontinental Airport, a hub for competitor United Airlines, but would provide business travellers with a convenient alternative to Bush Intercontinental for international travel, primarily to Mexico and Central America.

The expansion of the destination base provided by AirTran can only help Southwest’s ability to acquire lucrative corporate traffic agreements. This effect is likely to be most pronounced in mid-sized and large cities such as Memphis, Charlotte, and Washington Reagan. On the downside, Aspire Aviation is doubtful of Southwest’s ability to maintain services in small airports like Key West, Flint, and Branson (MO), and feels that a suspension of these destinations is likely in the longer term. Thus integrating AirTran’s network with Southwest is likely to be very difficult, especially in terms of appreciating AirTran’s unit revenues to match Southwest’s.

Image Courtesy of Andertho

Atlanta Southwest’s biggest challenge
And nowhere will Southwest face greater difficulties in achieving integration than in Atlanta. In 2011, Gary Kelly was quoted as stating that Southwest expected to grow Atlanta revenues by at least US$2 billion over the next 3-4 years. However, Southwest will face significant challenges in achieving such gains, for a myriad of reasons.

The first is AirTran’s competitive position in the market, as well as the nature of the entire operation. Southwest has already announced a number of changes to the combined carrier’s operation in Atlanta, dropping numerous flights to smaller destinations, while adding flights to other markets, primarily Southwest strongholds, including Austin, Norfolk, and Louisville, destinations that lacked service from Atlanta on AirTran. All told, in August of 2012, Southwest will operate 28 daily flights to 11 destinations from Atlanta, with AirTran flight levels at around 170-180 per day.

Southwest will primarily suffer from AirTran’s current competitive position in Atlanta. With over 67.3% of passengers connecting in Atlanta, AirTran’s operation there is not as heavily dependent on origin and destination (O&D) traffic as most of Southwest’s largest ones. But with Southwest cutting smaller destinations to focus on larger cities, AirTran’s secondary competitive position in Atlanta’s O&D markets is a significant hindrance to integration plans.

Aspire Aviation reviewed origin and destination (O&D) data from the United States Department of Transportation (DOT) for the second quarter of 2011 in Atlanta, and it is startling to see just how effective Delta Air Lines has been at competing with AirTran on key Atlanta markets. The table below lists some key metrics in the 50 largest O&D markets from Atlanta for the second-quarter of 2011. The most striking feature is the stunning dominance of Delta in these markets, of which the SkyTeam alliance member is the market share leader in 47 of the 50 markets. Delta’s position as the lowest fare carrier in many of these markets show how aggressive they have been in matching fares offered by AirTran to be sure. But there is also strong evidence that Delta has managed to recapture pricing power on many of these routes, while simultaneously retaining its dominant share of O&D traffic. In 27, or more than half, of these top 50 markets, Delta is the market share leader for O&D passengers while AirTran is the lowest fare carrier. In these markets, Delta holds on average, about a 20.7% fare premium, and across the whole 50, holds about a 2-to-1 advantage in O&D market share versus AirTran.

Destination Leading Carrier Leading Carrier Market Share (%) Lowest Fare Carrier Low Fare Carrier Market Share (%) Market Yield Delta Revenue Premium vs. Air Tran
New York Metro Area, NY Delta 62.16 Delta 62.16 $0.29
Baltimore, MD/Washington, DC Delta 60.97 Delta 60.97 $0.33
Miami/Ft. Lauderdale, AirTran Delta 58.20 Delta 58.20 $0.24
Chicago Metro Area, IL Delta 49.41 AirTran 18.91 $0.29 29.9%
Los Angeles Metro Area, CA Delta 64.92 AirTran 17.76 $0.12 42.1%
Dallas/Fort Worth, TX American 41.63 AirTran 15.33 $0.28
Boston/Providence, MA Delta 68.46 AirTran 20.87 $0.23 23.5%
Philadelphia, PA Delta 50.69 AirTran 23.58 $0.29 29.1%
San Jose, CA Delta 60.75 AirTran 22.51 $0.13 23.9%
Houston, TX Delta 43.44 AirTran 27.73 $0.31 16.6%
Orlando, FL Delta 62.07 Delta 62.07 $0.46
Denver, CO Delta 49.02 Frontier 18.89 $0.17
Las Vegas, NV Delta 65.97 AirTran 26.16 $0.14 14.6%
Detroit, MI Delta 65.91 AirTran 29.38 $0.32 51.8%
Minneapolis, MN Delta 68.73 AirTran 26.77 $0.24 24.8%
Tampa, AirTran Delta 60.27 AirTran 36.82 $0.43 12.3%
Seattle, WA Delta 60.16 AirTran 18.18 $0.13 2.5%
Phoenix, AZ Delta 57.96 US Airways 19.28 $0.13
Raleigh/Durham, NC Delta 70.15 AirTran 25.73 $0.44 17.6%
Cleveland/Akron, OH Delta 41.16 AirTran 31.97 $0.34 16.3%
Kansas City, MO Delta 63.78 AirTran 32.84 $0.25 11.0%
New Orleans, LA Delta 67.89 AirTran 30.14 $0.39 21.3%
St. Louis, MO Delta 67.98 AirTran 28.99 $0.39 5.4%
Pittsburgh, PA Delta 61.95 AirTran 31.20 $0.33 32.4%
West Palm Beach/Palm Beach, FL Delta 73.93 AirTran 24.54 $0.26 9.7%
Newport News/Williamsburg, VA Delta 56.62 Delta 56.62 $0.35
White Plains, NY Delta 50.32 AirTran 44.30 $0.25 10.2%
Milwaukee, WI Delta 53.01 AirTran 44.85 $0.25 1.9%
San Antonio, TX Delta 63.54 AirTran 30.33 $4.20 8.3%
Indianapolis, IN Delta 65.52 AirTran 30.74 $0.40 16.1%
Jacksonville, FL Delta 70.27 Delta 70.27 $0.65
Richmond, VA Delta 58.80 AirTran 36.52 $0.36 17.7%
Memphis, TN Delta 67.94 AirTran 31.12 $0.54 6.3%
Buffalo, NY Delta 53.84 AirTran 39.92 $0.26 3.0%
Columbus, OH Delta 75.94 Delta 75.94 $0.41
San Diego, CA Delta 67.89 US Airways 17.98 $0.16
Salt Lake City, UT Delta 70.20 Frontier 10.46 $0.19
Charlotte, NC Delta 52.67 US Airways 36.42 $0.75
Austin, TX Delta 85.09 AA 7.45 $0.32
Dayton, OH Delta 53.04 Delta 53.04 $0.41
Fort Myers, FL Delta 57.19 Delta 57.19 $0.34
AirTranint, MI AirTran 57.99 Delta 40.93 $0.29 -6.6%
Rochester, NY Delta 57.18 Delta 57.18 $0.23
Hartford, CT Delta 77.57 US Airways 13.48 $0.36
Portland, OR Delta 61.62 US Airways 12.39 $0.16
Cincinnati, KY Delta 95.82 Delta 95.82 $0.64
Sacramento, CA Delta 62.95 Frontier 12.64 $0.14
Sarasota/Bradenton, FL Delta 65.33 AirTran 32.02 $0.35 26.6%
Wichita, KS AirTran 61.53 AirTran 61.53 $0.23
Omaha, NE Delta 71.52 AirTran 12.06 $0.33 58.4%

On its network as a whole, AirTran’s revenues would need to appreciate 8%-12% to achieve parity with Southwest’s unit revenues. But in Atlanta that effect is even more pronounced. Southwest will face an uphill battle in appreciating AirTran’s revenues, and in achieving the US$2 billion of revenue gains. There is very little room for Southwest to enact the famed “Southwest Effect,” because AirTran has already stimulated most of these markets as far as it can go, with its position as the lowest fare carrier in 29 of the top 50 being a testament, and as such cannot achieve revenue gains through volume growth. In fact, with AirTran’s unit costs likely to rise appreciably in the face of its merger with Southwest which has much higher labour costs, many of these markets are likely to contract somewhat as fares naturally rise. Further hampering Southwest’s troubles will be the loss of baggage fee and other ancillary revenues in Atlanta. For full year 2011, such revenues, which AirTran has continued to collect while operating as a subsidiary of Southwest, even as the parent has launched a huge advertising campaign centred on its lack of bag fees, were between US$100 and US$130 million annually in Atlanta, according to Aspire Aviation estimates. This revenue will be lost as AirTran is slowly integrated, and will have to be made up to maintain profitability at the hub.

Southwest acknowledges some of these challenges, but chief executive Gary Kelly is confident of its success. In the carrier’s fourth quarter and full year 2011 analyst’s conference call, he stated; “Well, I’m not sure that I have anything new to add to the discussion. We feel like, and so does AirTran, we feel like we can add value to the Atlanta discussion. We can win customers in Atlanta. We can take existing Southwest customers to Atlanta. We can certainly significantly restructure the AirTran schedule and take advantage of the Southwest network, and that’s what we’re focused on doing.”

However, Aspire Aviation feels that Southwest’s situation in Atlanta is far more precarious, primarily due to the effectiveness of its chief competitor, Delta Air Lines. Delta Air Lines, perhaps as part of its heritage from Northwest Airlines, is a ferocious competitor with low-cost carriers (LCCs). Delta’s effectiveness in competing with AirTran has been noted above, but equally important has been its success in dealing with intrusions from Southwest before. For example, in Salt Lake City, Delta’s western hub, Southwest actually bought a carrier with a Salt Lake City hub, Morris Air, in 1994. However, over the next 10 years, Delta competed so vigorously for control of the Salt Lake City market that Southwest withdrew from many former Morris Air markets. Today, Southwest is less than one-tenth of the size of Delta in Salt Lake City, whereas its operation was one-third of the size of Delta’s in 1994. A similar pattern has occurred in former Northwest, now Delta strongholds Detroit, Minneapolis, and Memphis, as well as in key Delta markets such as Cincinnati. In the former two, Southwest has only a token presence, and never served the latter despite Memphis will come online as part of the AirTran merger.

Moreover, Delta Air Lines has several advantages over Southwest. Corporate traffic in the region skews heavily to Delta, which has a much larger global network than AirTran or Southwest, especially when one considers Delta’s membership in the SkyTeam alliance. This corporate traffic base buys heavily on Delta for its leisure travel, and is especially enticed by Delta’s strong frequent flier programme, while retaining a strong personal loyalty to the Delta Air Lines brand. With Southwest transitioning from AirTran’s point-per-flight model to Rapid Rewards’ point-per-dollar spent model for frequent fliers, Delta’s mileage/point-per-flight model could steal away many AirTran frequent fliers from Southwest. Another factor that could shift traffic from Southwest to Delta is the product difference with AirTran. In Atlanta, AirTran has over time built up a strong following for its unique product that offers business class seating with its resultant amenities, as well as assigned seating. Delta offers these amenities, plus in-flight WiFi, and in-seat video entertainment on a majority of its Atlanta flights. Southwest Airlines, on the other hand, offers only a single class of seating, open seating that is done by groups but still essentially a limited free for all, passengers have no guarantee of an aisle seat, for example, and limited but growing in-flight WiFi. Passengers looking for a premium product will likely move to Delta simply via attrition, affecting Southwest’s ability to attract lucrative business travellers.

Make no mistake, this is not to say that Southwest cannot compete with Delta in Atlanta, with Southwest’s no checked baggage fees is expected to have a stimulatory effect on the transfer of unaligned leisure passengers from Delta Air Lines to Southwest. And for the average economy class passenger will actually see increased comfort as AirTran’s 737-700s and 717-200s are reconfigured in the Southwest configuration. But the combination of effects means that there is limited scope for Southwest to achieve the broad-based origin and destination (O&D) unit revenue gains required for Atlanta to be profitable on the Southwest scale. Thus in the near term, or in the next 2-3 years, Southwest will have no choice but to maintain Atlanta as a “connect-first” operation, with a connection to O&D ratio of at the lowest 55/45 split. Even longer term, Southwest will likely be unable to ever bring connections in Atlanta down to around 45% of Chicago Midway. This is troublesome because of Southwest’s persistently increasing unit costs. From 2000 to 2010, Southwest’s unit costs rose from 77% of those of Delta’s to 95% of those of Delta’s, and even with recent increases at Delta and a growing appetite for cost discipline at Southwest, the two carriers are likely to have similar cost profiles over the next 5 to 7 years. This ramp-up from AirTran’s lower cost base will afford Delta Air Lines additional pricing power in the market and Aspire Aviation thinks this will boost the profitability in what is already Delta’s most profitable hub, according to that carrier’s fourth quarter and full-year 2011 earnings call. The unspoken reality is that Southwest Airlines, despite its fearsome reputation, might actually be easier for Delta to compete with than AirTran ever was.

Image Courtesy of Southwest Airlines

Product investments culminate in “Evolve” seats
Beyond its network strategy, Southwest Airlines has also enacted a string of recent product enhancements, targeted primarily at enhancing revenues. Moves such as increased amenities for the “Business Select” product, as well as the introduction of in-flight wireless connectivity unquestionably enabled Southwest to improve its income streams. However, its most recent announcement of the new “Evolve” in-flight seating was, in Aspire Aviation’s opinion, intended to substantially lower Southwest’s unit costs.

Earlier in January, Southwest announced a new seating configuration for its fleet of 370 Boeing 737-700 aircraft, which would increase seat counts from 137 to 143 seats in single-class configuration. The capacity up-gauge is enabled by the usage of new slim-line seats, as well as a reduction in recline and seat pitch by one inch, whose combined effects allowed Southwest to add an extra row of seats.

The new configuration will be placed on all current Southwest Airlines 737-700s. As AirTran’s 737s and 717s slowly are converted to Southwest operations, the combined carrier will also evaluate utilising “Evolve” seating in these aircraft. 737-300s and 737-500s will not be retrofitted with “Evolve” as they are scheduled to be replaced by a mixture of Boeing 737-800s and Boeing 737 MAX 8s over the next decade, both of which will utilise elements of “Evolve” seating, as well as the Boeing Sky Interior.

Southwest touts that the, “improved durability of the redesigned seat coupled with fuel savings from 635 pounds less weight per aircraft is expected to result in more than US$10 million in ongoing annual cost savings.” However, in Aspire Aviation’s view, that figure underestimates the true cost savings of the configuration change. Adding 6 seats represents a 4.4% increase in capacity on every flight operated by a 737-700. US$10 million are essentially the direct savings due to lower weight and the resultant drop in fuel burn per seat. However, Aspire Aviation feels that the capacity up-gauge will limit the increases in Southwest’s unit costs, putting downward pressure on cost per available seat mile (CASM) while simultaneously allowing increases in unit revenues and total revenues due to the relatively inelastic nature of Southwest’s demand profile when compared to other ultra low-cost carriers (LCCs). In fact, Aspire Aviation estimates that the effect of “Evolve” seating on Southwest’s CASM is to decrease it by 1.7%-1.9%, or US$0.14-0.15 cents, holding other factors constant. In addition, Aspire Aviation estimates the “Evolve” seats would increase Southwest’s operating margin by 0.2-0.4 percentage points.

Southwest continues to delay the inevitable showdown with employees
Between the increase in 737-700 seat count, and the addition of 175-seat 737-800, which is the largest aircraft in Southwest’s history, Southwest Airlines using its fleet to naturally push down unit costs. But the fact remains that Southwest’s unit costs have been tracking upwards for a long time. Having lost its advantage in fuel costs in earlier this decade, Southwest’s unit costs are now actually comparable to those of the full service carriers in the US, although those carriers have had the benefits of shedding costs in Chapter 11 bankruptcy protection.

Equally evident is the correlation between increasing employee costs, and the rise in overall unit costs. In fact, labour costs now represent about 15% of the overall cost per available seat mile (CASM) growth, with fuel prices that are not in the control of the company after the expiration of its hedges, comprising the balance of the rise.

This trend of unchecked growth in employee compensation can have disastrous long-term effects on Southwest’s profitability. The company to an extent acknowledges this, with Gary Kelly noting in a December letter to his employees that, “Our labour rates are now, far and away, the highest in the industry. Through bankruptcy, very large new airlines have emerged with lower rates than us and better productivity. Next to fuel, labour is our highest expenditure. We can’t have lower overall operating costs if our labour costs aren’t lower. We can’t have lower labour costs if we aren’t more productive. The good news is that we have a lot of opportunities to improve our productivity, eliminate waste, and preserve our pay rates and benefits for the foreseeable future. It’s crucial that we take advantage of those opportunities.”

This letter was sent out in response to the Chapter 11 bankruptcy filing by American Airlines in late November, and Kelly also warned that American’s lower costs would be especially troublesome for Southwest, as the two carriers overlap in about 30% of Southwest’s capacity. However, it is equally clear that Kelly does not necessarily have the stomach to truly confront the labour cost issue head-on. Recapturing lost productivity is a great ideal to strive for, but only wage cuts or freezes would reduce labour costs down to the levels at their legacy peers. To be sure, there is certainly a valid rationale for Southwest’s actions in this regard. Southwest has always enjoyed a superb relationship with its heavily unionised employees and hence the persistently rising pay rates. Moreover, Southwest’s employees are amongst its most valuable assets, they make possible Southwest’s strong productivity and their quirky and unique approach to in-flight service is frequently cited as one of the industry’s best. From top to bottom across all of Southwest’s employee groups, their superb customer service ethic has resulted in Southwest garnering one of the best service reputations in the industry, with the fewest passenger complaints per capita of any major US carrier, despite having a poor statistical customer service record, baggage lost, delays, on-time performance, and the likes. Therefore, it is understandable that Southwest’s management is loathe to change the status quo with its unions, in fear of adversely affecting customer service.

However, there will come a time when Southwest will have to confront its employees with pay reductions as the rest of Southwest’s costs are simply too volatile. An interesting prism through to view Southwest’s shifting business focus and fleet moves is that they allow Southwest to delay this final confrontation with its employees. Of course revenue growth and fleet manipulation would have likely occurred regardless of Southwest’s employee costs, but the order in which they occurred certainly lends credence to this theory of an inevitable eventual showdown over labour costs. The issue lies in the fact that revenue growth is finite, demand for air travel is becoming more and more price-elastic over time, and as such, Aspire Aviation estimates that under current conditions, Southwest could probably grow passenger yields by another cent or so before growth flattens out. The fleet manipulation is also limited, both by capital, and by pure results. However, between these two effects, Southwest should have 3-4 years of breathing room before having to deal with its employees. At any point during this period, Southwest could strike a deal with its employees. However, Aspire Aviation thinks that it is more likely that Southwest will choose to further delay the final confrontation with the employees, and instead enact a drastic change in its business model. Southwest has limited ability to affect its non-labour costs beyond current plans, so it ultimately comes down to 3 options to expand revenues: international long-haul flights, converting to two-class seating, or adding checked baggage fees.

The first two options are both capital-intensive, with the former also representing a remarkable shift away from Southwest’s single fleet model, and requiring the latter to generate sufficient revenues. Thus, checked baggage fees, while controversial, would allow Southwest to most effectively increase net revenues. In fact, baggage fee revenues are typically around 95% profit, and are untaxed by the federal government in the United States.

In the short term, Southwest has committed to not charging baggage fees, even launching a widespread “Bags Fly Free” advertising campaign centred on the theme. However, Aspire Aviation believes that over the longer term, the upside of huge potential revenues is simply too large to ignore. Charging a checked baggage fee would not be without consequences for Southwest, after the carrier has repeatedly stated that it has seen upticks in market share and position since the rest of the industry with the exception of JetBlue Airways added such fees. It would adversely affect Southwest’s excellent customer service reputation and would likely result in some leakage of travellers to other carriers. Furthermore, over the next 3-4 years, passengers are likely to become more de-sensitised to checked baggage fees as they will be forced to pay them when flying other carriers.

But in the same vein, the additional revenue gained would be very lucrative. Utilising a “back-of-the-envelope” calculation method, Aspire Aviation has roughly estimated the revenues Southwest would have received in 2011 from baggage fees. In 2011, Southwest carried roughly 104 million revenue passengers. Assuming 5% leakage to other carriers because of the fee, and using the figures for flow versus origin and destination (O&D) passengers given to Aspire Aviation by Southwest Airlines, and assuming that around 70% of passengers check baggage at US$25 a bag, Southwest would have received roughly US$1.47 billion dollars worth of baggage fee revenue. Even that figure is conservative, as AirTran manages to get close to US$30 worth of ancillary revenue per revenue passenger whereas Southwest Airlines in this scenario would only be getting about U$15 per passenger.

Thus, Aspire Aviation believes charging a checked baggage would allow Southwest to continue to reward its employees for their efforts, while ensuring profitability with minimal investment.

In conclusion, Southwest obviously has a tonne of decisions to make over the next few years, and the good news is that it does have a decent period of time. The transition from Southwest to AirTran will undoubtedly raise the latter’s cost profile, thereby necessitating the elimination of formerly profitable flying like the service to Sarasota, whose withdrawal greatly angered airport management. A tough battle lies ahead in Atlanta, where Aspire Aviation remains sceptical of Southwest Airlines’ ability to easily generate large revenue gains. Moves such as “Evolve” seating and adding checked baggage fees may debase the passenger experience to a certain extent. But from a long-term point of view, these initiatives are imperative to boosting Southwest’s profitability, and can prevent Southwest from having to go through a similar stage of employee cuts as American Airlines which plans to cut 13,000 jobs during its bankruptcy process.

9 Comments

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  • keesje 2012 Feb 08 / 22:50

    Good extensive piece of information. I really wonder how SW will develop its fleet to meet network requirements.

    The 737-8 seems large to replace the -300/500 everywhere. It seems even unlikely. Standarization on a bigger type is ok when operating costs (fuel) are low. They are high. SW publicly was very positive on the CSeries as well as on the Pratt GTF (as part of a NEO proposal)

    SW openly discussed a multi type fleet approach. Then they bypassed the 737-7i in their recent order.

    A two type approach would IMO be feasible. 737-8i for the bigger markets, benefitting from commonality with the 737 fleet (& the great offer Boeing made them) and a leaner lighter ~135 seat CS300 for the smaller markets, replacing the -300 and -500 and (heavier) -700 eventually. I can imagine Bombardier/ UTC would also go deep to get them on board at this stage.

  • TC 2012 Feb 09 / 00:27

    Just read a story about some assigned seat carrier trying to charge Ralph Nader $2000 extra for an aisle seat. Even if you select a seat at booking, some different seat will print out on the boarding pass, what’s up with that? The reason people are loyal to Southwest is because unlike most other airlines, they don’t subscribe to highway robbery.
    As for the CSeries, yes. Americans have literally outgrown the 737 and the wider seats of CSeries are needed.

  • Brian 2012 Feb 09 / 05:19

    My view, in looking at SW’s recent orders, is that they are anticipating increased demand and the need for increased capacity over the next 8-10 years as the economy improves. If some of their forecasts turn out to be wrong, they do still retain the option of converting some of their MAX orders to the -7. Plus, they do still have over 100 new -700s coming in over the next two years, so I don’t think they’re looking to move out of that size class. I think their main goal is simply to get rid of the old -300s and -500s which are comparative fuel hogs; the change of -700 orders to -800s may also have been motivated in part by trying to decrease fuel burn per seat. This move to larger aircraft also opens the door for another potential cost-saving measure: frequency reduction. Southwest could easily replace, say, 5 -300 or -700 flights on a particular route with 4 -800 flights, which would cut costs while maintaining the same capacity with minimal impact on schedule convenience. The alternative option of ordering CS300s to replace -700s is interesting, depending on pricing and the actual costs of moving from a single- to a two-type fleet.

    While SW needs to find some ways to cut operating costs, I do think they need to tread very carefully around their employee contracts. As others have said, so much of Southwest’s reputation is founded on friendly service and the “no bullshit” philosophy. Having flown on Southwest for years, I agree that they are a relatively smooth flying experience. All of these advantages stem directly from having happy, motivated employees who are willing to put in a little effort to help a passenger out rather than simply saying “I’m sorry, our policy doesn’t allow that” or something similar. A surprising amount of the “bullshit” involved in flying can be caused or avoided at the level of the individual employee, and Southwest needs to keep that advantage.

    • Vinay Bhaskara 2012 Feb 09 / 08:13

      Brian,

      Re recent orders: Exactly; the -800s allow natural decrease of CASM, and they can minimize overlapping frequencies while still providing competitve schedules.

      My estimation is that Bombardier would need to discount C-Series 40-50% and throw in nearly free support on most future ancillaries, and even then might not be able to. Why not just keep commonality, the few points of cost decrease of CS300 outweighed by other factors.

      As for the “bullshit” issue, it’s why I think they’ll add bag fees before harming their employees, too much potential additional revenue, though most travel bloggers who read the article prefer to think about it short term.

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  • Julia Pavlicek 2012 Feb 21 / 22:17

    Gary Kelly is a lot smarter than you give him credit. Southwest is not going to charge for bag fees now or in the future. We don’t believe in nickle and diming people to death. That is one reason while people love us. One of the beauties of working for Southwest is the profit sharing so it is all of our best interests to watch for ways to cut back on waste and save money on our daily operations and we do that. Our passengers generally love us and we love them. Alot of people come back once they fly us because they enjoy the experience and they tell their friends. One of the greatest things about our passengers is their loyalty. We, by the grace of God, will remain profitable because our management knows how to run a successful airline and treat their employees as well as customers.

  • debbie 2012 Feb 22 / 01:20

    ditto You said it all Julia

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