Challenges of Southwest Airlines Essay

Southwest Airlines has long gotten a free ride in terms of its great brand reputation because of its “bags fly free” policy for the first two checked bags. But, Southwest revealed yesterday that it anticipates $100 million in new fee revenue for 2013 as it will be charging no-show fees when passengers with restricted tickets don’t cancel before the flight; selling open A1 to A15 boarding positions at the gate, and increasing existing ancillary fees, perhaps for excess baggage, pets, and unaccompanied minors.

Southwest has yet to detail the breakdown of its new fees, which are slated to take effect early in 2013. Southwest’s new fee blitz will undoubtedly conflict with one of the key goals it espoused yesterday at an investors’ day: to “maintain brand, culture & operational excellence. ” Keeping its passengers enthusiastic about the Southwest brand will certainly clash with fee increases and new programs that are expected to bring in an additional $100 million in new ancillary revenue in 2013. If you expect to see a whole lot of the old Southwest in the future, you may be disappointed.

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Or at least passengers should brace themselves for the changes. Just take into account what Bob Jordan, Southwest’s chief commercial officer and president of its AirTran subsidiary told investors and analysts about the new ancillary revenue initiatives: Finally, we’re focused on several new or improved ancillary revenue opportunities. The industry and consumer behavior has changed substantially over the past 10 years, and we know that. At Southwest,we realized that we cannot sit still if things change, and I would tell you that we have not.

Southwest even sees itself in somewhat of a paternalistic role, teaching its customers how to change their behavior with the new no-show fees. “This should add ancillary revenue and promote customer behavior that allows us to resell the open seat prior to departure,” Jordan said. “So you have a double win there. ” Southwest has still not revealed what happens with AirTran’s checked bag fees once the integration of the two airlines is complete, although Southwest has argued that its bags fly free policy for the first two checked bags has been advantageous when compared with AirTran’s bag fees.

Despite the public relations plaudits that Southwest receives from its two checked bags for free policy, many people do not realize that the airline is one of the leaders in collecting ancillary fees before and after those two bags are loaded onto the plane. In the third quarter of 2012 alone, Southwest took in about $75 million from ancillary fees, including $41 million for EarlyBird Check-in, and $19 to $20 million for pets, unaccompanied minors, and excess bags. And, here’s a chart from IdeaWorks Company showing that Southwest took fifth place among the top 10 airlines in ancillary revenue in 2011.

These fees, including partner sales and commissions from its Rapid Rewards frequent flyer program, accounted for nearly € 950 million ($1. 2 billion) in 2011. As Southwest cranks up its ancillary revenue in 2013, the airline will be hard-pressed to keep its brand reputation unscathed. For more than three decades, Southwest Airlines has been the star of the airline business, with nonstop growth, an unprecedented string of profits and a culture that transcended the industry’s notoriously bitter labor relations.

But as it flies into 2009, the Dallas-based discount carrier is under pressure as never before: Southwest lost $176 million during the second half of last year, its first two unprofitable quarters in a row. The airline is retreating for the first time, cutting flights and slowing its flow of new airplanes after years of steady expansion. A vaunted fuel-hedging program, which gave Southwest a significant advantage over rivals, turned negative when the price of oil plunged, costing Southwest hundreds of millions of dollars.

Renowned for its low costs, Southwest is facing rising expenses as it downsizes. Investors are clearly worried. Shares of Southwest have fallen by about 40 percent during the past three months, including an 18 percent one-day drop — the largest in the company’s history — the day after it reported its fourth-quarter earnings. That’s more than double the decline of the Amex airline index, which tracks large airlines’ stocks, during the same period. “Southwest is in the midst of a ransformation right now, and that means some real challenges,” said airline consultant Stuart Klaskin of Klaskin, Kushner & Co. In a recent report, airline analyst Jamie Baker of JPMorgan called Southwest “competitively neutered. ” Tom Parsons, chief executive of Arlington-based BestFares. com, said Southwest is discounting fares for spring travel more steeply than in past years. “I haven’t seen sales like this at this time of year since 9-11,” Parsons said.

“You know what that means? It means their bookings look really bad. But Chief Executive Gary Kelly says it would be a mistake to count the airline out. “We are very, very well-prepared for some really tough times, and that’s when our low-fare brand and our people have historically really excelled,” Kelly said in a recent conference call with analysts and reporters. With plans to begin a North American low-fare alliance with two other airlines, an intense focus on business travelers and strategic moves such as new service at LaGuardia Airport in New York, some industry observers say Southwest is the airline to watch in 2009. I really think Southwest is going to be the big story this year,” Klaskin said.

‘Coming to kill us’ For much of the past decade, Southwest was considered the most formidable competitor in the industry, and its entry into new markets terrified entrenched rivals. In 2004, when the airline announced an expansion into Philadelphia, the chief executive of US Airways, which operated a hub there, warned employees in usually blunt terms. “Southwest is coming to Philadelphia in May,” David Siegel said in an Internet broadcast. They’re coming for one reason. They’re coming to kill us. ” One of the most powerful weapons in Southwest’s arsenal was its fuel hedges — contracts that allow the airline to buy most of its fuel at prices set in advance. During the second quarter of last year, for example, Southwest paid, on average, $2. 19 per gallon while Fort Worth-based American Airlines paid $3. 17 per gallon. Few competing airlines had hedging programs as strong as Southwest’s, and thus the airline had a distinct advantage that let it keep its fares lower than its rivals’.

When competitors matched Southwest fares — which they often did to hold onto market share — they would lose money on their flights while Southwest remained profitable. That advantage was erased in the fall when oil prices plunged as the global economy weakened. Southwest found itself buying fuel at higher than market prices, and the value of its portfolio of hedge contracts plunged. The oil-price decline also wreaked havoc with the airline’s finances, requiring it to post collateral to cover future losses and write down the value of its hedges.

The airline quickly announced a plan to unwind its fuel hedges this year so they cover just 10 percent of fuel purchases. While that will let Southwest pay less for fuel, it will also increase its vulnerability to swings in oil prices. Most importantly, it means that Southwest won’t have an edge over most of its competitors on the price of jet fuel. But executives said the airline hasn’t given up its hedging program and is ready to start locking in prices if oil rebounds. “We have not changed our fundamental philosophy,” Chief Financial Officer Laura Wright said.

Expansion grounded Another casualty of the grim economic environment has been Southwest’s steady growth, once a driving force in its success. During the past 10 years, the number of seats available on every mile of Southwest’s network more than doubled. And the number of paying passengers on the airline soared from about 53 million in 1998 to 89 million last year, when Southwest carried more passengers than any other U. S. airline. But growth flattened during the fourth quarter of last year, and Kelly said Southwest will shrink by more than 4 percent in 2009.

Any growth plans are suspended indefinitely. As it shrinks, it faces more pressure to cut costs or risk declines in its operating margins. Analyst Baker said that he “would not be surprised” to see Southwest’s costs rise by as much as 8 percent this year, not including fuel, “and even that may prove optimistic. ” The airline’s costs related to airports, aircraft maintenance and labor are also rising. And new contracts that award raises to mechanics and pilots could add to the pressure over the next few years. Kelly said he has no plans to lay off employees.

But he wouldn’t rule out using voluntary buyouts or early retirements to reduce Southwest’s work force if necessary. Road to recovery? Despite the difficulties with fuel and other costs, Southwest has made significant progress in bringing in money. During the fourth quarter, operating revenues were up nearly 10 percent despite the economic downturn. And Kelly is adding several tools that he hopes will keep his airline at high altitudes despite the new challenges: Luring business fliers: The airline launched business-select fares, which enable early boarding and include a free drink and other perks for a higher price.

The new fares brought in $75 million in extra revenue last year. International service: Southwest is teaming up with Canadian airline WestJet and Mexican carrier Volaris to create the first international low-fare airline alliance. The deal will allow Southwest to book passengers to cities in Canada and Mexico by transferring them onto partner airlines. Strategic schedule: While it pares flights, Southwest is moving some resources into new cities that it hopes will attract more revenue. Service begins in March in Minneapolis/St. Paul, and the airline hopes to begin service to LaGuardia Airport in New York as well. Currently Southwest’s only New York-area service is to Islip Airport on Long Island, so service to LaGuardia would be a big draw for business travelers. Bulked-up balance sheet: The airline has bolstered its finances in recent months, drawing $400 million from a revolving credit facility, raising $400 million through a loan and collecting $173 million in an aircraft sale-leaseback deal. The airline has $1. 8 billion in its coffers to help cushion any additional losses.

Moneymaking perks: Southwest is revamping its Rapid Rewards frequent-flier program to make it more attractive to business travelers and hopes to offer in-flight wireless Internet access for a fee in the months ahead. “We’ve got a very in- tense focus to transform the airline that you’re very familiar with,” Kelly said. “So I think we’re undertaking the next three years from a very strong position. ” The luck has never run out at Southwest Airlines. Recently it very nearly did. Just months after James Parker replaced the irreplaceable Herb Kelleher as chief executive last June, along came the Sept. 1 attacks. Southwest’s planes were grounded for three days, while Parker — mindful of the company’s no-layoff tradition — continued to pay 31,000 pilots, flight attendants, desk clerks and reservationists $5. 2 million a day.

All this while revenue was falling for the first time ever at the airline — down 2 percent to just under $5. 6 billion for the year. Wild Turkey and Tough Talk Was Parker up to the job? That’s what Kelleher — who, as chairman, still plays an active role — wanted to know soon after the attacks. I told Herb I had put too much of my life into Southwest Airlines to walk away from a chance to try and move it ahead,” recalls Parker, who joined the carrier in 1986, after seven years as a partner in Kelleher’s former law firm. Parker is no Herb Kelleher; he’ll tell you that himself. A University of Texas-trained lawyer who looks like he’d be more comfortable writing wills in a country town than running an airline, Parker is a stark contrast to the cigarette-smoking, Wild Turkey-swilling Kelleher. But the new chief is no pushover.

He has been Southwest’s lead labor negotiator for years, and his opponents say he pursues the company line forcefully, if politely, in talks. “He will surprise you because he doesn’t look like he’s tough,” says Steve McPhail, a pilot and former vice president of the Southwest pilots’ union. “But he doesn’t give anything away. ” ‘Low-Cost Flyer’ Parker’s immediate challenge is to contain operating costs. If he can’t, expenses may outpace earnings as air travel slowly recovers. If he can, perhaps Southwest can resume its growth trajectory.

Until disaster-scarred 2001, its revenue was zooming ahead at a compound annual rate of 15 percent — triple the industry’s average — while earnings per share was increasing 27 percent. Southwest has long been the low-cost flier. It cuts out all the frills (like meals for passengers); it runs a streamlined point-to-point (rather than hub-and-spoke) network using a single model of aircraft; and its rah-rah employees — many getting rich off stock options — simply deliver more bang for the buck than their counterparts at other lines. Southwest’s Internet ticketing saves it $50 million a year, or 1 percent of revenue.

But Parker is facing some big challenges this year. Liability insurance for the airline’s 364-plane fleet has soared to $100 million a year from $20 million. And Southwest’s largely unionized workers have been agitating for raises to match the rich contracts negotiated at other carriers before Sept. 11. A Deal They May Refuse Southwest’s 4,100 pilots want to renegotiate a 10-year contract, due to expire in 2004, this summer, to close a 35 percent pay gap over the next five years. A veteran Southwest pilot makes $142 an hour, or $135,000 a year.

Profit sharing and stock options for the most tenured can add another $80,000, but Southwest’s pilots still trail 737 jockeys at Delta, United and American. With Southwest’s stock down 27 percent from its high of $23 in January 2001, pilots are unlikely to accept more options in lieu of cash. “We’re not going to break the company, but we’re not going to work for less than scale ever again,” vows Jon Weaks, president of the Southwest Airlines Pilots’ Association. Parker’s opening offer was a 20 percent raise over three years, according to Weaks (Parker won’t say).

He might be able to keep it in that range, with US Airways threatening bankruptcy and United close to the brink. But then he has to deal with the machinists and flight attendants, who will probably follow the pilots’ lead. Add it all up and labor expenses at Southwest, which traditionally have run about 3 cents per available seat mile, might be headed closer to the 4. 2 cents at Delta or 5. 1 cents at United. Stow the hanky. Parker still has some powerful advantages over rivals, even if he has to pay his employees a bit more in coming years.

James Parker (no relation), an analyst at Raymond James & Associates in Atlanta, says a 20 percent pilots’ raise will cost Southwest 5 cents a share by 2004. It can cover that if airfares and its load factor — industry jargon for the percentage of seats filled — return to pre-Sept. 11 levels. A recovery to a 70 percent load factor and revenue of 12. 5 cents per passenger mile flown, half a cent below its peak in 2000, would boost earnings by 28 cents, analyst Parker says; Southwest is currently operating at 62. 9 percent and 11. 7 cents per passenger mile flown.

Non-Stop Service Meantime Southwest continues to grow. From 3 cities in 1971 (all in Texas), the airline has expanded to 58, in cities as far-flung as Seattle, Providence and Fort Lauderdale. While no new cities will be added this year, Southwest will take delivery of 18 new Boeing 737 planes at about $30 million each — another 436 planes are on order through 2012 — and fly those on nonstop routes between cities it already serves with connecting flights. It’s a strategy Southwest’s Parker calls “connecting the dots,” and, like a lot of things there, other airlines an’t execute it easily. Traditional carriers operate hub-and-spoke networks where 60 percent of passengers hop on connecting flights to get to their final destinations.

Adding non-stops to such a network siphons off traffic from connecting flights and hurts the economic advantages of the hub. Southwest doesn’t have that problem. About 80 percent of its passengers get off at each stop. So Southwest can overlay its Chicago-Las Vegas-Los Angeles route with a non-stop flight and the revenue is almost entirely incremental. We think of it as a new market,” says Parker. “Our share of the Chicago-L. A. market is so infinitesimally small that we are really appealing to a new group of passengers. ” Southwest will add more than 30 routes this year by connecting the dots, as Parker says, and exploiting the longer range of new Boeing 737-700 jets to fly a transcontinental route for the first time. Passengers will have to figure out for themselves how to survive the five-hour flight on peanuts alone — another Southwest hallmark.

Next year it plans to start adding cities again, working from a backlog of 40 or so it has determined will respond to its combination of low fares and frequent flights. Competing High-Flyers That’s bad news for other carriers: When Southwest moves into a market, it tends to drive fares down. After initiating Baltimore to Providence flights in 1996, Boston area fares fell. Now passengers forego Logan Airport, landing instead in Providence where tickets average $46, down from $104. * PREVIOUS Traditional carriers can still make money on passengers catching connecting flights to destinations Southwest doesn’t serve, but they must cede lots of the local market to the low-cost competitor.

* In many cases Southwest doesn’t even have to charge the lowest fares. By blitzing a route with up to 60 flights a day, the airline bets that passengers will rate convenience above cost. * It can take the risk of flying half-empty planes in the afternoon if the 8 a. m. and 5 p. m. flights are full; after all, the pilots and flight attendants are still on the clock. “Southwest no longer has to be the price leader, which is rather ominous for the other airlines,” says Michael Roach, an associate at Unisys R2A Transportation & Management Consulting. “Sooner or later they will replace the other carriers. ” * Southwest could accelerate growth if US Airways throws its East Coast markets up for grabs. But don’t look for Parker to deviate from Southwest’s cautious strategy of adding just three cities a year, even if provoked by another carrier’s demise. * Southwest is a funny place.

Few of the top executives have worked for another airline, and they blissfully ignore strategies like complex fare structures that are commonplace elsewhere. * Much of the industry, in fact, has tried to imitate Southwest, down to its 737 jetliners, but can’t seem to get it right. * Parker thinks he knows why. “There are a lot of people who have said they are going to duplicate what Southwest does, but it’s always Southwest with ‘improvements,'” Parker says, smiling malevolently at the word “improvements. ” * He adds, almost unnecessarily, “And the improvements haven’t proven to be successful. “