Strategic Report for
`Southwest Airlines
`
`Tycen Bundgaard
`John Bejjani
`Edmund Helmer
`
`April 12, 2006
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`Table of Contents
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`EXECUTIVE SUMMARY...............................................................................................3
`COMPANY BACKGROUND .......................................................................................6
`PORTER’S FIVE FORCES............................................................................................ 10
`MARKET DEFINITION.............................................................................................................. 10
`INTERNAL RIVALRY................................................................................................................. 11
`ENTRY....................................................................................................................................... 12
`SUBSTITUTES AND COMPLEMENTS ........................................................................................ 14
`SUPPLIER POWER ..................................................................................................................... 15
`BUYER POWER.......................................................................................................................... 18
`FINANCIAL ANALYSIS.............................................................................................. 19
`OPERATION FINANCIALS ........................................................................................................ 20
`CASM ANALYSIS.................................................................................................................... 21
`STOCK PRICE VALUATION...................................................................................................... 24
`DU-PONT ANALYSIS ............................................................................................................... 26
`STRATEGIC ISSUES AND RECOMMENDATIONS...........................................27
`MAINTAINING COST ADVANTAGES...................................................................................... 27
`GROWTH OPPORTUNITIES...................................................................................................... 30
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`Executive Summary
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`Southwest Airlines has been a strong growth company over the last 35 years. Using its
`low-cost, passenger friendly, point-to-point operational strategy, Southwest has been
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`able to sustain considerable growth year after year and remain profitable for 33 straight
`years. Southwest Airlines now has a market capitalization of $14 billion and is
`positioned as one of the strongest airlines in the struggling airlines industry. Over the
`
`last five years as many airlines have reported record losses and five of the ten largest
`airlines have filed for bankruptcy, Southwest has been able to remain profitable and
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`continue to grow.
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`While Southwest has gained market share in recent years, legacy carriers have
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`struggled due to depressed market conditions. The enire airline industry has endured
`expensive labor contracts, soaring energy costs and reduced consumer demand.
`Southwest has continued to grow in the harsh airline industry because its no frills
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`business model focuses on controling costs. Southwest targets routes with high
`consumer demand and the advanced experience of Southwest’s personnel allow
`Southwest to quickly turnaround aircraft and keep their planes in the air more hours
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`per day than its rivals. Though the airline industry appears to be on the mends,
`Southwest has firmly positioned itself as a price leader and a strong market force with
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`the lowest CASM of any airline.
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`Southwest has experienced remarkable growth in the airline industry by steadily taking
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`market share from large legacy airlines. However, Southwest’s success has brought
`considerable change to the market conditions of the airline industry. The struggling
`legacy airlines have been forced to streamline operations and new airlines with
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`aggressive low-cost strategies have entered the industry. Damaging price wars have
`forced many airlines to drastically alter their cost structure in order to remain
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`competitive. By its success, Southwest has begun to alter the market conditions that
`were partially responsible for its success.
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`To ensure its future success, Southwest needs to maintain its cost advantages and find
`new growth opportunities. Even though Southwest has the most fuel hedging of any
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`airline, those hedges only last through 2009. Fuel costs remain a major concern and
`Pandora Group recommends that Southwest take steps to improve the fuel efficiency of
`its fleet by purchasing new Boeing 737-700s. Southwest has considerable cash reserves
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`and significantly less debt to total capitalization compared to other airlines which it
`should use to switch from renting Boeing 737-300s to owning Boeing 737-700s. In
`addition to fuel costs, labor costs are a primary concern for Southwest. In the next
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`several years many of agreements for Southwest’s 80 percent union force will up for
`negotiation. Southwest’s success could lead its union workers to demand more
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`generous compensation packages. Labor market conditions in the airline industry are
`such that Southwest will need to take a strong position with its unions to
`maintain/lower costs. Since Southwest has always maintained good relationships with
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`its employees, it may be able to convince its employees to help in maintaining its low
`cost advantage. Pandora Group recommends that Southwest begin planning its strategy
`to do just that.
`
`Pandora Group notes that Southwest’s traditional strategy for growth may not continue
`to work in the future. Eschewing the hub airport strategy of the legacy carriers,
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`Southwest traditionally selects only highly profitable city pair routes on which they can
`establish a strong market share through low prices and high load factors. However,
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`Southwest has already entered many of the most profitable markets. Pandora Group
`notes that growth opportunities still exist for Southwest in expanding operations in
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`cities already serviced. Pandora Group also recommends that Southwest enter new
`cities especially those that have been serving as hubs for weakened legacy airlines.
`Pandora Group also encourages Southwest to expand by opening service to
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`international destinations using their current operational strategy.
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`Company Background
`Southwest Airlines was incorporated as Air Southwest on March 15, 1967 by Rollin
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`King and Herb Kelleher. However, the newly created Texan airline was not to leave the
`ground for several years. Immediately after inception, Air Southwest was grounded
`from a joint lawsuit filed by several of the prominent airlines of the time. In 1971, after
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`three years of legal battles, the lawsuit was lifted and the airline that had become
`Southwest Airlines embarked on its maiden flight.
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`Southwest Airlines was founded on several principles of business; “If you get your
`passengers to their destinations when they want to get there, on time, at the lowest
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`possible fares, and make darn sure they have a good time doing it, people will fly your
`airline”.1 Southwest realized the potential of airline travel to be used by the common
`people and not as just a means of travel for the elite. From the beginning, Southwest’s
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`operational strategy profited from its understanding that in the airline industry
`customers’ choices were primarily driven by price. The beginning of Southwest Airlines
`in 1971 can be seen as the start in the series of events that led to the deregulation of the
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`airline industry in 1978. Southwest’s competitive business model directly challenged
`the government protected industry that had always been dominated by a few large
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`incumbent airlines.
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`Southwest eventually was to revolutionize the airline industry but it started from an
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`extremely humble beginning. The airline only had three Boeing 737-200 aircrafts in 1971
`when it commenced its service out of Love Field in Dallas. Southwest began with short,
`no-frills flights between Dallas, Houston and San Antonio.1 The short hop service and
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`simple fare structure became the standard for Southwest. Southwest’s intentions were
`not to compete with the incumbent long freight airlines but instead to provide an
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`alternative option to ground transportation between cities. That is why Southwest has
`remained in regional airports that they believed are closer to their passengers instead of
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`nearby international airports. Maintaining that philosophy, Southwest has stationed its
`headquarters and operations out of Love Field in Dallas instead of Dallas/Forth Worth
`International Airport.
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`By 1977, Southwest was flying into Austin, Corpus Christi, El Paso, Lubbock,
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`Midland/Odessa and Rio Grande Valley.1 With the official deregulation of the airline
`industry in 1978, Southwest began to plan the expansion of its operations outside of
`Texas. However, with the urging of several competing airlines, Congress passed the
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`Wright Amendment. The Wright Amendment restricted Southwest’s flight capabilities
`from Love Field to only Texas and the states directly surrounding it.2 Southwest’s
`growth plans were stifled but were not stopped. In 1979, Southwest added it first intra-
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`state flights by providing service to New Orleans from Dallas.1
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`As Southwest grew throughout the early 1980s it continued to add cities to its
`destination list. In 1982, Southwest added San Francisco, Los Angeles, San Diego, Las
`Vegas, and Phoenix to its list of cities. Then again in 1985, Southwest added St. Louis
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`and Chicago. With rising gas prices during the 1980s, customers realized that Southwest
`represented a viable alternative to ground transportation between several major cities.
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`The 1990s Southwest become a prominent airline in the US. In 1992, Southwest won its
`first Triple Crown award which it went on to win for three consecutive years. The
`Triple Crown is a prestigious award given to an airline that has the best on-time record,
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`best baggage handling, and fewest customer complaints during that year as published
`in U.S. Department of Transportation consumer reports. Additionally, each year
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`Southwest added more destination cities until it included Seattle, Spokane, Portland,
`Boise, Tampa Bay, Omaha, Manchester, Orlando, and New York to name just a few.
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`Each city was selected because it represented an area in the US with high passenger
`frequency and demand with considerable opportunity for productivity for Southwest.1
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`Southwest grew considerably during the 1990s but the 1990s were also a strong period
`for the entire airline industry. Southwest differentiated itself for other airlines when it
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`successfully negotiated the industry wide slide following the Sept. 11 attacks in 2001.
`Southwest was the only major US carrier to maintain its full flight schedule and to have
`no layoffs during the next several years.2
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`Southwest emerged as a dominant airline from this tumultuous period for several
`reasons. First, its low price strategy allowed it to maintain and expand its market share
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`after the 1990s demand surplus dwindled. Second, previous positive management-
`employee relations allowed Southwest to negotiate with its labor force to lower costs. In
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`its history Southwest has only had one labor strike. Third, Southwest has extensive
`price hedging of fuel that they gained through oil futures that extended through 2009.
`This has allowed Southwest to largely avoid the increased cost of oil that has devastated
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`many other airlines. Furthermore, in 2004, Southwest began its first domestic
`codesharing arrangement by negotiating a deal with ATA. Industry experts have
`speculated that this arrangement has generated $50 million in revenue for Southwest.3
`
`Southwest has recently added transcontinental service but its primary focus remains
`short point to point flights. Currently Southwest serves 61 airports in 31 states with
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`additional cities petitioning to host Southwest every year.3 Its fleet of 737’s now
`numbers over 400 but its average flight time remains under 2 hours and its plane
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`turnaround at a gate still averages under 20 minutes.2 By only flying one type of
`aircraft, Southwest is able to fly a heavier flight schedule than its competitors. This
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`results from the fact that the loading and unloading of Southwest’s aircrafts is
`completely standardized. The equipment operators and pilots only have to learn one set
`of skills which they used repeatedly. This allows them to develop the ability to
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`instinctively and more efficiently handle the aircrafts. Furthermore, only one type of
`specialized equipment is required to service and maintain the airplane fleet.
`
`In response to the success Southwest has had with its business model additional airlines
`have tried to entire its low price, point to point airline market. Airlines such as Jetblue
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`have been developed directly from the Southwest model and have seen positive results.
`Additionally many legacy airlines have created subsidiary airlines in an attempt to
`directly compete with Southwest Airline, such as United creating Ted. These new
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`subsidiaries are creating competition for Southwest but they are also cannibalizing sales
`from the parent airline. Many airlines have attempted to emulate Southwest but
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`Southwest has developed a niche. The key company elements that have allowed
`Southwest to succeed in the airline industry will be difficult for rival airlines to adopt
`individually to increase productivity; Southwest has taken its entire history to cultivate
`
`those key elements. To begin, Southwest has only Boeing 737s in its fleet. Working a
`single type of aircraft increased the experience of employees which in turn means that
`its employees are extremely efficient in the maintenance, piloting, and general use of
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`the Boeing 737. Increased efficiency along with a culture of positive employee
`participation results in significant cost reductions. This type of culture and
`infrastructure for an efficiently run low cost, point to point carrier requires time to be
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`copied by other airlines.
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`Porter’s Five Forces
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`Market Definition
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`Southwest Airlines is classified by the North American Industrial Classification System
`(NAICS) as category 4811, “Scheduled Air Transportation.” Southwest Airlines operates
`in two sub-categories, “Scheduled Air Passenger Transportation” (481112) and
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`“Scheduled Air Freight Transportation” (481111) but receives the majority of its revenue
`from passenger transportation.4 Further industry analysis divides passenger
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`transportation into sub-categories based on the size of the area serviced by an airline
`carrier. Southwest Airlines is categorized as a major airline based on its annual revenue
`but is categorized as a regional airline based on its operational strategy. Southwest
`
`Airlines’ unique position makes it difficult to ascertain which firms constrain the
`strategic decision-making of Southwest Airlines. Legacy airlines such as Delta Air Line
`Inc. AMR Corp. (American Airlines), UAL Corp. (United Airlines), Northwest Airlines
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`Corp., US Airways Group Inc. (USAir), Continental Airlines Inc., and America West
`Airlines compete with Southwest Airlines but have very different operational strategies.
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`Instead of the classic hub-and-spoke system used by most major airlines, Southwest
`Airlines uses a point-to-point system that allows them to cherry-pick the most
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`profitable routes to operate. Southwest Airlines provides service to 61 airports in 31
`states with its fleet of 445 Boeing 737s as of October 2005.5 In terms of annual revenue
`and available seat-miles (ASM) Southwest outperforms many of the legacy airlines and
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`ranks as one of the largest U.S. airlines. However, Southwest Airlines is also categorized
`as a regional/discount airline because of its point-to-point operational strategy and
`discount services. Most regional/discount airlines have only a fraction of the market
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`capitalization of Southwest Airlines. Only Jetblue and AirTran can be categorized with
`Southwest as both major airlines and discount regional carriers. Both Jetblue and
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`AirTran may be growing as discount carriers but they remain considerably smaller in
`terms of market capitalization as compared to Southwest Airlines.
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`Internal Rivalry
`The airline industry is characterized by numerous sellers who have very little
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`differentiation in their product. As a result of these factors and the current market
`conditions, the airline industry is in a very weak position. Currently four of the top ten
`airlines are in bankruptcy; Delta Airlines Inc, Northwest Airlines Corp., United Airlines
`
`and ATA Airlines. Additionally, US Airways Group Inc, only recently emerged from
`bankruptcy in Sept. 2005. Southwest Airlines was the only airline of the ten largest U.S.
`carriers to report a profit in 2004.6 The deterioration of many major airlines’ balance
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`sheets is the result of several factors as will be discussed in later sections but it has been
`compounded by severe price wars during the last five years. The limited differentiation
`of the product of most major airlines coupled with the increased price sensitivity of
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`consumers has forced the airline industry to use price competition as its primary mode
`of rivalry. Price competition has eroded profits in the airline industry and significantly
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`reduced the price-cost margins of most major carriers. Additionally, the emergence of
`discount airlines, such as Southwest Airlines, in the major airline industry has
`exasperated the already damaging price competition in the industry.
`
`Non-price competition has mostly disappeared from the airline industry because of the
`extreme price sensitivity of consumers. Many firms have continued to try and
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`differentiate their product through the advertisement of improved passenger service,
`more comfortable seats or exceptional frequent flyer programs but these programs have
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`largely failed to increase revenue or market share. Even business travelers have become
`price sensitive, which has removed the primary way airlines had been able to price
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`discriminate. The combined effect of increased consumer price sensitivity in the airline
`industry has led to increased rivalry. The industry currently has significant excess
`capacity and because of the perishable nature of their product and high fixed costs most
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`airlines are left in a difficult negotiating position.
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`Southwest Airlines is in a unique situation since it is one of the principal driving forces
`in the current price competition. Currently Southwest Airlines has the lowest cost per
`available seat mile (CASM) of the major airlines. This allows Southwest Airlines to
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`control prices to maintain its profitability level. However, Southwest Airlines CASM
`has been slowly increasing due to increased labor costs and a decreasing fuel hedge (see
`“CASM Analysis” for details on Southwest’s fuel hedge). The major airlines are
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`attempting to trim their margins and other discount carriers have the potential for even
`lower CASM as compared to Southwest Airlines.
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`Entry
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`The airline industry is a highly consolidated industry with the top ten airlines
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`accounting for over 90% of total U.S. air traffic in 2004. Despite the centralization of
`industry and the weak earnings of most major airlines, many new carriers have
`attempted to enter the airline industry in past years. A success story for new airline
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`entrants has been Jetblue who began in 2000 and has shown sizeable profit margins and
`high load factors. Jetblue has become an exception to the rule. Most new carriers have
`failed to establish their place in the industry and have halted operations or filed
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`bankruptcy. In the last three years Mesaba Airlines, Transmeridian Airlines, Aloha
`Airlines, Southeast Airlines, Great Plaines Airlines, and Midway Airlines have all halted
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`operations.6 Entry for these firms and others into the airline industry is made difficult
`because of several strong barriers to entry present in the airline industry.
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`High startup costs may appear to be a major obstacle for new entrants but capital
`markets have historically been willing to fund new startups in the airline industry
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`despite high failure rate. Capital markets avid interest in the airline industry has
`recently waned. The massive financial losses experienced by many major airlines in
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`recent years and the lower consumer demand that has occurred in the aftermath of
`September 11 have resulted in the tightening of the capital markets for the financing of
`start-ups.6 However, new industry analysis has predicted a strong change in both
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`industry demand and profitability which could correspond with increased access to
`capital markets for new airlines. The potential for funding from capital markets and the
`profitability of some airlines, especially Southwest Airlines, have increased the
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`incentives for new entrants to enter the airline industry.
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`The most significant barrier to entry that new entrants face is significant post-entry
`competition from existing major airlines. The typical strategy of new carriers is to
`pursue regional markets which offer the most profitable routes. In these markets,
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`entrants can often offer lower prices then existing carriers because of lower marginal
`costs since they have lower labor and maintenance cost. However, the preexisting price
`competition amongst the major airlines has created a strong incentive for them to
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`preserve their market share. When an entrant competes head to head with an existing
`major airline, the major airline will lower prices on that route below those of the entrant
`while maintaining higher fares on its non-competing routes.6
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`There are many barriers to entry in the airline industry but there remains the possibility
`that new competitors could arise. However, with the current market conditions and the
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`steep experience curve it would take years for a new airline to become a viable
`competitor to any of the major airlines.
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`Substitutes and Complements
`The airline industry competes with bus, automobile and train travel in the
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`transportation of individuals. The primary substitute for the airline industry is the
`automobile. The extensive interstate highway system in the U.S. makes it possible to
`travel virtually anywhere by car. Auto travel dominates short distance travel because of
`
`the impractical nature of flying such short distance. However, as distance needed to
`travel lengthens usage of airlines dramatically increases. In 2004, only 13% of
`automobile trips were longer than 1000 miles, compared to 75% of airline trips.6 Trips of
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`extended distance are impractical by automobile and do not provide sufficient cost
`benefit. A less popular substitute is the intercity railroad transportation. Trains may
`have many disadvantages but they have considerable cost advantage as compared to
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`airline transportation. Amtrak is the leading intercity railroad operator and has
`benefited from U.S. government subsidies that allow it to keep prices exceptionally low.
`
`The dramatic difference in price allows Amtrak to compete with the airline industry for
`those customers who have a large price elasticity of demand for airline transportation.
`Low costs may attract a small percentage of customers away from the airline industry
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`but the slow rate of travel for trains guarantees that the majority of long distance
`travelers will chose to travel by airplane.
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`These regional forms of transportation do not represent a direct substitute for the airline
`industry but they may be a competitive force that regional airlines need to consider.
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`Southwest Airlines operates a point-to-point destination schedule between regional
`cities which may also be connected by considerable bus or railroad traffic. Increased
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`wait times at many airports due to increased security means the time advantage gained
`by using air travel has diminished. Therefore the marginal benefit of using airlines for
`transport has decreased and the use of train or automobile may become more viable
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`alternatives.
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`There are many complements to airline travel but it is difficult to determine the
`magnitude of the relationship. Many services and products related to travel are
`complements to airline industry such as hotel rooms and car rental prices. The lower
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`the cost of these services and products the greater demand there will be in the airline
`industry. However, these complements only affect the leisure traveler not the business
`traveler. The true determinants of demand for airline travel are economic and political
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`factors.
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`Supplier Power
`The airline industry is sensitive to supplier power through three primary inputs; jet-
`fuel, airframes and labor. The greatest source of increased supplier power has come
`
`from the suppliers of jet-fuel. Jet-fuel prices do no perfectly correlate with oil prices but
`the historical price level of $70.85 for oil reached in 2005, which meant problems for the
`airline industry. Historically crude oil has averaged around $20/barrel in the U.S. but
`
`since it reached its historical high, the price of crude oil has remained above 60$/barrel.
`Increased “crack spreads” have further worsened the position of the airline industry to
`its jet-fuel suppliers. The crack spread measures the difference between the cost of a
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`barrel of crude oil and a barrel of jet-fuel. The “crack spread” has traditionally
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`fluctuated between $5 and $10/barrel but spiked to over $60/barrel in the aftermath of
`Hurricanes Katrina and Rita.6
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`Like the rest of the airline industry Southwest Airlines faces declining margins due to
`increasing fuel costs but Southwest Airlines has the most extensive price hedge on fuel
`
`in the airline industry. Traditionally, many airlines have operated under the assumption
`that remaining exposed to fuel prices is the norm for the airline industry and therefore
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`acceptable. Discount airlines, such as Southwest and JetBlue, have deviated from that
`traditional form of thinking. Both airlines now utilized dynamic hedging strategies
`which allow them to use hedging to control the episodic nature of jet fuel prices by
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`capping higher prices in the future. Southwest currently has an advanced hedging
`program that is continually trying to determine future cash flows relating to jet fuel
`prices to optimize their hedges.7 However, each year Southwest Airlines fuel hedges as
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`a percentage of total fuel consumption decreases. In 2005, Southwest Airlines fuel
`hedges cover 85% of fuel use but by 2009 they will only cover only 25%.8 This yearly
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`reduction in hedge coverage will dramatically increase effective costs and cost per
`available seat mile (CASM) each year. Since low CASM has been the foundation for
`Southwest Airlines’ competitive advantage in the airline industry, the loss of their fuel
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`hedge could pose potential problems for Southwest Airlines.
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`Current economic conditions have greatly increased the indirect power jet-fuel
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`suppliers have over the airline industry but those same conditions have lessened the
`supplier power of both airframe manufacturers and labor unions. Only Boeing and
`Airbus exist as suppliers of commercial airframes for the airline industry. Historically,
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`the high concentration of airframe manufacturers and the limited availability of
`substitute inputs have allocated Boeing and Airbus significant direct power in price
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`negotiations with the commercial airlines. However, the current weakened economic
`position of the entire airline industry has altered the industry’s bargaining position with
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`Boeing and Airbus. The head-to-head competition of Boeing and Airbus and the large
`purchase volume of large airlines mean that suppliers are highly sensitive to airlines
`switching suppliers. For Boeing, Southwest Airlines is currently the largest single
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`purchaser of Boeing 737s. Southwest Airlines’ single aircraft strategy may make it
`reliant on Boeing but Southwest plans to continue to grow their fleet by 25-30 new
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`planes each year. With the comparative weakness of the rest of the industry this may
`make Boeing dependent on Southwest’s continued business.8
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`Labor costs represent the single largest expense for the airline industry. In 2004 labor
`costs accounted for 34.4% of total revenue and 39.9% of total costs.6 The majority of
`airline employees belong to one of the many industry unions. Historically these unions
`
`have allowed airline employees to garner premium wages and benefits. However,
`financial pressure from large pension funds has been responsible for the disruption of
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`many airlines balance sheets and a leading cause of financial difficulty for the airline
`industry. Many analysts have speculated that the recent wave of bankruptcy filings by
`major airlines was completed in order to cut labor costs. United Airlines and US
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`Airways have already cancelled their benefit pension plans while in bankruptcy and
`passed the obligation on to the Pension Benefit Guaranty Corp. (PBGC), a government
`agency responsible for insuring U.S. corporation pension funds. The risk of further
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`pension cancellations and bankruptcies has resulted in loss of supplier power by unions
`and widespread concessions on employee compensation. Unions will maintain
`significant supplier power in the airline industry but the power has recently been
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`reduced and may continue to decline if market conditions do not improve.
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`Buyer Power
`Consumers currently have considerable buyer power over the airline industry. The
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`economic recession beginning in 2000 and the terrorist attacks of Sept. 11, 2001 had a
`significant negative impact on consumer demand. From their high in 2000, revenue
`passenger-miles (RPM) have decreased dramatically and though they have rallied
`
`recently they remain at a suppressed level [Revenue passenger-miles are an industry
`measure for consumer demand which is calculated by multiplying the total number of
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`passengers carried by the number of miles flown]. During this period the airline
`industry did not experience a corresponding drop in available seat-miles (ASM)
`[Available seat-miles are an industry measure of capacity which is calculated by taking
`
`the total number of seat multiplied by the total number of miles flown]. The industry
`has attempted to reduce ASM (capacity) to react to decreased RPM (demand) but the
`reaction has not been sufficient which has resulted in lower load factors. Airlines excess
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`capacity and the perishable nature of airplane seats have allowed consumers to exert a
`tremendous amount of pressure on the price of airline tickets.
`
`The majority of airline consumers are highly price sensitive. Southwest Airlines was the
`first to offer online reservations but other airlines rapidly followed in order to reduce
`
`costs. Additionally, in an attempt to eliminate the commission required for travel
`agents, airlines such as Northwest Airlines and United invested in a travel website
`called Orbitz. This centralized site for online reservation eliminated the 3.5%
`
`commission for travel agents but its also increased price competition. The introduction
`of joint travel websites which allow customers to price shop with ease has also greatly
`increased consumers price sensitivity. Now reservations can be made for most airlines
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`through a travel site such as Orbitz, Expedia, Travelocity or their individual home
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`websites. Only Southwest Airlines and JetBlue do not offer services through joint travel
`website; they only offer online reservations through their individual websites.
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`Current market conditions and consumer preferences have made it difficult for airlines
`to price discriminate. The airline industry previously relied on business travel for price
`
`discrimination but with the ease of internet booking virtually all consumers