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Southwest Airlines: April results show some signs of hope, but revenue slide will continue

21-May-2009
Southwest CEO, Gary Kelly
Southwest CEO, Gary Kelly
  • April results show contraction is helping
  • Union pay accords nearly all bedded down
  • Employees find downsizing a difficult concept
  • Fuel hedging will continue, but less aggressively
  • A first step with the Volaris codeshare
  • No baggage fee policy set to stay

Southwest Airlines flew 6.5 billion revenue passenger miles (RPMs) in April 2009, a 4.1% increase from the 6.3 billion RPMs flown in April 2008, while available seat miles (ASMs) decreased 1.9% to 8.5 billion from the April 2008 level of 8.6 billion.

As a result, the drop in capacity and the increase in passenger volume has delivered a load factor for the month of 77.0%, compared to 72.6% in April last year.

April 2009 passenger revenues per ASM are in line with last year, but revenue and booking trends continue to be adversely impacted by the weak economic environment and are now being exacerbated by concerns over the swine flu outbreak.

Therefore, Southwest expects the year-on-year decline in 2Q 2009 passenger revenues per ASM to exceed the first quarter decline of 2.8%.

For the four months ended 30-Apr-09, Southwest flew 23.4 billion RPMs, compared to the 23.9 billion RPMs recorded for the same period in 2008, a decrease of 1.9 percent. Available seat miles decreased 3.5 percent to 32.6 billion from the 2008 level of 33.8 billion. The year-to-date load factor was 71.7%, compared to 70.5% for the same period last year.

To maximize the revenue potential of its network, in early May-2009 Southwest eliminated 32 existing roundtrip flights and added 19 roundtrip flights for a net system-wide reduction of 13 roundtrip flights.

The reduction in ASMs must inevitably mean at least a temporary reduction in aircraft utilisation, which will add an unwelcome additional cost overhang.

Meanwhile, the airline's Board of Directors has kept faith with its shareholders, who have enjoyed nothing but success for over three decades. At Southwest's AGM, the Board declared a 1Q-09 dividend of $.0045 per share - the 131st consecutive quarterly dividend to be paid, and unprecedented in the airline industry.

However, Southwest remained largest in 2008 passenger numbers

The US DOT figures for calendar 2008 reveal that Dallas-based Southwest again enplaned more passengers than any other US airline.

US Department of Transportation Passenger Emplanements - 2008

Carrier

Passengers (million)

% change year-on-year

Southwest

101.9

No change

American

92.8

-5.5

Delta

71.6

-1.8

United

63.1

-7.7

USAirways

54.8

29.9

Northwest

48.8

-9.1

Continental

46.9

-4.2

AirTran

24.8

3.5

JetBlue

21.8

2.4

SkyWest

20.7

-6.3

Union Pay Accords successfully struck as Southwest ages

Southwest Airlines has reached a tentative agreement to give pay raises to about 5,300 customer-service employees, with the arrangement also providing benefit increases in a trade-off for giving the company more scheduling flexibility and productivity improvements.

The agreement, with the International Association of Machinists and Aerospace Workers, which requires ratification by employees, is retroactive to last year and runs for 4 years to October 2012.

Last month, ground workers ratified a contract containing 3% annual raises, and pilots will vote on a five-year deal that includes increased pay and retirement benefits. The pilots have included a commitment from the company that the airline must recommence fleet growth by 2011 - with 541 aircraft in service by the end of that year (near to the current 539), rising to 568 aircraft in 2012.

The airline has announced that its more than 9,700 flight attendants, have voted to ratify a new four-year contract which is retroactive from June 2008 and runs through to May 2012.

The union said flight attendants will get 3% increases in each of the first three years of the contract, while any rise in the fourth year will depend on company performance. The contract also includes larger contributions to employee retirement plans, with Southwest agreeing to match 8.5% in 2009 and 9.3% in 2010, and improvements in leave policies.

Gary Kelly, Chairman, President, and CEO of Southwest Airlines, said, "I commend the negotiations teams for delivering a contract that benefits our outstanding Employees and also demonstrates a commitment to sustain our financial strength in an increasingly tough economy."

Southwest has now struck tentative or final agreements with all its major labor groups, most calling for annual pay increases of about 3%, despite the global economic crisis.

The carrier currently employs about 35,000 workers overall, but is trying to cut that number.

The world's largest low cost airline expects to reduce capacity 5% this year and is offering "buyout" incentives to workers who choose to leave. The buyout offers are understood to include cash averaging USD30,000 to USD50,000, plus health insurance and travel incentives.

A shrinking Southwest is hard to grasp....

In preparing for the buyout offers, even supervisors struggle to accept a dwindling workforce at the world's largest discount airline, said Kelly. He had to stress to managers at a recent forum that workers who take the offers won't be replaced.

"We've always had a bias to be lean and mean, but also to continue to build the company," Kelly, 54, said in an interview. "Can't do that now."

Kelly's buyouts and cuts in seating capacity mark the end, at least for the present, of the growth era at Southwest, whose uninterrupted annual profits since 1973 and 38 years without layoffs set it apart from all other players in the US aviation industry.

Southwest shelved its expansion plans because of a revenue and demand slump, which, said Kelly "is easily the worst that I've ever seen." He estimates he's at least "70% along the way" in convincing workers and leadership that enlarging the airline must stop for the foreseeable future.

"It's just coming to grips with the fact that, 'Oh, so you don't think we're going to add 20 airplanes next year,'" said Kelly, who is reducing seating capacity by 5% this year and won't rule out furloughs or seeking union concessions.

Over the past decade, the Southwest fleet increased by an average of 24 aircraft annually, to reach its current strength of 539 B737s, while the workforce grew by an average of 1,245 employees in each of the past five years.

However, the potential for a fast turnaround is still there...

Southwest's current 2009 fleet plan includes taking delivery of 13 new B737-700 aircraft and retiring 15 aircraft by the end of the year, as set out in the carrier's Jan-2009 guidance.

But the airline retains sufficient flexibility to turn from contraction to expansion very quickly should opportunities, admittedly currently unexpected, show themselves out of the current recession.

In 2011 there remain enough firm orders and options to allow the addition of 20 aircraft, should conditions display appropriate improvement.

Southwest fleet plan: 2009 to 2016: as at Mar-2009 (Sep-2008 plan in brackets)

Firm

Options

Purchase Rights

Total

2009

13

 

 

13

2010

10 (16)

(6)

 

10 (22)

2011

10 (13)

10 (19)

 

20 (32)

2012

13

10 (27)

 

23 (40)

2013

19

4 (1)

 

23 (20)

2014

13 (10)

7 (8)

 

20 (18)

2015

14 (11)

3 (6)

 

17

2016

12 (4)

11 (0)

 

23 (4)

2017-18

 

17 (0)

54

71 (54)

Total

104 (99)

62 (67)

54

220

Was fuel hedging an Achilles heel?

Southwest's losses have been attributed, at least in part, to its strategy of locking in fuel prices in advance - as far out as five years. The hedge contracts helped ensure profits as prices rose, but became a liability in the second half of 2008, following a fuel price decline of some 65%, after reaching a peak in early July-08.

Southwest had been the airline industry's most aggressive fuel hedger, and remains committed to hedging to lock in future fuel prices, according to Laura Wright, Southwest's CFO.

Between 2000 and 2007, fuel hedging was a hugely successful policy for the carrier, with savings of some USD3.2 billion being accumulated over this period. This gave Southwest a massive advantage over its generally unhedged competitors, but this might just have masked other problems that were creeping up on it - such as running out of suitable new hubs.

Despite being burnt in the second half of 2008, hedging paid off over the full year, with savings of USD1.3 billion realised - and these savings actually permitted the 2008 full year net profit of USD178 million to be reached.

Amid today's volatile oil prices, Southwest has placed new hedges this year using only call options. "That's our favourite way to hedge," Ms Wright said, because it offers protection against rising prices, but allows the company to pay market rates if prices remain low.

In the near term, Southwest expects fuel prices to remain volatile but believes prices will climb higher as the world economy begins to recover and grow. As crude oil prices in 2009 continue to remain around USD50-60 per barrel, the airline has worked to de-hedge contracts that protected against rising fuel prices.

Accordingly, control of costs across the board remains an important priority. Fuel still represents some 30% to 35% of Southwest's total costs. Wright has commented that Southwest risk management needs hedges for the same reason they have always been needed - so that the airline has a range for fuel costs that can be used for overall business planning.

In 2008, following the steep fall in oil prices, it was ironically airlines that couldn't afford to hedge that fared better than those who made hedging decisions that that turned ugly when marked to market.

But new hubs are certainly not off the agenda during the downturn

Gary Kelly announced at Southwest's AGM that the airline intends to begin services from Milwaukee's Mitchell International Airport late this year. The carrier has not released specific service details, but said it will offer multiple destinations from the airport of choice.

The new Milwaukee operations will commence after already-announced new services operating to New York LaGuardia from 28-Jun-09 and Boston Logan from 16-Aug-09.

"As we have previously announced, we essentially slowed our 2009 and 2010 fleet growth to zero. All of these new market opportunities are made possible without the addition of a single airplane by our continuous flight schedule optimization process," Kelly said.

Southwest and Mexico's Volaris take a step toward codeshare - but plans catch the flu.

Southwest now offers passengers the ability to book flights to Mexico on Mexican low cost airline, Volaris, via a link to Volaris' booking portal from Southwest's web site. This is small first step towards culmination of the two airlines' previously announced plans to enter a codeshare agreement by early 2010.

Southwest Airlines does not offer service to Mexico, and with Volaris only serving Oakland and Los Angeles in the USA, there is much ground to cover before the plan can be fully realised. By 2013 Volaris plans to reach some 12 different US destinations, while Southwest is yet to indicate the extent of any plans for direct operations to Mexico.

An immediate problem to attracting passengers to any new product offering to Mexico is the ongoing fear of swine flu, which is likely to continue generating nervousness for some time to come.

Southwest must also overcome resistance from its pilots and flight attendants, who are wary of the Southwest code being used on other carriers - to the detriment of expansion of services of their own company, and therefore of their own future job prospects.

No "First Baggage" fee for Southwest. Kelly takes on the conventional wisdom on auxiliaries.

Southwest Airlines remains steady in its belief that profitability can be achieved without following most other US carriers which have adopted fees for first or second checked passenger bags.

All US majors now charge for the first checked bag, and low-fare carriers including AirTran Airways and Virgin America have followed while JetBlue, which currently only has as a $20 fee for a second bag, recently said a first-checked bag fee could unlock $10 million in revenue.

Southwest stands alone in opting not to institute a bag charge, and CEO Gary Kelly remains unconvinced it would be revenue positive for the carrier.

It has even been suggested that baggage fees could have meant the difference between profit and loss in the first quarter of 2009, where Southwest losses, including special items, were USD91 million.

However, Kelly believes Southwest's "No Hidden Fees" advertising campaign promotes its passenger base during the economic downturn. "We believe we are having a meaningful impact in creating awareness among customers that we are virtually alone in not charging the bag fee. "That is translating into higher demand for Southwest Airlines," he explains.

Despite Kelly's confidence that Southwest is winning passengers with its decision not to charge for first or second checked bags, he doesn't dismiss a baggage fee in the future if the absence of a charge isn't a competitive advantage, or should the amount of missed revenue "render us unsuccessful."

While carrying two checked pieces free of charge, Southwest charges USD25 for a third bag, with 4th to 9th bags being $50 a piece and any other bags after that charged at $110 each.

GDS fees become auxiliaries in disguise?

Concern has been raised by travel-management companies, the large agencies widely used by corporate customers, over a deal Southwest has with one of the intermediaries in the process of selling tickets. The travel managers worry the deal could eventually raise the cost of flights, not only for their companies but for all customers as well.

These companies say the only way they can have access to all of an airline's fares is by using a global-distribution system (GDS).

It appears Southwest struck a deal in 2007 with one GDS, Travelport, in which Travelport charges agencies $1.25 for each Southwest flight sold through its system. Traditionally, airlines paid the agencies and distribution systems to get their tickets in customers' hands, not the other way around.

Southwest says that it's up to Travelport to determine who ultimately pays the per-flight fees, either the agency, or the customer, but any saving in distribution costs must be attractive to airlines in the current environment.

Background Information:

  • Commenced service in Jun-71, with three B737 aircraft serving three Texas cities - Houston, Dallas, and San Antonio;
  • Has flown over 16 million flights and has served almost 1.2 billion customers - four and one-half times the entire population of the US;
  • Transported nearly 102 million passengers in 2008 - largest US carrier by passenger number;
  • Operates 539 B737s: 188 B737-300s; 25 B737-500s, 326 B737-700s;
  • Operates network of 65 cities in 33 US states, with some 3,400 services per day;
  • An unprecedented string of 35 consecutive years of growth and profitability from 1973 to 2008, but this could come to an end in 2009.

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