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Southwest's preservation of its renegade image hinders innovation

23-Jun-2013

Recently Southwest CEO Gary Kelly declared the carrier has been, “a disruptive force for five decades”. But while the company has taken great care to preserve its pioneering low-cost and low-fare image (neither of which still neatly applies), full service carriers have fundamentally changed their businesses - at the same time as ultra low-cost airlines and hybrid carriers have structurally evolved the business model on which Southwest has built its legend.

As the strict adherence to Southwest’s simple low-cost carrier playbook has been abandoned by the new breed of hybrid carriers that began making their marks during the early to mid-2000s, Southwest has undergone its own subtle transformation, albeit on its own terms. The downside of maintaining a pioneering image is the constraints it sometimes creates in attempting to alter outdated elements of a business.

Southwest’s influence in the respective evolving airline business models – revamped full service carriers, hybrid airlines and ultra low-cost operators – has arguably been diminished as its conservative approach has resulted in the carrier moving slowly to embrace new approaches to its business. Southwest as a consequence will be less disruptive in the coming decades as it works to determine where it falls in a US market place which may be about to reach a new level of maturity as the mergers creating three large network carriers take full effect.

Southwest adopts its typical cautious approach to product unbundling

Southwest has admitted it can no longer brandish the low-cost leader banner as Allegiant Air and Spirit Airlines have markedly lower unit costs than Southwest. During 1Q2013 Southwest’s USD8.21 cent unit costs excluding fuel were solidly higher than the USD6 cents recorded by Spirit and the USD5 cents posted by Allegiant. For FY2012 on a stage-length adjusted basis, there was roughly a 30% difference in Southwest’s unit costs versus Allegiant.

US carrier 2012 stage length adjusted unit costs excluding fuel: 2012

US carrier 1Q2013 third quarter unit costs excluding fuel in USD (cents) 

Carrier CASM
American 9.27
Alaska Air Group 8.62
Allegiant 5.18
Delta 9.75
JetBlue 7.62
Southwest 8.21
Spirit 6.04
United 9.52
US Airways 8.77

Accompanying Allegiant and Spirit’s significantly lower unit costs is strong profit growth – Allegiant’s profits jumped 47% year-on-year during 1Q2013 and Spirit’s grew roughly 37% excluding special items.

Key to their profit generation is a focus on non-ticket revenue garnered from traditional products such as hotel and car rental partnerships, and additionally from the ever-growing product unbundling adopted by full service and low-cost carriers. Both types of airlines operate under the premise that the unbundling is a benefit to customers in the respect that they only pay for the services they desire, and as Spirit argues, do not subsidise services such as checked bags for other passengers.

Other popular unbundled products are priority boarding, expedited security clearance and extra legroom. Southwest embraces some of that unbundling; but again, under its own terms. While the carrier remains dedicated to its decades-old unassigned seating, it has over the years introduced ways for customers to improve their chances at gaining their preferred seats through a USD12.50 charge for “EarlyBird Check-In”, which allows passengers to check-in for flights prior to the traditional 24 hour window, and jockey for a more favourable seating position.

One of Southwest’s fare classes, Business Select, also includes its version of priority boarding that entails getting access to the first boarding group – A1 to A15. Passengers opting for the higher Business Select fares also gain expedited security screening at select locations, a free cocktail (recalling the long-ago free bottle of bourbon) and extra rapid rewards points. Southwest netted USD22 million in Business Select revenues during 1Q2013, while Early Bird sales helped lift Southwest’s other revenues by about 2% to USD207 million. In early 2013 the airline began selling boarding positions for group A at the gate for USD40.

Southwest believes network strength will outshine ancillaries in the short term

Unlike its hybrid colleagues, Southwest has no plans to offer additional legroom. Almost immediately after unveling its acquisition of AirTran in late 2010, Southwest declared AirTran’s business class would be eliminated. But throughout the integration process Southwest has left AirTran’s baggage fees intact, and netted USD30 million from those charges during 1Q2013 - admittedly a drop in the ocean beside its full service competitors. JetBlue, meanwhile, estimates revenues from its “Even More” (extra legroom and expedited security clearance) should reach USD165 million in 2013.

During early 2013 Southwest CEO Gary Kelly remarked that initially when the carrier purchased AirTran, it was generating roughly USD300 million in fees Southwest does not charge. “So yes, we were trying to figure out how we transition from AirTran to Southwest and keep the profit wheels on,” Mr Kelly remarked. “And it’s just, we haven’t had a problem with it, so I think again we’ve been pretty pleased with the revenue conversion process here.”

Southwest’s top-line revenues grew approximately 2.3% during 1Q2013, compared with 23% growth at Spirit and a 15% increase at Allegiant. Its top-line revenues were also lower than the 9% and 8% increases posted by Alaska and JetBlue, respectively. Those carriers offer a more hybrid product than Southwest. Delta and United’s overall revenues were lower than Southwest’s during 1Q2013, but those carriers had significant passenger unit revenue premiums compared to Southwest during the quarter.

Percent change in US carrier unit revenues, unit costs, yields and traffic: 1Q2013

Carrier CASM (ex-fuel) PRASM Yield Traffic
Alaska Air Group -2.3% 0.3% 0% 9.1%
American -3.2% 2.6% -0.3% 4.1%
JetBlue 6.6% 1.8% 0.6% 7.6%
Southwest 2.8% 1.8% 2.1% 0.3%
Delta 5.1% 4.1% 2.1% -0.6%
United 13.9% 5% 1.3% -1.6%
US Airways 0.7% 2.3% 0.6% 0.6%

US carrier top-line revenue increase year-on-year: 1Q2013

Carrier Increase/Decrease
Alaska 9%
Allegiant 14.8%
Delta 1%
JetBlue 8%
United 1.4%
US Airways 3.5%

But ancillaries have been the near-exclusive source of network airline profitability

Ancillaries have been instrumental in most of US full service network carriers achieving and sustaining profitability during the last couple of years. As evidenced by Allegiant and Spirit, non-ticket revenues also play a major role in the evolving businesses of ultra low-cost and hybrid carriers. But Southwest continues to chafe against the grain, as Mr Kelly declared that ancillary revenues are not the answer to Southwest hitting its earnings target. But he did allow for some leeway, noting he could not predict, “where the world is three years from now [...] for all we know, customers will say we want you to separate out bag fees”.

Southwest’s almost-singular focus for the near future is in optimising the combined network with AirTran, as Mr Kelly declared that is the number one deliverable for 2013. He believes as the Southwest-AirTran networks are combined, there are significant opportunities to drive unit revenue improvement through the elimination of underperforming routes and careful capacity management. “That is the number one opportunity that will dwarf any ancillary fee idea,” Mr Kelly stated.

See related report: Southwest continues de-hubbing Atlanta as ROIC targets start to look murky

Prior to its acquisition by Southwest, AirTran accounted for roughly 3.5% of US domestic capacity, and during the next few years AirTran’s contribution to the combined network will diminish, as 88 of its Boeing 717 narrowbodies are transferred to Delta, its long-time nemesis in its Atlanta hub.

By eliminating unprofitable routes throughout AirTran’s network, Southwest has already shrunk AirTran by roughly 25% since it acquired its smaller rival in 2011, so the network scale of the combined carrier will still result in Southwest becoming the fourth largest US carrier once all the consolidation among the major carriers is complete. Competition will be fierce as the integrated network will touch all the major markets served by legacy, hybrid and ultra low-cost carriers with varying product offerings and similar schedules.

Southwest has a lot riding on integrating the two networks, as the company continually pledges that it intends to hit its 15% return on invested capital (ROIC) target during 2013 (after missing it in 2012). The carrier embarked on 2013 with a decent unit revenue performance, and executed a 2% rise in that specific metric in Jan-2013 and Feb-2013. But US Government budget cuts and general economic uncertainty have pressured its unit revenues from Mar-2013 through May-2013. During Mar-2013 unit revenues remained flat year-on-year, fell 4% to 5% in Apr-2013 and slid 2% in May-2013.

See related report: Southwest Airlines plots course to meet previously missed ROIC targets

The carrier has repeatedly stated that its determination to hit its target rests on improvement in unit revenue trends that are loaded in 2H2013 once a full codeshare with AirTran that took effect in Apr-2013 reaches fruition. Now all eyes will be on Southwest's revenue performance throughout the remainder of 2013 as the LCC repeatedly states it will hit its ambitious return goals even as it strikes a cautious tone about demand during the summer high season in the US and highlights yield weakness in its network.

See related report: Delta, United and Southwest hint at mixed fortunes for 2Q2013

Southwest’s attempts at forging partnerships have faltered

Southwest has also opted out of fostering partnerships that could boost its revenue while hybrids including Alaska, JetBlue, Virgin America and WestJet continue full speed ahead in adding interline and codeshare partners that make varying contributions to their respective revenues.

Aside from a codeshare with now defunct ATA in the mid-2000s that was basically part of a broader deal to increase Southwest’s footprint in Chicago Midway, Southwest has adopted its slow, cautious approach to partnerships.

A deal between Southwest and Mexican carrier Volaris that facilitated passenger transfers between the two carriers ended in early 2013 as Southwest intends to use AirTran’s network in Mexico and the Caribbean to finally move forward on its often discussed desire to serve neighbouring international destinations. Hyped commentary regarding a codeshare between Volaris and Southwest never translated into a more formal agreement as Southwest appears to be skittish in implementing codeshares.

There is some baggage; IT limitations and Southwest's influential pilots intrude on many decisions, explicitly or influentially. But the carrier's partnering hesitation largely stems from a feeling that it may lose control of its product and image through creating those types of partnerships. Meanwhile, JetBlue’s brand remains robust even as it continues to grow its base of more than 20 interline partners and works to institute two-way codeshares. While the connecting passengers might be incremental, the added revenue helps JetBlue through seasonal troughs in demand while offering a broader network to its customers. And it is growing; it has an expansion trajectory.

Southwest had also previously attempted to tie up with WestJet, but ultimately walked away from the deal. WestJet recovered nicely from the break-up, forging a codeshare with Delta at New York LaGuardia and a codeshare with American. Canada’s second largest carrier is targeting CAD100 million (USD96 million) in revenue from its numerous tie-ups with other carriers.

For now Southwest sees no value in additional codeshare partnerships outside of AirTran, where it obviously has full control of the process. Recently Southwest CFO Tammy Romo remarked the carrier has no plans for additional codeshares in 2013 and 2014 as it works to complete the integration of AirTran, puts reservations system technology in place to support international flights and makes changes to its revenue management systems. But given its track record of breaking off relationships with other carriers before they deepen, it’s a good bet Southwest won’t be evolving its philosophy on codeshare during the next few years.

Hesitation in investing in technology hampers Southwest's innovation

A serious barrier to potential deeper partnerships with other carriers is Southwest's years-long on-again, off-again overhaul of its reservations system. During that time both JetBlue and WestJet concluded the often-painful IT systems cutovers, but now that the short-term pain has abated those carriers have added a nimbleness in implementing codeshares and other product innovations.

Southwest finally settled on a technology platform supplied by Amadeus to support its international flights that enter a new phase when it launches transborder service from Houston Hobby in 2014. The carrier is presently learning the ropes of international operations through the addition of AirTran’s transborder routes into its network, and plans to debut its own branded service from Atlanta to San Juan, Puerto Rico in late 2013.

While it is considered a major step for the carrier finally to execute its vision to operate near-international service, launching flights to Mexico and the Caribbean is hardly innovative. Other carriers including JetBlue and Spirit have quickly exploited opportunities supplied by growing traffic between Mexico, the Caribbean and Latin America and the US. Although Southwest’s sole domestic focus through its 42-year history has resulted in tremendous brand resonation in the US domestic market, it faces an uphill climb in ensuring it translates its star power to markets that have distinct cultural nuances.

Even as the AirTran acquisition enables Southwest to fulfil its goal of serving international destinations, the reality is that the seven international markets served by AirTran (Cabo San Lucas, Mexico City, Cancun, Montego Bay, San Juan, Punta Cana and Aruba) only account for 7% of the 97 destinations served in the combined network as of Mar-2013. Given Southwest’s cautious approach to innovation, it is likely that its international push will be precise and controlled, which means those flights will remain a small portion of the network during the next few years.

Cracks appear in Southwest’s historically positive employee relations

Southwest's unique culture has long been the foundation of its prolonged success. But today its employees are among the highest paid in the industry, after almost every US major carrier completed a formal restructuring in the mid-2000s entailing a reworking of labour contracts.

CAPA in early 2013 estimated that salaries, wages and benefits represented roughly 29% of Southwest’s cost structure. Presently, the carrier is in negotiations with its five largest union groups, and has previously admitted it has labour cost challenges it needs to overcome.

As salary negotiations continue some cracks are surfacing in the legendary Southwest employee culture.

In Mar-2013 members of the Transport Workers Union, which represents more than 9,000 of the carrier’s employees, picketed at several airports in protest of management proposals for outsourcing. “By refusing to reward employees for their contribution to our airlines’ success, management is taking a terrible wrong turn from Southwest Airlines’ past emphasis on putting employees first and maintaining positive labor relations,” the union stated.

The episode illustrated the formidable challenges Southwest faces in achieving productivity improvements in its labour contracts - essential if it is to improve the shrinking cost gap with its legacy peers.

Southwest’s overly cautious approach inhibits innovation

Southwest occupies an interesting space in a US landscape where three business models are emerging.

With legacy costs but fewer frills than full service carriers and some hybrid airlines, it does not fit squarely into one of those models, and its costs are certainly outside the ultra low-cost carrier space.

Its move to contribute to US consolidation through the acquisition of AirTran is commendable, but the slow integration process exemplifies Southwest’s cautious approach, which paradoxically has been instituted to preserve its renegade image. The result of that perpetual caution is an unimaginative approach to its business.

Perhaps the carrier needs a mid-life crisis to reignite the disruption it claims to still impose in a market where its influence could be diminishing.


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