Southwest, gaining cost efficiencies from 737 MAX order, now looks to improve labour costs

The deal includes a USD4.7 billion order for CFM LEAP-1B engines that promises 16% more fuel efficiency than current competitor aircraft models, according to Boeing.

Total 737 delivery schedule

Source: Southwest Airlines

For Boeing, according to president Jim Albaugh, the Southwest order is the first definitive order it has received of the 948 commitments for the MAX airplanes. He pointed out that number was up from only a couple of weeks ago and was expected to rise to between 1400-1500 by the end of 2012.

Southwest, with 699 aircraft at the end of the third quarter, is scheduled to take 33 737-800s in 2012 to replace retiring aircraft. Boeing recently increased its monthly production rate for the 737 to 35 and is upping it again to 38 in 2Q2012 and 42 in 2013.

However, the order also includes 242 options (150 for the MAX and 92 for the NGs) set for delivery through 2027 that would provide for growth "to take advantage of the market opportunities that present themselves", according to COO Mike Van de Ven. Initial deliveries will be for fleet replacement, of which Southwest is accelerating.

Good year for the airline, more ahead

Southwest acquired AirTran in May, affording it the ability to go international earlier than thought possible given its IT issues. It even inked a seniority integration deal between the Southwest's 6000 and AirTran's 1700 pilots, a major hurdle that will allow it to squeeze out all the cost and revenue synergies the merger promises, probably before US Airways and United-Continental can, given their contentious labour issues.

It is also expected to be the prime beneficiary in the expected capacity cuts American will make as the result of bankruptcy. American is expected to shrink from its current domestic footprint at 21% to as little as 15% during bankruptcy. In addition to benefiting from cutbacks at Dallas, Los Angeles and Chicago, Southwest also has AirTran's Atlanta integration to look forward to since it fills what otherwise was a white space on Southwest's map. It will also increase business traffic although doubts are already circulating as to whether its conversion of the Atlanta hub from connecting to point to point may cost it traffic.

AirTran also brings hot consumer markets in Mexico and the Caribbean into its revenue stream, which means it will likely benefit from any cuts in American's position there as well. Southwest could also spring-board off the Mexico/Caribbean service to tap one of the world's hottest markets in Latin America. The ETOPs clearances AirTran has could speed up introduction of Southwest's own Hawaii service which seems to have been put on the back burner.

Hopefully in 2013, it will have its long-awaited IT upgrade choosing between Amadeus and Sabre CRS offerings, which will increase not only its ability to field ancillary products but increase ancillary revenues as well. It has already integrated some Sabre upgrades in the interim.

AirTran prompted the delay to the IT makeover but changes to accommodate the new consumer regulations have also taken their toll. This is a huge problem since a new system is long overdue and critical to maximising the benefits of AirTran and growing ancillary revenues. The Passenger Service System has stalled international expansion prior to the AirTran acquisition and is said to have been behind Southwest's popular bags fly free policy (its reservation system could not handle checked bag fees), which serendipitously lead to a share shift as bag fees rose at legacies.

Still Southwest lags in ancillaries and thus has a revenue problem since ancillaries are the key to future industry profitability. In the third quarter, Southwest passenger revenue per available seat mile rose 6.4%, compared with 10.1% for United and 10.9% for Delta owing to its ancillaries lag.

During earnings calls, Southwest has often discussed the 2014 sunset of the Wright Amendment at Love Field limiting the service radius around the airport. Once that is gone, it becomes a prime growth market for the carrier and could offer nearly USD500 million in additional revenues.

In addition, it could follow in the JetBlue/WestJet/Alaska model of codesharing with all comers at international gateways which has been lucrative for all three airlines.

It has played the spoiler in three of the 18 industry-wide fare increase attempts and a change in that policy could spell more revenues in 2012 for the entire industry.

While it may have lost the LaGuardia/Washington National slot contest to JetBlue, it did not want to pay what JetBlue did for the slots, because it knew it would lose money. Even so, it will have more than enough on its plate integrated another golden opportunity in its system, Atlanta.

Those events provide a counterpoint to the unusual loss in the third quarter that was the first indication the airline was set to do something about its costs. Always costs conscious, the airline was one of the first catalysts for the complete restructuring of the US airline industry. But the order provides a long-term strategy for cost cutting that will address one of its two major cost centres, fuel.

Mr Kelly indicated the MAX will be 10-11% more fuel efficient than the 737-800NG on top of the 6-7% achieved by replacing the classic with the -700NG more efficient than the classics.

Even so, the order, according to Mr Kelly, means it will be able to keep its 15% pre-tax return-on-invested-capital target although margins in the last several months have been half that.

The order also keeps capital expenditure over the life of the order at an average of about USD1.2 billion annually.

The order also puts Southwest in the cat bird seat on the development of the program as Boeing said several times its intent was to ensure the MAX was everything Southwest needed.

The question was raised about the AirTran 717s that Southwest has already said it wants to shed. However, Mr Kelly would only say the company is obligated to operate them throughout the leases which expire between 2017 and 2024. However, he added Southwest is working with Boeing to see if they can reach a deal on retiring them much sooner. The betting is that the 717s come out of the fleet early, especially since Mr Van de Ven added "if we have to" to the company's commitment to honouring the leases.

The order

The order for 150 737 MAX jets not only is a record for the Boeing company in terms of aircraft numbere (208 aircraft worth USD19 billion at list prices - seven aircraft more than Lion Air's recent 737 order, but USD2 billion less at list prices since Lion Air ordered more expensive -900ER models). Southwest will be the launch customer for the 737 MAX, as it was for the 737-300, -500 and -700. It is also substituting 737-800s for its 2012-2013 737-700 deliveries.

The order also gives Southwest a leading fleet sooner than its rivals given its intention to accelerate its fleet replacement plans. Finally, it means Southwest is expecting to cut fuel burn by 15-18%, according to the latest promises from Boeing about the aircraft. This comes at a time when CEO Gary Kelly has been voicing growing concerns about rising costs at the carrier.

It was clear that the tipping point in the Southwest negotiations was its desire for fleet commonality but Mr Kelly said the company did its due diligence on the Airbus neo with its Pratt & Whitney GTF engine, which, Mr Kelly said, he really likes. However, the company said its requirement for short-field capability for such airports as Chicago Midway was very much part of the mix in the aircraft choice. In addition, Mr Van de Ven indicated the primary factors were the fleet commonality and that the 737 MAX-8 would be lighter and have better mission flexibility for the airports served by the carrier.

The airline also needs the MAX to, at least, fly the same mission as the NG with the same payload and range, "if not better." 737 Chief Project Engineer John Hamilton said Boeing was now working with airlines to understand what the market requires in terms of payload and range. The company plans to "dial in" the exact payload and range needed.

However, Mr Kelly also cited the history of the CFM Leap 1B engine that will power the jets compared to Pratt's PurePower engine. Mr Van de Ven again echoed him saying Southwest views the aircraft as a package including engines. He also cited the LEAP 1B's max fuel burn and the fact it has millions of flight hours to its credit.

While the company has not changed its fleet strategy, the order, said Mr Kelly, positions the airline for future growth.

Mr Van de Ven and Boeing's John Hamilton responded to a questions about whether the final parametres of the jet would meet Southwest's needs by saying that while the final configuration will not come until mid 2013, the configuration is well enough known that it gave Southwest the confidence to go forward with the deal.

Now that Southwest has addressed its number one cost centre, it is turning to other costs, including labour, although it was quick to tell employees that increased productivity and the elimination of waste will preserve pay rates.

Competition now stronger thanks to bankruptcy

The move is an important one because there has been an increasing drumbeat suggesting Southwest has peaked, given its recent slow growth rates which are expected to continue next year and the fact that its overall costs as well as labour costs costs are higher than peers.

Southwest unit labour costs rose 22% between 2002 and 2009 even as United's dropped 34%, Delta's 26%, Continental's 7%. Even at American it dropped 11%. Its pilots, in 2009, earned 20-40% more than pilots at other airlines. Much of that is balanced by better productivity but clearly the airline needs more. The increase for AirTran pilots is expected to create another cost headwind for the company.

Mr Kelly also addressed labour rates saying they are the highest in the industry thanks to bankruptcy adding, "we can't have lower overall operating costs if our labour costs aren't lower and we can't have lower labour costs if we aren't more productive." He was probably referring to the companies more restrictive work rules compared to AirTran.

After American became the last major airline to enter bankruptcy, Mr Kelly sent a missive to employees about costs frankly noting that it is looking for productivity gains as it enters negotiations for new pilot and other contracts next year. While CFO Laura Wright was quick to say the company is not asking for concessions, Mr Kelly pointed out that its cost advantage has been halved as competitors emerged and thrived post-bankruptcy and the same is expected from American.

That means that it no longer has the wherewithal to enter and stimulate markets as was its model in the past solely because the fare differences with what Mr. Kelly called the New Airline competitors, have narrowed significantly. Meanwhile, competition from ultra-low-cost carriers such as Spirit and Allegiant is making themselves felt.

"The sloth-like industry you remember competing against is now officially dead and buried," he told employees. "We fought against them and won. Now our enemy is our own cost creep, our own legacy-like productivity and our own inefficiencies."

That cost pressure will only increase as Delta and American take their new generation aircraft. Both have made their narrow-body bids, leaving only United to cut a narrow-body order, expected next year.

Mr Kelly also pointed out that the "New Delta" and "New United" were no longer the weak, unprofitable carriers of the past but were now stronger with better profit margins than Southwest in the third quarter despite the gains Southwest has made in increasing revenues in the past few years. Indeed, its revenue increases, he said, outpaced peers but did not make up for the cost challenge the company faces. He said the new legacy profitability puts them in a position to grow.

The aircraft order, coupled with AirTran, definitely puts Southwest on an upward trajectory but it still must regain its former position as the low-cost airline and, as the legacies have discovered, that is easier said than done.