Southwest: Low-cost pioneer tackles new challenges April 2009

Southwest: Low-cost pioneer tackles new challenges

n past recessions Southwest Airlines, the low-cost pioneer and the largest US carrier in terms of domestic passengers, could always be counted on to financially outperform its competitors and provide a safe haven for investors. But this time around market sentiment about Southwest has been largely negative, amid fears that the world’s most admired airline has lost some of its competitive advantages. Southwest faces challenges on several fronts. First, it has lost its fuel hedge advantage. After reaping savings from fuel hedges to the tune of $4.5bn in 2000-2008, the airline saw its hedges turn into a huge liability when the price of oil collapsed late last year. Having neutralised the hedge positions, like other airlines, Southwest now has virtually no protection against future fuel price hikes. The out-of-money fuel hedges caused Southwest to report its first quarterly net losses in 17 years for the third and fourth quarters of 2008. The airline also saw its cash reserves dip alarmingly due to cash collateral posting requirements related to the hedges, forcing it to scramble to raise new funding in a tough environment. Second, Southwest has temporarily stopped growing. It has suspended its fleet growth plans, entered a “no-growth era” and expects its ASMs to decline by 4% in 2009 – its first-ever annual contraction. The no-growth strategy may make economic sense, but there is investor concern about the possible implications. How much will unit costs rise? Will Southwest be able to maintain employee morale during a period of contraction? Will it have to forgo market opportunities arising from a pullback by competitors? Third, there is concern that Southwest faces significant cost pressures even without the reduction in ASMs. Southwest’s share price has fallen sharply in recent months. Its market capitalisation has roughly halved since July 2008,

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when oil prices peaked and Southwest was thought to be the only certain long-term survivor at $150-per-barrel oil prices. By comparison, the Amex Airline Index is currently roughly at the same level as it was in July. Many analysts have downgraded Southwest’s stock to “hold” or “sell” in recent months, arguing that the “premium multiple” previously enjoyed by Southwest’s shares due to the fuel hedges and continued growth at the expense of the legacy carriers was no longer justified in light of the “no growth, little hedging” strategy. As one analyst put it, Southwest is now “just like anyone else” from the earnings power point of view”. Yet this is the airline that has proved repeatedly in the past that it can prosper in any kind of environment. In terms of survival prospects, with continued ability to build market share and longer-term earnings potential, Southwest clearly remains in a category of its own. Southwest’s CEO Gary Kelly argued very effectively at a recent conference why the airline still stands out from the crowd. First, all of Southwest’s traditional strengths are intact. The airline remains a low-cost producer, with an unbeatable culture, staff morale and brand. It still has one of the strongest balance sheets in the industry and $8-9bn worth of unencumbered assets. As the only US airline with an investment-grade credit rating, it is well placed to continue to access the credit markets. Second, despite this year’s overall contraction, Southwest will still be able to add three major cities to its network, thanks to new flight schedule optimisation tools. The airline is also prepared to “take advantage of opportunities if some of our competitors falter”. Third, Southwest has developed new strengths as it has adapted its business model to a changing competitive environment. There is a growing range of new products aimed at bringing in extra revenues and

further strengthening the brand. Also, the past few years’ technology development drive is finally bearing fruit, giving Southwest new capabilities in revenue management, to optimise the network and (from later this year) launch international codesharing. Southwest’s revenue performance has continued to outpace the industry in recent months, reflecting its lack of international exposure and higher concentration of leisure traffic. Given the legacy carriers’ much sharper capacity cuts, Southwest will undoubtedly also see market share gains this year.

$m SOUTHWEST’S 12,000 10,000 8,000 6,000 4,000

OPERATING REVENUE

99 00 01 02 03 04 05 06 07 08 09F 10F $m 1,200 1,000

SOUTHWEST’S FINANCIAL RESULTS

Operating result

800 600

The fuel hedge issue

Instead of treating the fuel hedges as a totally negative issue, it would seem more appropriate to focus on how much Southwest has gained from the strategy overall. In the wake of September 11, Southwest was the only US airline with the cash (and the foresight) to take on extensive new fuel hedges at crude oil prices in the $20s and $30s (per barrel). Those hedges paid off handsomely when oil prices subsequently surged, saving the airline $3.2bn in 20002007. Because of the hedges, Southwest was able to continue reporting healthy 810% operating margins through 2007, even in the toughest years. By 2007 the hedges were wearing off, but when oil prices surged to new heights last year, Southwest still had the best hedge position in the industry (by a wide margin) and reaped another $1.3bn in savings in 2008. The sharp decline in oil prices in the second half of 2008 meant large mark-to-market unrealised losses on hedge contracts. As a result, Southwest reported net losses in the second half of last year. However, the results were positive when the hedge losses were excluded and the 5.5% fourth-quarter operating margin was among the best in the industry. The $178m net profit and 5.8% ex-item operating margin in 2008 were excellent results in an extremely difficult year. It was

Net result

99 00 01 02 03 04 05 06 07 08 09F 10F

Note: *Consensus forecasts as of 30th March.

Southwest’s 36th consecutive year of profitability. The $1.3bn fuel hedge savings obviously rescued the results, though it can be argued that had the fuel hedge protections not been there, Southwest would have taken earlier remedial action such as reducing its growth rate. Southwest acted quickly to reduce its hedge exposure. In late October it still had 75% of its 2009 fuel needs hedged at an average crude equivalent price of $73, plus further significant hedges in 2010-2012. In November-December the net hedge position was reduced to only 10% of fuel needs each year between 2009 and 2013. It was done by selling swaps against the existing out-ofmoney fuel hedge positions, effectively capping the mark-to-market losses at around $1bn. Southwest paid no additional premiums, avoided having to fork out an additional $500m in cash collateral and will realise the $1bn in losses as future fuel is consumed. The cash collateral requirements on the fuel hedges had caused Southwest’s unrestricted cash holdings to dip as low as $1.3bn (11.8% of last year’s revenues) just before Christmas – quite a deterioration from the $5.8bn held six months earlier. Under the revised deal with the hedge counterparties, the cash collateral obligation was effectively limited to $300m. Southwest also raised

more than $1bn in cash through credit lines, a public debt offering and aircraft sale/leasebacks. Its unrestricted cash position was an adequate $1.8bn at year-end. The management has obviously had to work extremely hard to stabilise the situation arising from the out-of-money fuel hedges, but Southwest could not have managed it any better. It is true that in respect to fuel hedges Southwest is now just like any other airline. But it never had a fuel hedge advantage before 1999, and it had a significant advantage only in 2008. Like the other US airlines, Southwest can be expected to quickly return to hedging if oil prices begin to move up meaningfully. deferred 737-700 deliveries from 2010-2012 to 2013-2016. It now has only 10 firm deliveries in 2010 and 10 in 2011. These and the earlier deferrals have reduced capital spending from its peak in 2009-2010 by $1bn. Further reductions may not be possible because of the difficulty of finding buyers for either new or used aircraft in the current environment. Of course, the fleet growth suspension is only temporary. According to local newspaper reports in Dallas, Southwest has made a commitment to its pilots to begin growing the fleet again in 2011. The new tentative pilot contract reportedly stipulates that the airline must have 541 aircraft by year-end 2011 and 568 by year-end 2012. Southwest obviously retains flexibility to accelerate growth at any point. As in previous recessions, there could be sudden opportunities that are too good to miss. When the 737-700 options kick in from 2011, it would be possible to resume adding 20plus new aircraft annually. Southwest’s total firm orders, options and purchase rights through 2018 remain at 220. Southwest is finding it easier to temporarily suspend fleet growth because it has new schedule optimisation technology at its disposal which it did not have before 2004. The new tools have allowed it to trim less popular flights and reallocate the capacity to promising new markets. Of course, the ASM reduction will come from reduced aircraft utilisation. The schedule optimisation effort often involves eliminating early-morning or late-evening flights, which would not be any more popular elsewhere in the network. Kelly said last month that Southwest may continue to reduce its headcount through natural attrition. The airline has never had a furlough, layoff, pay cut or benefit cut and would use those strategies only as a last resource. This is because Southwest regards employees as its number one asset and its culture as its greatest strength. It is hard to imagine that employee morale would be adversely affected by the temporary shrinkage. But it is interesting how the retrenchment and gloomy industry prospects have helped bring to conclusion

The “no-growth” strategy

After long growing at a brisk 8-10% annual rate, Southwest began to slow growth in 2007 and last year increased its ASMs by only 3.6%. In October the airline deferred some 737 deliveries from 2009 to 2016. In January Southwest further revised its aircraft delivery schedule and indicated that its ASMs would decline by 4% in 2009. Southwest is still taking 13 new 737-700s in 2009, but because it is retiring or returning to lessors 15 older 737s, the size of the fleet will decrease by two aircraft to 535. Under the revised deal with Boeing, Southwest SOUTHWEST'S 737-700 DELIVERY SCHEDULE* Firm Options Purchase Total orders rights 2009 13 13** 2010 10 10 2011 10 10 20 2012 13 10 23 2013 19 4 23 2014 13 7 20 2015 14 3 17 2016 12 11 23 2017 17 17 Through 2018 54 54 TOTAL 104 62 54 220

Notes: * As revised in January 2009. **The current plan is to return or retire 15 older 737s in 2009, to reduce the fleet by two aircraft to 535 at year-end.

difficult contract talks, some of which had dragged on for years. Since January four of Southwest’s key unions – mechanics, ground workers, flight attendants and pilots have either reached tentative agreement or ratified new 3-5 year contracts. Some of the new deals incorporate job security protections, including no-furlough clauses and limits to maintenance outsourcing and domestic codesharing. tive five-year pilot contract, which was endorsed by the union’s board in late March, includes 2% annual pay increases for the first three years (two of which are retroactive), further pay rises in 2010 and 2011 depending on profitability and improved retirement benefits. The new tentative fouryear flight attendant contract provides pay increases and improvements in retirement and other benefits. The mechanics’ new fouryear contract grants 3% pay increases in most years, plus 7% in possible bonuses, while the ground workers’ three-year deal also provides 3% annual pay increases. As previously, the aim is to try to offset pay increases with productivity improvements. The contracts incorporate work rule changes, flexibility provisions and some were even described as “cost neutral”. But, with ASMs declining, it will be an uphill battle to boost productivity. The main benefit to Southwest may simply be that it got the negotiating process out of the way (for all unionised employees except for customer service and reservations agents) and that the workers seem happy with the new contracts.

Cost pressures

There is a general perception that Southwest’s cost advantage over competitors has narrowed, especially because of the legacy carriers’ deep cost cuts earlier this decade. Also, AirTran has in the past couple of years had lower ex-fuel CASM than Southwest on a stage length-adjusted basis. But Kelly stated in early March that Southwest retains a cost advantage over the legacy carriers “ranging from 50% to near100%” on a stage length-adjusted basis – that is now, without the fuel hedges. Southwest has remained among the lowcost leaders despite being 38 years old with a senior workforce and industry-leading wages. It has the highest-paid pilots for narrowbody aircraft in the US airline industry. Southwest has held its non-fuel CASM at around 6.5 cents for the past eight years (6.64 cents in 2008), thanks to continued productivity improvements. But keeping costs under control will be a major challenge as the ASM base shrinks. The pressures were already evident in last year’s fourth quarter, when ex-fuel CASM rose by 6.9%, reflecting increased airport and maintenance costs and ASM growth grinding to a halt (up 0.8%). By most estimates, Southwest is likely to see its ex-fuel CASM surge by 8-10% this year. Southwest’s maintenance cost pressures, evident since mid-2008, reflect a sharp increase in the number of engines coming up for major overhaul. As a 100% domestic carrier, Southwest is heavily exposed to airport cost increases resulting from the sharp traffic declines at US airports. Labour costs continue rising. The tenta-

New revenue strategies

Since about mid-2007 Southwest’s primary focus has been on boosting revenues. Originally the purpose was to compensate for the waning of the advantageous fuel hedges. Also, the airline realised that, as the largest domestic carrier, it was uniquely well positioned to develop ancillary revenues and capitalise on southwest.com. It wanted to improve the customer experience and go past the “one size fits all” approach it had used in the past, in particular to appeal even more to the business customer. Other US LCCs had already aggressively developed premium products and ancillary revenue sources. Southwest was relatively late in tapping ancillary revenues, first, because there was no pressing reason to do it earlier. Second, Southwest was built very differently from other airlines and, as a result, it has had some serious “catching up” to do on the

technological front (see the Jan/Feb 2008 issue of Aviation Strategy for a more detailed discussion). The result has been a batch of revenue initiatives — including a new “Business Select” product and a new boarding method, both introduced in late 2007 — that do not go as far other LCCs’ offerings in wooing the business segment but have, nevertheless, been rated huge successes. Business Select is a modest (and low-cost) premium product even by LCC standards, and Southwest never adopted assigned seating. However, Southwest did not need to go further than that, because it already carried large volumes of business customers and had a business model that its customers loved. After one full year, customer response to the new offerings has been “overwhelmingly favourable”. Business Select brought in $75m extra revenues last year. It will take Southwest another year or two to complete all its planned revenue initiatives, many of which are technology-enabled and include a new FFP and a new southwest.com. While developing new products aimed particularly at business travellers, Southwest maintains a commitment to low-fare leadership and what it calls a “no hidden fees” policy (meaning no fees on items that previously were included in the ticket price, such as checked bags). As Kelly put it: “In this environment, we are dependent on our low-fare brand to keep us strong”. Analysts have questioned the wisdom of the no-fees policy, arguing that, now that every other US airline charges extra for items such as checked bags, Southwest is just leaving large amounts of money on the table. But Southwest’s management is adamant that “no hidden fees” is a key element of the low-fare leadership, helps reinforce the brand and may even be a positive contributor on the revenue side. ing expansion on selected key cities and then growing aggressive at those locations. After long flying mainly to cheaper and less congested secondary airports, Southwest is now adding service (seemingly exclusively) at big legacy hubs or highly competitive major airports. The management says that there is no desire to depart from the point-topoint strategy, though at many of its focus cities Southwest has effective hub operations. Southwest’s initial experiments with the “major hub” strategy, at Philadelphia (US Airways’ hub) since 2004 and at Denver (United’s hub) since 2006, have been huge successes. Denver has been Southwest’s fastest-growing city; after only three years, the operation has grown to 115 daily departures to 32 destinations. After several “route alignments” since August 2007, which have eliminated some 10% of daily flights from its schedule, Southwest is ready to step up the new expansion strategy this year. There are three very important opportunities: Minneapolis, New York LaGuardia and Boston Logan. Minneapolis is a classic overpriced and underserved market. But it represents a bold move for Southwest since it is the home base for Northwest (now part of Delta), which has long been the dominant carrier in the Midwest. Southwest started cautiously with service only to Chicago Midway, which acts like a hub for Southwest, but demand has exceeded expectations and a second route, to the Denver stronghold, will be added in late May. With fares initially as low as $49, there clearly is potential for the famous “Southwest effect” in Minneapolis. LaGuardia, which will be added on June 28, is a very big move for Southwest, which has so far served the New York area only via Islip on Long Island. Southwest is gaining access to this congested hub by acquiring ATA’s 14 daily slots at LGA for $7.5m (as part of its former partner’s liquidation process). Southwest will connect LGA to two of its key markets, Chicago Midway and Baltimore-Washington, with a total of eight daily flights (the ATA slots plus one return flight outside the slot control hours).

Growth opportunities

In recent years Southwest has become more strategic with its growth efforts; it has pulled back in less profitable markets, focus-

Nevertheless, the LGA entrance will be too modest to have real impact, and the slot restrictions will prevent rapid expansion. LGA is something that Southwest’s customers have wanted for a long time. It will be an interesting experiment for the airline. Southwest is looking to add Boston Logan to its network this autumn. Its customers have long asked for it. The airline already serves the Boston region through Manchester (New Hampshire) in the north and Providence (Rhode Island) in the south, but it is not drawing many customers from downtown Boston, so Logan represents an opportunity to draw new traffic. Since there are no slot or space constraints, Southwest sees tremendous growth possibilities. Southwest has shifted its focus from secondary to major airports for a host of reasons. First, Southwest is now more able to deal with congestion and delays at large East Coast hubs. It gained experience through its partnership with ATA, and it now has more sophisticated scheduling tools to help minimise any delays at LGA through the rest of its network. Second, Southwest is responding to changes in the competitive environment. In the old days it could go to a region like Boston, pick an alternative airport and people were happy to drive long distances to get cheap fares. That was when Southwest was the only low-fare airline. Now that there is low-fare competition throughout the US, including JetBlue with a major presence at Logan, the strategy no longer works. Third, Southwest’s large size and nationwide presence probably obligates it to serve the nation’s largest city, New York, as well as the main gateways to cities such as Boston. Fourth, focusing on the main airports is obviously compatible with aim of catering better for the business segment. Fifth, now is probably an opportune time for Southwest to make aggressive forays into major markets, because recession is making more travellers, both leisure and business, seek low fares. Currently, Southwest is determined to continue flying just one aircraft type, to retain simplicity and low costs. According to Kelly, the airline is no longer interested in 100-seaters; while the larger 737-800 might make sense in sufficient numbers (50-75) at some point, in the current environment it would be “absolutely foolish” to take on that kind of risk. While Southwest clearly still has good opportunities to develop its network in the US, it has taken the first concrete steps to go international: signing codeshare deals with Canada’s WestJet and Mexico’s Volaris, and seeking US-Canada route authority from the DoT (even though it does not currently have plans to operate to Canada with its own aircraft). The Canada and Mexico codeshares, to be flown by partners’ aircraft, are expected to start in late 2009 and early 2010, respectively, when Southwest will have the systems in place to sell international itineraries. The next stage could be similar deals to Europe and Asia, though that may be a couple of years away. At some point in the next few years, Southwest is expected to begin its own flying to “near international” destinations. There is considerable pressure from the pilots, who have questioned why Southwest is not launching its own service to Mexico, Canada or the Caribbean, like JetBlue, AirTran, Frontier, WestJet and other LCCs. The new pilot deal limits such codesharing to 6% of the flying done by Southwest’s pilots.

By Heini Nuutinen in New York hnuutinen@nyct.net

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