Southwest: Major remodelling or just tinkering? Jul/Aug 2007

This is turning out to be a difficult year for low–cost pioneer Southwest Airlines. The hitherto hugely successful carrier, which has been profitable for 34 consecutive years and recorded stellar earnings growth in 2005 and 2006, has seen its profits plummet in the past two quarters. In the three months ended June 30, Southwest’s economic net income fell by 28.6% to $195m and its operating margin plunged by 4.8 points year–over–year.

Southwest has been hit by the double whammy of rising fuel costs and declining unit revenues. Its average fuel cost per gallon, including hedges, was up by 14.1% in the second quarter, while its PRASM fell by 4%.

The airline’s profits are falling mainly because its industry–leading fuel hedges are wearing off. 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.

In CEO Gary Kelly’s estimates, Southwest saved a staggering $2.5bn in 2000–2006 because of its fuel hedges. Now that the hedges are diminishing, the airline has to pay more for fuel year–over–year even when there is no change in oil prices.

As the largest domestic carrier, Southwest has felt the full impact of this year’s slowing domestic demand. The airline saw its first quarterly RASM decline in two years (also partly due tough first–half 2007 RASM comparisons).

Even though demand outlook has improved somewhat and RASM comparisons will be easier in the second half of 2007, Southwest will obviously not be achieving its target of 15% EPS growth in 2007. The current consensus estimate is a 7% decline, from 71 to 66 cents per share.

None of this has helped Southwest’s share price, which has effectively gone nowhere in the past five or six years. Since early 2004 the stock has fluctuated in the $14 to $18 range; in late May the price was again closing in on $14, before bouncing back to the $16 range ($16.35 on July 20).

Many analysts have lost confidence in Southwest’s prospects. Until a few months ago, there was a near–universal "buy" rating on the stock; now it is mostly "hold" and some "sell" recommendations. "A growth story comes to a close", noted one particularly bearish analyst in April, in reference to the diminished earnings prospects.

Southwest has faced criticism from Wall Street that its ASM growth rate is too high for the current demand conditions, which has made it difficult to raise fares to boost earnings.

Calyon Securities issued a memorable research note in early May that sounded like a direct appeal to Southwest: "Raise ticket prices… seriously". Analyst Ray Neidl argued that Southwest’s resistance to fare increases, which was resulting in a low return on equity, was the key driver behind the stock’s lacklustre performance over the past five years.

Southwest has long had a strategy of growing at a brisk pace — 8% annual ASM growth is the target these days — and resisting fare increases so as not to drive away traffic. The management has made it very clear that they fear any retrenchment could embolden competitors.

But this strategy, which Calyon Securities summarised as being "willing to sacrifice short–term profitability for market share and what they believe to be a long–term strategic advantage" clashes with the objectives of shareholders and analysts, who often take a relatively short–term view.

It is hard not to sympathise with Southwest: why should it forgo good growth opportunities to strengthen its strategic position when it has ample resources and a strong balance sheet to support such growth?

To add insult to injury, Southwest has had to worry that it may be under–leveraged. In April there was much speculation that it might become a target for an LBO. The reason was that, technically speaking, it fit the criteria of an LBO candidate: ample cash flow and reserves, modest debt, high percentage of aircraft ownership, cheap stock and good growth opportunities.

No–one actually came forward to support the idea; the management and Wall Street were in broad agreement that piling on debt would be disastrous in a volatile industry and that an LBO would be detrimental to Southwest’s unique corporate culture.

However, the management has nevertheless felt it necessary to change some of their financial goals to make Southwest look less attractive as an LBO target.

First, Southwest plans to increase its debt leverage from the current 35% (lease adjusted debt–to–capital ratio) to the 35–50% range by issuing additional debt before year end. The current level is at a record–low, having declined steadily from about 50% nine years ago. However, the airline indicated that it is not comfortable with leverage above 50%.

Second, Southwest is continuing aggressive share repurchases. It has bought back $1.6bn of its stock since January 2006 and expects to authorise new programmes. The shares are either retired or used to fund the company’s employee stock plan.

Kelly noted recently that Southwest’s management has never been this busy. The executives have been scrambling to try to please everyone.

The results of some of those efforts — all aimed at improving near–term profit growth — have been outlined in recent weeks, beginning at an "Investor Day" held at the NYSE on June 27 and continuing in Southwest’s second–quarter earnings conference call on July 18.

Southwest is talking about pursuing an aggressive "transformation plan" that targets $1bn–plus in incremental annual revenue by 2009 or 2010 to offset higher fuel costs and reach its financial targets. The airline is trimming capacity growth, introducing a voluntary early–out programme, making some route changes, developing ancillary revenues, revamping its fare structure and planning to expand internationally through code–sharing.

The key questions are: How much of it will be major remodelling and how much just tinkering? Is it all really necessary and helpful to Southwest’s future prosperity, or is some of it merely aimed at pleasing analysts and shareholders?

Still highly profitable

In many respects, the concerns about Southwest are overblown. The airline continues to be highly profitable, with industry–leading margins. The second–quarter operating margin, at 12.7%, was still in a different league from AMR’s and Continental’s 7- 8% margins. Delta came closer with 10% and Northwest is expected to do likewise. But the other US LCCs are not likely to report margins higher than 5–7% for the second quarter.

Southwest’s management is confident that, with the help of the $1bn revenue initiatives and other measures, the airline will achieve its 15% EPS growth target in 2008 and also its 15% ROIC target by 2009. In other words, 2007 could be just a small dip in an otherwise steady upward profit growth trend.

In the past four years, Southwest’s operating margins have improved steadily from 8.8% in 2003 to 10.8% in 2006. The consensus estimates suggest that 2007 could see the margin dip to the mid–8s — not exactly a worrisome scenario — and 2008 would see a return to near–10%.

Southwest remains a low–cost producer, with industry–leading CASM (though AirTran has almost caught up) and incredible efficiency levels. Despite labour and other cost pressures, the airline has held its non–fuel CASM at around 6.5 cents for the past seven years. This has been accomplished through continued productivity improvements; for example, headcount per aircraft declined from 86 in 2003 to 68 in 2006.

Of course, Southwest still has good fuel hedges compared to the rest of the industry. A decision to add to this year’s hedge positions in the fourth and first quarters, when crude oil prices dipped briefly, is paying off handsomely now that the price again exceeds $70 per barrel. Southwest has hedges in place to cover 90% of its second half 2007 needs at an average price of $51. It has also hedged 65% of next year’s needs at $49, 50% of 2009 needs at $51 and 15–25% of 2010–2012 needs at $63–64.

Southwest’s culture, staff morale, popularity and brand are as strong as ever. The airline has staged a very smooth and successful leadership transition since 2001, with Gary Kelly taking over from Herb Kelleher. The company has an unbeatable balance sheet and continues to pay dividends (having done so for 124 consecutive quarters).

Structural and other issues

In other words, Southwest’s operating model is obviously not broken and the company continues to present an attractive opportunity for the longer–term investor. But Southwest does face some structural issues, in addition to the fuel and demand challenges. And those structural issues have worsened in recent years — essentially the reason why the airline is now taking extensive action.

Because it is based on low costs, the Southwest model is very recession resistant, always coming on its own in hard times. By contrast, the legacy model comes on its own in boom times when the emphasis shifts to revenue generation. The legacies have more fare buckets to play with and international markets to turn to when the going gets tough domestically.

However, the legacy carrier’s deep cost cuts in recent years, in or out of Chapter 11, have narrowed Southwest’s cost advantage, particularly on the labour front. Southwest now has the highest–paid pilots for narrowbody aircraft in the industry.

Although Southwest continues to have excellent labour relations, its upcoming pilot contract negotiations may be complicated by the continued weakness in the share price (some of the compensation is tied to stock performance). On the non labour front, Southwest may simply be running out of cost–cutting options.

The other major structural change, of course, is the surge in competition, both from the revitalised legacies and LCC copycats.

The remedies

Consequently, to prosper in a changing and more competitive domestic environment, Southwest needs to make adjustments to its business model. Southwest, which takes great pride in the fact that it has never laid off staff or cut pay, has found a potentially very good way to tackle the labour cost challenge: a voluntary early–out programme. It has offered early–out packages, consisting of a $25,000 cash payment plus some benefits, to about 25% of its workforce — some 8,700 operational employees (excluding pilots and mechanics) who have been in their jobs for at least ten years.

The aim is not to cut the workforce but to reduce the number of highly paid workers so that they can be replaced by people on entry–level rates. It can be done without alienating labour; in fact, employees suggested it, and it was thoroughly discussed with the unions. The eligible workers have until August 10 to decide.

Southwest has also bowed to Wall Street pressure and slightly slowed its growth rate. The airline is reducing its planned ASM growth in the fourth quarter of 2007 and in 2008 from 8% to 6%. Southwest said that it was also reviewing growth plans for 2009 and 2010 but that it continued to see "tremendous long–term growth opportunities".

The ASM growth adjustment and more efficient schedules will mean Southwest taking 15 fewer aircraft in 2008 (19 rather than 34). As of July 18, the airline had agreement with Boeing to defer five 737–700 deliveries to 2013 and was exploring alternatives for the other ten 737–700s. The 15 fewer aircraft will free up $200–300m in cash to support additional share repurchases.

Southwest is also shifting capacity to more profitable markets. In the fourth quarter, it will eliminate 39 round trip flights, including long sectors such as Philadelphia- Los Angeles and Baltimore–Oakland, while adding 45 new flights in growth markets such as Denver and New Orleans. This is expected to boost fourth–quarter earnings by $10m.

To achieve the $1bn annual revenue improvement target, Southwest is looking to develop ancillary revenues, expand internationally through code–sharing and implement measures that will help attract more business traffic.

Southwest expects to disclose details of many of those initiatives in the fourth quarter — somewhat later than had been anticipated. The early announcements are likely to include assigned seating or priority boarding for a fee. The airline is also considering in–flight offerings, such as wireless internet access, and selling travel–related products and services through its website.

Raymond James analyst Jim Parker suggested in a recent report that Southwest has enormous potential to generate incremental revenue and earnings. Ancillary revenues currently account for only 2% of its total revenues. Parker calculated, as a hypothetical example, that if 20% of Southwest’s 92m passengers in 2008 purchased an assigned seat for $10, it would generate incremental revenue of $184m. Assuming a pretax margin of 90%, there would be $103m additional net income.

Southwest’s management also sees "hundreds of millions of dollars" revenue potential from expanded code–sharing. The airline will have upgraded systems in place by 2009 to accommodate international ticketing. The plan is to initially expand code–sharing with ATA to the Caribbean and Canada (Mexico and Hawaii are already served). Later Southwest may look for additional partners to fly from Baltimore to Europe and Asia.

Other planned initiatives include major enhancements to the fare structure and revenue management, upgrading the FFP and a new business traveller–focused ad campaign. CEO Kelly said that some of it is simply "catching up" with competitors but that there would also be innovation.

It is not clear at this point to what extent Southwest’s business model will change. Its future position will definitely be a little more upmarket, but Kelly also noted in the second- quarter call that the new initiatives would maintain the airline’s "low fare, low cost leadership".