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Blue Skies for Southwest Airlines

Southwest Airlines

A study of the current and future state of growth and acquisition strategy, by Thunderbird students Manash Banerjee, Owen Chen, Chris Hardesty, William Keller and Dustin Ward

“If the Wright Brothers were alive today, Wilbur would have to fight Orville to reduce costs.” — Herb Kelleher, founder of Southwest Airlines

Southwest Airlines (SWA) transports more passengers (101M) than any other US carrier while maintaining an 80%+ on-time performance rate. Further, SWA recorded its 39th consecutive year of profitability1 – a remarkable accomplishment for a company that previously did not fly outside of Texas and especially considering the general turmoil and collapse of the airline industry as a whole. SWA is known for its committed approach to short-haul, point-to-point service with “no frills”. Nevertheless, the question for the future is – how can SWA continue its low-cost advantages and current operational strategy to achieve successful growth targets? In other words, where is the next blue sky for SWA?

Strategic Challenges for SWA in the Current State

Despite what is perceived to be a capital-intensive business, the barriers to entry in the airline industry remain relatively low given the ability to lease aircraft and outsource many of the organizational functions. More specifically, the industry is divided between the fast-growing Low Cost Carriers (LCCs) (SWA, JetBlue, Virgin American), the traditional incumbent Network Legacy Carriers (NLCs) (American Airlines, United, Delta), and the new entrant Ultra Low Cost Carriers (ULCCs) (Spirit, Allegiant). After decades of unprecedented success and innovation from SWA, the current circumstances are faced with increased pressures from imitators and industry consolidation. Even abroad, other airlines have emulated the SWA model, particularly in the ULCC sector. Azul, launched by JetBlue founder David Neeleman, focuses on domestic, point-to-point routes in Brazil.

On the hot topic list for SWA and the airline industry in general are mergers and acquisitions. SWA, while maintaining its core values and business model, acquired Morris Air in 1993 in an effort to increase the number of operating stations. Similarly in 2011, SWA acquired one of its largest competitors and like-minded LCC in AirTran Airways (FL) for $1.4B2. Combined with FL, SWA has roughly 25% of the US market in terms of passenger traffic, serving 76 cities in 39 states3. SWA is even taking on FL routes to Mexico and the Caribbean and is investing in expansions of the Houston Hobby Airport in order to service as many as 25 flights abroad a day4.

Although on the outset these acquisition activities appear to be a competitive advantage amidst an industry clearly in a state of swirling red ocean, the incorporation of FL into the SWA model has posed numerous operational problems. For starters, due to the antiquated reservation system, SWA does not have the ability to book international travel, representing a roadblock in streamlining the reservation systems of both entities. Until SWA can institute a system that will support the functionality necessary for code-sharing and international travel booking, funds will be expended to support required patch-work and, more importantly, SWA and FL will continue to operate as a non-integrated business.

SWA-AirTran MergerThe impact of acquisition difficulties is moreover present for the consumer base. SWA customers must make international travel reservations through FL, diminishing aspects of SWA brand equity previously achieved through decades of dedicated customer service experience. Even further, customers traveling from a SWA location to a FL destination may have to purchase two separate tickets, considering as well that FL continues to operate in a hub-and-spoke model rather than point-to-point. The aspects of the “no frills” service for SWA such as free baggage checking do not necessarily carry over to FL passenger travel. With increased market share, SWA is able to establish a competitive advantage through the FL acquisition; however, due to the aforementioned restrictions the customers are unlikely to comprehend the long-term benefits.

Aside from the operational challenges associated with acquisition, SWA continues to face unpredictable external market forces that constitute the majority of the operating expenditures. Specifically, fuel and labor are two areas that SWA has been able to manage effectively in the past, but new market conditions may dictate otherwise. As a combined company with FL, SWA spends more than $5B annually on fuel5. SWA hedged roughly 60% of this thru 20126, although the hedges decrease each year and shrink exponentially as new fleets are added to the SWA portfolio via acquisition activity. Other airlines facing similar circumstances have passed on the rising fuel costs to the customers through higher ticket prices, a move that deviates greatly from the SWA model. Prior to FL, SWA achieved competitive advantages by leasing only the Boeing 737 plane, making maintenance and planning more convenient. With FL, SWA picked up 88 of the Boeing 717 aircraft with leases that do not set to expire until 20245. SWA has stated their intention to transition these aircraft to Delta in 20137; however, in the interim the rise in jet fuel prices has made the economics of the FL routes nearly unprofitable. Fuel costs will remain a strategic concern for SWA, especially if growth is to be achieved through route expansion and longer flight times.

Labor contracts and unions as well create a volatile financial expense for the entire airline industry. Similar to the circumstances with fuel, SWA has been able to successfully negotiate with the labor force up to this point. SWA is in fact the most unionized carrier in the nation with 87% of its employees belonging to one of the associations. SWA has never had a strike and as other NLCs reduce salaries and benefits, SWA employees are generally the highest paid in the industry. SWA has about 30% fewer employees per aircraft8, however, so domestic and international growth represent challenges for maintaining the streamlined labor model. It is possible that as SWA attempts to keep a strong foothold in the LCC space that the employees will need to accept additional wage and/or benefit restrictions. This action goes against union interest and thus will be an ongoing struggle for SWA and its acquisition interests.

A final note regarding strategic challenges faced by SWA in the future relates to government regulation. With the airline industry in trouble, the government could decide to step back in and control price-setting and/or other market forces, thereby generating business practices that are misaligned and subsequent operational inefficiencies. Any such re-regulation and government-mandated policies would negatively impact the competitive advantages enjoyed by SWA today.

Certainly, SWA established a blue ocean of domestic expertise in a highly-competitive airline industry with its low-cost, “no frills” approach. After decades of maintaining a competitive advantage, market entrants, supported by low entry barriers, and NLC rivals have begun to effectively replicate the SWA model. The opportunity to broaden services internationally represents a new blue sky for SWA; however, the company will first need to overcome its existing acquisition integration struggles as well as to develop creative approaches to combat the rising costs of fuel and labor.

Future Growth & Acquisition Strategy of SWA
Despite the various operational and market-oriented challenges faced by SWA and, more specifically, its acquisition of FL, the company has positioned itself well and furthermore has a multitude of strategic options to consider with regards to the outlook for future growth & acquisition strategy. Clearly, SWA must maintain its approach of differentiation while looking at opportunities to expand both domestically and internationally. As it pertains to the FL acquisition, SWA now has intra-continental routes but must design a template for integrating systems and processes to be competitive as it transitions into a long-haul airline.

Most experts agree that, above all, SWA must protect its business model as a source of competitive strategy in the midst of rapid growth expectations. This includes no seat numbers and no baggage fees on flights, coupled with top-quality customer service as compared to the rest of the industry. It is furthermore anticipated that customer service will become a key point of brand differentiation in the airline industry as cost pressure is increasingly competitive and the consumer base seeks out not only the lowest fare price but also superior treatment. Fundamentally, this means that SWA can and should continue to keep its operations simple, driving value over price. The real competitive positioning for SWA is that each step of the operational model reinforces the vision and fit of the company. For example, since every seat on every flight is essentially identical, customers know exactly what to expect when making a purchase. Growth, however, will force SWA to make strategic decisions (e.g. business class options for longer flights – see below). For SWA, it is imperative that management re-instill in the growth strategy that the “no frills” approach and standardized equipment has led to the low-cost, low-fare position the company finds itself in today.

SWA

Another source of competitive advantage for SWA and potential impact on future growth & acquisition strategy is that of the point-to-point route planning. SWA has already confirmed the intention to convert FL operations at 22 domestic and international airports to SWA locations over time3. The point-to-point system is designed for short-haul flights but remains unproven in international travel, however. By avoiding the hub-and-spoke model to this point, SWA has not had to make the infrastructure investments like many of its competitors. FL manages a hub-and-spoke system, which provides SWA with a set of alternatives when evaluating expansion into international travel services. A key revenue stream / new growth area will be to leverage the SWA business model in another country, albeit with thorough positioning analysis beforehand. Recommended starting points are Mexico and Canada to learn about the obstacles to overcome in this type of potential paradigm shift in strategy. Similarly, SWA can acquire other point-to-point, short-haul airlines to add complimentary domestic routes for those areas in which the company does not already operate, such as Hawaii.

There is an opportunity for SWA to investigate the integration of operations with FL with a low-cost, “no frills” business class option for some of its longer routes. This can be accomplished either by incorporating specialized seating and benefits into the new planes or by creating a 100% business class 737, both of which offer a premium service that still fits within the SWA core capabilities. Similar to the international route-planning, now is the time for SWA to review such options while undergoing restructuring activities and setting growth targets.

For SWA, growth under the current operational strategy will require the new markets combined with a decrease in Cost per Available Seat Miles (CASM). Increasing fuel costs have the greatest impact on CASM; however, SWA cannot control the market forces. Therefore SWA must manage the efficiency through which fuel is invested and used. This can be achieved by continuing the company strategy of aggressively leasing fuel-efficient aircraft and streamlining with one type of carrier despite the capital assets received during the FL acquisition. In addition to the transition of its 717 planes, SWA recently announced a 150-plane order through the Boeing 737-MAX program9, a fuel-efficient aircraft that compliments the short-haul flight strategy. The point-to-point business model contributes as well to a reduced CASM for SWA, where savings allow each SWA plane to fly an extra route per day as compared with the competition. And while fare price remains a dominant factor in consumer purchase behavior and CASM, the SWA differentiated service offerings are a key driver for a sustainable, integrated strategy.

Finally, SWA can counter rising fuel costs with improved non-fuel cost management. Specifically, target areas include maintenance and labor. Nearly 40% of the CASM is a result of wages and benefits2. For SWA, many of the union contracts will become amendable during the next several years. Rather than go with the strategy of bankruptcy to renegotiate the contracts like many of its competitors, SWA maintains a friendly management-employee relationship and can get out ahead of these cost savings opportunities.

Concluding Remarks
As SWA grows, the company must resist the temptation to become like all other short and long haul airlines. Doing so would erode the competitive advantage that SWA has built over the last three decades. In addition to expanding routes using a proven and profitable approach, SWA is recommended to learn from other business models that have culminated as unsuccessful, even if it means scratching some of the FL platforms.

In a highly-competitive and price-sensitive industry with low entry barriers, it is pertinent that SWA sustainably differentiate itself from the competition. Operational effectiveness is important, but, without a solid positioning strategy, the other airlines, especially the ULCCs, will slowly eat away at the market share. As author Jim Collins highlights in Great by Choice, SWA is one of the few commercial airlines (much less companies from any industry) that understands core capabilities and has established a fit supporting the company position within their sector. The SWA model is simple and consistent, and ensures that each of the strategy pieces maintains the competitive, low-cost advantage. The next evolution will be for SWA to identify its new blue sky with effective growth & acquisition into the international arena.

1Bundgaard, Tycen; Bejjani, John; Helmer, Edmund. “Strategic Report for Southwest Airlines.” Pandora Group: Apr 2006.
2 “Southwest Airline Co.: Company Profile”. Datamonitor: Nov 2011.
3“Southwest Airlines and AirTran Airways Confirm Plans to Maintain AirTran Airway Operations at 22 Domestic and International Airports.” PR Newswire: Jan 2012.
4Jones, Charisse. “Domestic Giant Southwest Sticks Nose Into International Air.” USA Today: May 2012.
5Maxon, Terry. “Southwest Airlines: Boeing 717 Not Part of Future Fleet Plans”. Dallas Morning News: Aug 2011.
6Plunkett, Jack W. “Discount Airlines Compete with Legacy Airlines.” Plunkett Research Online: Mar 2012.
7Wilhelm, Steve. “Moving On: Boeing-Owned 717s Will Transfer from Southwest to Delta”. Puget Sound Business Journal: Jul 2012.
8Brancatelli, Joe. “Southwest Airlines’ Seven Secrets for Success.” WIRED: July 2008.
9Gates, Dominic. “Southwest’s Order Gives Huge Boost to Boeing’s 737 MAX Program”. The Seattle Times: Dec 2011.

Note: This article was reviewed and confirmed by internal SWA team members responsible for planning the strategic direction of the company.