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Southwest Airlines (NYSE:LUV) is the largest domestic carrier by total passengers, carrying over 101.9 million passengers in 2007 on over 1.1 million flights.[1] Southwest thrives on maintaining low operating expenses, primarily through its extensive fuel hedging, which saved the company an estimated $791 million in fuel costs in 2007.[2] Because of its low costs, Southwest has been able to remain profitable for 35 consecutive years, a feat unmatched in the airline industry.[3] The company earned $9.86 billion in revenue in 2007, an 8.5% increase from 2006 as Southwest continued to expand and increase its capacity or Available Seat Miles (ASM) during a period when most competitors were reducing ASM.[4]
As with other airlines, Southwest is vulnerable to dropoffs in consumer demand for air travel, which are often a consequence of high profile terrorist attacks or a slowing economy. However, as a result of its fuel hedges, Southwest is less vulnerable to oil price fluctuations than other airlines, whose profits can diminish when oil prices rise. For example, in 2008 Southwest has 70% of its fuel needs hedged at $51 per barrel, while most other major airlines have only between 20% and 30% of their fuel hedged at an average $100 per barrel.[5] Because of its hedges, Southwest maintained an industry-leading average price of $1.70 per gallon of jet fuel in 2007.[3]
Southwest's hedging contracts extend until 2012, although the amount of oil hedged drops steadily after 2009, with only 15% of its oil needs in 2012 hedged at $63 per barrel.[6] Therefore, Southwest will become more vulnerable to fluctuations in fuel prices as its contracts mature.
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[edit] Company Overview
Southwest Airlines offers short domestic-only flights with minimal service and a simple, cheap fare structure.[3] Southwest replaced the expensive hub and spoke route structure common to most other carriers in favor of short, point to point direct flights using its homogenous fleet of 520 Boeing 737 aircraft.[3] Using its point to point flights, Southwest offers frequent direct flights over short distances, like from Los Angeles to Las Vegas.[3] In 2007, Southwest served 411 nonstop city pairs, in 64 cities in 32 states[3] and carried over 101.9 million passengers, the most of any domestic carrier.[4] As the low-fare leader, Southwest's average ticket price was $106.60 in 2007[2] compared to an average $123.23 at its closest competitor, JetBlue Airways (JBLU).[7]
Southwest's operating metrics are shown below.
Southwest Key Operating Metrics
| 2001 | 2002 | 2003 | 2004 | 2005 | 2006 | 2007 | ||
|---|---|---|---|---|---|---|---|---|
| ASM (seat capacity x miles flown) | 65,295 | 68,887 | 71,790 | 76,861 | 85,173 | 92,780 | 99,636 | |
| RPM (filled seats x miles flown) | 44,494 | '45,392 | 47,942 | 53,418 | 60,223 | 67,954 | 77,319 | |
| Filled seat percentage (Load) | 68% | 66% | 67% | 69% | 71% | 73% | 73% | |
| Revenue per filled seat mile (Yield), in cents | 12.1 | 11.7 | 12 | 11.8 | 12.1 | 12.9 | 13.08 | |
| Cost per Available Seat Mile (CASM), in cents | 7.5 | 7.4 | 7.4 | 7.7 | 8.0 | 8.7 | 9.10 | |
| Non-fuel (CASM) (cents) | 6.34 | 6.28 | 6.29 | 6.42 | 6.48 | 6.46 | 6.37 | |
| Fuel (CASM) (cents) | 1.16 | 1.12 | 1.11 | 1.28 | 1.52 | 2.24 | 2.73 | |
Southwest's low cost structure enables the company to offer low prices to its customers. The company minimizes its costs through its use of a single type of aircraft, efficient point to point route structure, highly productive employees, and its hedging of oil prices.[3] For example, Southwest paid an average $1.70 per gallon of fuel in 2007[3], compared to American Airlines (AMR) average $2.13 per gallon.[8] As a result of its low costs and low-fare position, Southwest has maintained 35 years of consecutive profitability.[9] Moreover, because of its low operating expenses, Southwest became the second most profitable domestic carrier in the U.S. in 2007 (Northwest was the most profitable but it was acquired by Delta Air Lines Inc. (DAL) in October 2008), earning $645 million in net income.[1]
[edit] Financial Analysis
As previously mentioned, 2007 marked 35 years of consecutive profitability for Southwest, the longest streak in the airline industry.[9] Southwest's low fares have helped the company grow by more than 66% since 2003, increasing its fleet by 132 aircraft during the period.[4] Additionally, the company's annual passengers carried has increased by more than 36% between 2003 and 2007, as the company expanded its fleet and its flight destinations.[4] In 2007, Southwest earned $9.86 billion in revenue, an 8.5% increase from 2006 that was driven primarily by an 8.1% increase in passenger revenue (ticket sales).[2] The increase in passenger revenue was spurred by an 8% increase in fleet size and flights during 2007 which led to a 7.5% growth in capacity, or available seat miles (ASM).[2] Overall, Southwest's revenue yield per passenger miles (RPM) or its revenue divided by passenger miles flown, increased from 12.93 cents in 2006 to 13.08 cents in 2007.[4]
Southwest's operating expenses increased 11.3% in 2007, which outpaced its 7.5% growth in capacity, which is usually the main driver of increases in operating expenses.[10] As a result, Southwest's Cost per Available Seat Mile (CASM) increased 3.4% compared to 2006.[10] The company attributes approximately 80% of this increase to higher fuel costs, which jumped by 10.4% in 2007.[10] Furthermore, higher maintenence costs, which rose 21.6% in 2007 because of maintaining its aging fleet contributed to the remainder of Southwest's increase in CASM.[10] To mitigate higher fuel costs, Southwest implemented several initiatives in 2007 aimed at reducing its non-fuel costs. For example, Southwest reduced the amount of employees per aircraft to 66 in 2007, down from 68 in 2006 which helps the company save on wage and compensation expenses.[10] Furthermore, since 2003, Southwest has reduced employees per aircraft by 22% by implementing more efficient technology.[10]
Southwest earned $791 million in operating income in 2007, a 15.3% decrease from 2006, which was primarily due to the increase in fuel expenses.[2] As previously mentioned, Southwest benefited greatly from its hedging program, which saved the company an estimated $686 million in 2007.[6] However, only 70% and 55% of its fuel needs are hedged at prices near $50 per barrel in 2008 and 2009 respectively. Furthermore, Southwest's hedging contract only extends until 2012, where it has secured 15% of its fuel needs at $63 per barrel.[6] Therefore, Southwest must secure further fuel hedging contracts in order to avoid being vulnerable to rising fuel costs in the future.
[edit] Trends and Forces
[edit] Available Capacity Drives Growth
The total supply of available seats is a key indication of airline growth, as increases in available seats are driven by additions of new aircraft and routes. Seat supply is tracked as Available Seat Miles (ASM), the total number of available seats times the number of miles flown. In 2007, Southwest's ASM increased by 7.5%, driven mainly by an the addition of 39 new planes to its fleet and added flights.[2] However, because of higher fuel expenses and declining demand, Southwest joined the rest of industry by cutting capacity for early 2009. The company announced in August 2008 that it will cut 196 flights and add 6 new routes in Q1 2009, a net of 190 flights cut which reduces its ASM by about 6%.[11] These cuts will only decrease the number of flights however, not the actual amount of cities served.[11] Furthermore, Southwest has reduced its expansion plans for 2008, with plans to expand its fleet by only 7 aircraft during the year, compared to an average of 34 new aircraft annually between 2005 and 2007.[4] As a result, Southwest only plans to increase its ASM by 4% to 5% in 2008.[9] In 2008, Southwest announced plans to expand its service to Minneapolis and New York La Guardia.[12] Luv's move into La Guardia is particularly crucial as New York is the largest domestic air market and is frequented by Luv's coveted business travelers.[12]
[edit] Southwest Seeks to Attract Business Consumers to Increase Revenue
Business travelers are attractive to airlines because they are less price sensitive than leisure travelers, and because business traveler demand is less cyclical than that of leisure travelers. For example, economic downturns may lead leisure travelers to cancel their vacation in the Bahamas, but business travel is impacted less dramatically.
Unfortunately, Southwest has had limited success attracting business customers. Southwest's single-cabin service makes it difficult to attract lucrative business executives seeking business-class seats. Additionally, Southwest's limited route map makes it difficult for a company to use Southwest for all its travel needs, and most companies choose a single favored carrier. In 2007, Southwest implemented its Business Select offering, which allows passengers to be among the first passengers to board the aircraft.[13] Business Select fares cost an additional $10 to $25 in order to guarantee a prime spot onboard the aircraft.[14] This incentivizes business travelers as they no longer have to wait in long lines before boarding.[14] Southwest believes that this initiative will boost its revenue by about $100 million in 2008.[14]
[edit] Southwest's Low Operating Expenses Enable Low Fares
Airline operating costs are measured in Cost per Available Seat Mile (CASM). Southwest has the lowest ex-fuel operating costs of any U.S. airline, largely due to its operating strategies that lead to faster turn-around times between flights, more flying time per pilot, and fewer total employees per aircraft.[15] This allows Southwest to undercut competitors' prices while still remaining profitable.
First, Southwest's point-to-point service allows for more direct nonstop routing than the traditional hub and spoke system, which minimizes connections, delays, and total trip time.[16] As a result, about 78% of Southwest's customers in 2007 flew nonstop.[16] This point-to-point system enables Southwest to offer frequent, conveniently timed flights to its markets. For example, Southwest offers 30 daily roundtrips between Dallas Love Field and Houston Hobby.[16] Additionally, Southwest serves mainly secondary airports in the markets it operates in like Chicago Midway (instead of O'Hare) which are less congested than larger hub airports. This helps Southwest maintain its turnaround times of 25 minutes, compared to the industry average of 35 to 60 minutes.[17] Lastly, Southwest's homogenous fleet of Boeing 737s simplifies the company's scheduling, maintenence, and training for its aircraft which help reduce their operating expenses.[16]
In 2006, Southwest employed 68 employees per aircraft, compared to an average of 75 for other low-cost carriers like JetBlue Airways (JBLU).[18] Furthermore, Southwest reduced the amount of employees per aircraft to 66 in 2007 which helps the company save on wage and compensation expenses.[10] As a result of these strategies, Southwest's operating margin is higher than its competitors, as the company earned $10.94 in operating profit per passenger in 2006, compared to the industry average of $6.56.[18]
[edit] Hedging of Oil Prices Leads to Significant Cost Savings
Southwest's key to financial success is its fuel hedging, where the company agrees to future fuel contracts that secure a particular price. Although the company's average price per gallon of jet fuel has increased from 72 cents in 2003 to $1.70 in 2007,[3] Southwest's fuel hedges have allowed the company to prolong its profitability. For example, Southwest's average cost per gallon of jet fuel was $1.98 in Q1 2008, compared to the industry average of $2.60 to $2.65.[6] In 2007, Southwest's fuel expenses increased by 10.4%, which was attributed to an 11.1% increase in costs of jet fuel per gallon.[6] However, this increase was minimal compared to other airlines, as Southwest's price per gallon of jet fuel in 2007 reflected prices of $50 per barrel of oil, when oil was often $100 per barrel during the same period.[6] For example, in Q1 2008 Southwest's fuel expenses increased 20%, compared to AMR's 50% increase in fuel costs.[5]Overall, the company believes that its hedging program saved the company $686 million in fuel expenses in 2007, and an estimated $3.5 billion between 1999 and 2008.[6][20]
As a result of different hedging strategies at each of the major airlines, oil fluctuations impact each of them differently. Southwest hedges more oil than any other airline, which has ensured the lowest prices on jet fuel following the spike in oil prices in 2007 and 2008.[20] In 2008, Southwest has 70% of its fuel needs hedged at $51 per barrel, while most other major airlines have only between 20% and 30% of their fuel hedged at an average $100 per barrel.[5] For example, Southwest's significant hedging led to its price of $1.98 per gallon of jet fuel in Q1 2008, while American Airlines (AMR) paid $2.73 per gallon as it hedged only 27% of its fuel needs.[20][5]
Southwest's hedging contracts extend until 2012, although the amount of oil hedged drops steadily after 2009, with only 15% of its oil needs in 2012 hedged at $63 per barrel.[6] As a result, Southwest will become more vulnerable to fluctuations in fuel prices as its contracts mature.
[edit] International Expansion Promotes Growth
In 2008 Southwest announced plans to expand its U.S. only service to include flights to Canada and Mexico.[21] In July 2008, Southwest announced a code-sharing agreement with WestJet Airlines to offer flights from the U.S. to Canada in late 2009. Under the code-sharing agreement, the airlines will sell tickets on each other's flights and share the revenue. WestJet will handle the flights across the border, connecting to Southwest flights at U.S. airports in which both airlines operate. In November 2008, Southwest entered into a similar agreement with Volaris airlines to offer flights between the U.S. and Mexico starting in 2010.[21] Southwest's code-sharing agreements are lower risks because they enable the company to expand its service without adding aircraft and employees.[21]
[edit] Competition
Southwest competes against many low-cost carriers or low-cost subsidiaries of larger carriers. Southwest's main low-cost carrier competitors are AirTran Holdings (AAI) and JetBlue Airways (JBLU). Its other competitors include American Airlines (AMR) (in Chicago, Texas, Los Angeles, and Miami), Continental (CAL) (in Cleveland and Houston), United (UAUA) (in Los Angeles, San Francisco, Portland, Chicago, and Washington, D.C.), and US Air (LCC) (in Baltimore, Phoenix, and Las Vegas). Because of its efficient cost-saving strategies, Southwest's 35 year streak of profitability is unmatched in the airline industry.[3] Additionally, due to rising costs and slumping demand, many competitors implemented various strategies including cutting food and beverage services and charging customers extra fees for checking in baggage to improve their profitability in 2008.[22] However, because of its already low operating expenses, Southwest has not instituted these cost-cutting measures.[22] Southwest is compared to these competitors along key metrics in the table below.
| Airline | Fleet Size[1] | Annual Departures (2007) (Thousands)[1] | Available Seat Miles (Millions)[1] | Passengers Enplaned (Thousands)[1] | Fuel Cost per Gallon[23] | Cost per Available Seat Mile (CASM)[1] | 2007 Revenue (Millions)[1] | Operating Margin[1] | Net Income (Millions)[1] |
| AirTran Holdings (AAI) | 137 | 262 | 22,680 | 23,741 | $2.23 | $.0957[24] | $2,309 | 5.9% | $52 |
| American Airlines (AMR) | 655 | 769 | 169,856 | 98,165 | $2.12 | $.114[25] | $22,833 | 3.1% | $356 |
| Continental Airlines (CAL) | 365 | 411 | 99,061 | 48.974 | $2.18 | $.108[26] | $14,105 | 4.4% | $460 |
| Delta Air Lines Inc. (DAL) | 446 | 553 | 127,323 | 72,924 | $2.24 | $.119[27] | $19.239 | 5.2% | $579 |
| JetBlue Airways (JBLU) | 134 | 196 | 32,148 | 21,304 | $2.09 | $.0838[28] | $2,843 | 6.0% | $18 |
| Southwest Airlines Company (LUV) | 520 | 1,162 | 99,636 | 101,910 | $1.70 | $.091[4] | $9,861 | 8% | $645 |
| United Airlines (UAUA) | 460 | 551 | 141,838 | 68,362 | $2.18 | $.135[29] | $20,049 | 4.8% | $349 |
| US Airways Group (LCC) | 356 | 525 | 75,790 | 57,829 | $2.20 | $.113[30] | $12,055 | 4.3% | $350 |
Southwest Airlines Company