Southwest Airlines

INTRODUCTION
From its humble roots, Southwest Airlines has emerged as a major airline in the U.S. In
an industry where failure is more common than success, the company has achieved
steady growth and an impressive performance record. With no reprieve from intense
competitive pressure in sight, Southwest needs to determine if its technological
innovations, procedural improvements, managed price hikes, and acquisition activity are
sufficient to overcome looming challenges in the industry.

What are the key industry conditions which render profits elusive for airlines?

Does Southwest Airlines have a durable competitive advantage?

Do recent issues (such as safety violations and a labor union dispute) signal
inherent weaknesses at Southwest or demonstrate the company's strength at
handling threatening situations as they emerge?

How can Southwest achieve long-term strategic competitiveness against its rivals?

What strategy (or strategies) should the company use to continue its growth?

Is Gary Kelly the right person to head up Southwest Airlines at this time?

ANALYSIS
Industry Environment
The commercial airline industry has experienced significant consolidation since
its inception over three decades ago. The market for air travel is highly competitive and
is characterized by extremely low customer loyalty. Price and destination are significant
decision factors in the traveler's selection of an airline. Various initiatives to build
loyalty, such as reward programs, have not been effective.
Commercial airline bankruptcies have become common in the U.S. and are
indicative of the difficulties facing domestic air travel service providers. The following
factors continue to exert downward pressure on the profitability of industry participants.
o
o
o
o
o

High operating costs

Increasing fuel costs
Consumer pressure for low prices
Decreased business travel, due to corporate budget cuts in the soft
economy
Increased costs associated with satisfying safety and security
regulations

Competing for market control against six major U.S. firms, Southwest is the
industry's low-cost leader. New entrants have been unable to successfully compete on the
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basis of cost, with the exception of 7th-place rival, JetBlue. Major airlines, recognizing
the need to lower prices, have had little success introducing cost-saving measures. In
response to strenuous industry conditions, these rivals have had to resort to aggressively
retracting their scope -- attempting to operate with fewer aircraft, employees, and flights
to restore profitability.
Competitor Analysis
To determine actions which could yield strategic competitiveness against its
biggest rivals, Southwest must first evaluate their strengths and weaknesses and then
remain continually alert to new conditions and opportunities in the marketplace. The
table below summarily compares the company to its top three mainstream competitors
and its sole low-cost competitor. Charts which illustrate revenue and employee
distribution in the industry and evaluate performance along margin, return, and debt-toequity measures are located in Exhibits I through VI at the end of the case notes.
Southwest
Pt-to-Pt
Low Cost
13.1%

JetBlue
Pt-to-Pt
Low Cost
4.0%

$9,457
$404
$9,861
8.50%

$2,636
$206
$2,842
20.3%

$20,705
$2,230
$22,935
1.6%

$11,803
$1,555
$13,358
na

$18,317
$1,826
$20,143
na

Full Time Employees

Revenue per Employee

34,378
$286,840

10,219
$278,109

85,500
$268,246

55,044
$242,679

44,861
$449,009

Operating Profit Margin

Pre-Tax Profit Margin
Net Profit Margin

8.0%
10.7%
6.5%

5.9%
1.4%
0.6%

4.2%
2.2%
2.2%

6.0%
3.9%
2.4%

5.1%
3.5%
2.0%

9.6%
4.3%
1.42

1.8%
0.3%
4.40

49.1%
1.7%
9.75

-18.0%
1.2%
2.21

17.7%
1.6%
9.02

Route Strategy
Business Strategy
Market Share
Revenue (in millions)
Passenger
Freight
Total
12 Month Revenue Growth

Return on Assets
Return on Equity
Total Debt/Equity

American
Delta
United
Hub-Spoke Hub-Spoke Hub-Spoke
Different'n Different'n Different'n
14.3%
17.1%
11.0%

The biggest airline company in terms of market share is Delta, but Southwest has
a respectable share compared to the top three airlines. And the low-cost leader is over
three times the size of JetBlue. (Refer to Exhibit I in the case.)
American and United generate the lion's share of the industry's revenues. Along
with Delta, the top 3 airlines generate about 10% of revenues outside of passenger travel
(freight and other). Even though Southwest's revenues exceed JetBlue's by a factor of
3.5, the smaller discount airline grew at a remarkable 20.3% in 2007. (Refer to Exhibit I
at the end of the case notes.)

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United maintains a significant advantage over the other airlines in terms of
revenues earned per employee. Southwest is on top of the other competitors for this
measure, but the gap between its performance and United's is enormous. In raw numbers,
American maintains the largest workforce. Because labor costs have a significant impact
on operating performance, this puts the company at a distinct disadvantage. (Refer to
Exhibits II and III at the end of the case notes.)
Southwest's operating, pre-tax, and net profit margins exceed each of the other
competitors' margins in this analysis. Operating profit margin is 25% higher than its
nearest rival, Delta. This performance measure is an indicator of operating strength. The
fact that the company's pre-tax profit exceeds its operating profit affirms the value of
Southwest's non-operating income-generating capabilities (such as fuel hedging). Its net
profit margin is more than double its nearest competitor's, which means that the firm
makes substantially more as a percentage of revenues than any other airline. (Refer to
Exhibit IV at the end of the case notes.)
A high return on assets highlights the firm's ability to avoid excess capacity and
service outages. American's return on assets is so much higher than the industry's that it
appears to be an anomaly. More research should be done to understand the source of this
achievement. United is also a strong performer in terms of its return on assets, but Delta
is losing money on its capital investments. Return on equity is less than 2% throughout
the industry. However, Southwest leads the pack with a 4.3% RoE, giving the company's
shareholders the best return on investment in the airline industry. And with 8% of its
common stock being held by employee shareholders, the company is not only pleasing
public investors but is also building workforce satisfaction in support of the company's
strong work culture. (Refer to Exhibit V at the end of the case notes.)
The debt-to-equity ratio is a measure of borrowed funds relative to funds sourced
by shareholders. Southwest has traditionally held a low level of debt. Consequently, the
company's D/E Ratio of 1.42 is significantly lower than its competitors'. Of this group,
Delta comes closest to Southwest's performance at 2.21. On the other hand, American is
debt-heavy at a disturbing 9.75. United also maintains dangerously high debt financing
with a D/E ratio of 9.02. In the middle, JetBlue has borrowed 4.4 times the amount of
equity to finance its growth. (Refer to Exhibit VI at the end of the case notes.)
As Southwest's only low-cost (or value) competitor, JetBlue has an equallyadvantageous point-to-point route structure. With 52 destinations in 19 states, the rival is
gaining on Southwest's 64 destinations in the same number of states. It is evident from
Southwest's stronger performance record (revenue, market share, etc.) that the company
has greater penetration in the cities where it operates or is serving more lucrative
destinations than the smaller competitor. Where Southwest is a no-frills low-cost airline
with an emphasis on service and a laid-back culture, JetBlue augments its low cost
approach by using service and style to add value. Flights outside the continental U.S. for
both airlines are focused on South and Central America, but JetBlue also flies to the
Caribbean. Southwest's activity beyond the U.S. is conducted through the use of strategic
partners, such as WestJet and Volaris. Again, if not necessarily a panic point, JetBlue's
20.3% revenue growth in 2007 should certainly have Southwest's attention.
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Financial Analysis
As discussed above, Southwest has superior financial performance over its
competitors in terms of critical margin, debt, and return indicators. Trends for the
company's income statement items are furnished below. They indicate solid revenue
growth, managed labor costs, and an improvement to non-operating expenses which yield
a significant increase in net income. However, fuel, maintenance, and fees are growing at
a rate disproportionate to revenue growth and are negatively affecting operating profit
margin. In the "Other" Other Expenses category, it is assumed that hedging gains are
responsible for turning a lower operating income into higher pre-tax and net incomes.
Operating Revenue
Passenger
Freight
Other
Total
Operating Expenses
Labor
Fuel
Maintenance
Aircraft Rentals
Fees
Deprec & Amortiz
Other
Total
OPERATING INCOME
Other Expenses
Interest Expense
Capitalized Interest
Interest Income
Other
Total
Pre-Tax Income
Provision for Taxes
NET INCOME
Net Income per Share
NI/Share, Diluted

2006

2007

% Change

$8,750
134
202
$9,086

$9,457
130
274
$9,861

8.1%
-3.0%
35.6%
8.5%

$3,052
2,138
468
158
495
515
1,326
$8,152
$934

$3,213
2,536
616
156
560
555
1,434
$9,070
$791

5.3%
18.6%
31.6%
-1.3%
13.1%
7.8%
8.1%
11.3%
-15.3%

$128
(51)
(84)
151
$144
$790
291
$499

$119
(50)
(44)
(292)
($267)
$1,058
413
$645

-7.0%
-2.0%
-47.6%
-293.4%
-285.4%
33.9%
41.9%
29.3%

$0.63
$0.61

$0.85
$0.84

34.9%
37.7%

Internal Environment
In addition to the company's financial strength, Southwest's business model
successfully facilitates the company's efforts to maintain cost leadership, customer
satisfaction, and cultural advantages.
Resources. Amongst Southwest's tangible resources are operating systems which
enable quick turnaround and efficiency, a training center for flight crews, and
technological advancements which improve customer processes, enhance customer
conveniences, and serve to improve the airport experience for travelers. While the
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company has achieved first mover advantages for its technological innovations, many of
these improvements are now common industry-wide practices. Ironically and
unexpectedly, online booking (while immensely convenient for customers) has ended up
increasing buyer bargaining power and exerting downward pressure on ticket prices.
Intangible resources at Southwest include its human resource practices (such as
the company's "no layoff" policy), its reputation for high customer satisfaction (based
upon the company's on-time, baggage handling, and low customer complaint records),
and its remarkable corporate culture (which is actively preserved by equipping a
corporate culture committee to carry out this important responsibility). Through
marketing efforts to increase differentiation -- such as "quirky" humorous advertising and
a "no fees" policy -- the company has carved an unconventional and sizeable niche out of
the airline industry.
Capabilities. Southwest's abilities to maintain low costs, punctuality, and a
satisfied workforce are the foundation of the company's success. A continuous focus on
overhead cost-cutting practices is strengthened by the company's standardized fleet, fuel
hedging capabilities, and innovative approaches to heighten engine performance for
reduced fuel consumption. Southwest's on-time performance surpasses its competitors by
half. By using a point-to-point service to simplify turnaround and secondary airports to
avoid congestion, the companys goals at punctuality are supported by an integrated
operational structure. In addition, Southwest's employee and management practices have
established the company's notable reputation as a desirable place to work, minimized
employee turnover, and contributed to its ability to provide outstanding customer service
for air travelers.
Core Competencies. Outlined below are Southwest Airline's core competencies
and an explanation of how they provide the company with a competitive advantage.
>

Fleet Standardization
For other airlines to take advantage of this practice would require
replacement of their largest capital assets. The amount of time it would
take to rotate non-standard equipment out of the fleet without incurring a
loss on the assets extends to the life of their current aircrafts. And
investments in new aircraft would have a harmful affect on competitors'
RoA.

>

Fuel Hedging
This activity requires cash to execute, and Southwest's struggling, debtridden competitors have limited financial resources. No other competitor
has hedged fuel for the years 2009 and 2010 (with the exception of Alaska
Air which has just a 5% crude oil hedge for 2009). The company's
hedging activity at the end of 2008 has secured a fuel cost advantage for
Southwest for the next five years. This cannot be matched by competitors.
For fuel hedging to remain an available strategy, the firm must retain its
position of financial strength.

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>

Fuel Consumption Reductions

Although other competitors can devise measures for innovatively
improving engine performance to reduce fuel coverage (they can even
imitate Southwest's blended winglets and EcoPower engine washing),
unless they attain financial security, their ability to pursue such
investments is disabled.

>

Point-to-Point Service
With the exception of JetBlue's similar flight structure, all other
competitors in the industry use a hub-and-spoke system, which introduces
complexities that contribute to travel delays and weakened on-time
performance. Changing to point-to-point service, while not impossible, is
a massive undertaking that would affect rivals throughout their entire
range of operations. Therefore, it is unlikely to be a change which would
be adopted in order to improve punctuality.

>

Secondary Airports
In addition to the service implications mentioned above, the use of
secondary airports in destination cities offers good terms for airlines.
More flight slots and terminals can be acquired at lower rates, which
enables increased flights between destinations for greater customer
convenience.
Airport slots are a semi-permanent asset. A significant investment is made
by airlines to gain access to landing rights and flight slots, and according
to Southwest's financial reports, this cost is increasing. Gate allocations
by destination are thoughtfully selected, closely managed, and do not
change over frequently. Again, while a change from primary to secondary
airports is possible, the difficulty implementing the change and the
distraction to major airline operations are likely to impede such changes
for the sake of possible improvements to punctuality.

>

Corporate Culture
At this juncture, it would be especially difficult for competitors to
establish a corporate culture which matches the effectiveness of
Southwest's. Plagued by financial issues, lay-offs, bankruptcies, and other
cost-cutting measures, getting ahead of the curve on employee satisfaction
would be an enormous undertaking and would take years to achieve
desired results.

Sustainable Competitive Advantage. In these ways, Southwest is uniquely

qualified to better serve its customers. The company's competitive advantages are
durable because they provide value, are uncommon, and although in some ways are
substitutable, would be extremely costly and disruptive to imitate.
Management Issues. Recent safety and labor issues have introduced new
challenges for Southwest's management to handle.
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Over and above the associated costs and fines, the potentially negative impact that
safety violations could have on customer perceptions threatens the greatest harm to the
company. Strict adherence to safety regulation compliance is necessary to isolate the
occurrence of such incidents, and pursuit of ethical practices exceeding legal expectations
can demonstrate the importance placed on consumer safety above all other
considerations.
The labor union dispute was also incidental. However, the long-term impact to
employee relations and Southwest's corporate culture remains to be seen. Most
importantly, the effect on internal cooperative spirit and customer satisfaction levels will
determine whether the company's culture has been weakened.
The company's ability to effectively address both the safety and labor problems
demonstrates the strength of Southwest's managerial capabilities. These issues were
handled quickly and decisively with minimal damage. While these incidents are not
indicative of inherent company weaknesses, they do reveal how quickly company
strengths can be compromised. Additional problems in safety and labor relations would
signal that more fundamental problems are at the root of these occurrences.
STRATEGY
Long-term Competitiveness. Despite lower revenue, flight volume, and ticket
sales than its major competitors and despite the significant advantage achieved through
fuel hedging capabilities, Southwest's low cost position, profitability (fueled by operating
strengths), and low debt financing are the cornerstones of the company's competitiveness.
As existing domestic conditions apply financial pressures and limit competitor options,
Southwest can take advantage of its own fiscal stability to strengthen customer
relationships, further reduce fuel costs, and grow the business. Because other airlines
may substantially boost revenues by raising ticket prices and applying new fees for
previously-complimentary services, there may be only a temporary window of
opportunity for Southwest to emphasize its customer orientation and use the company's
"no fees" stance to maximize its bond with the consumer.
The company depends on competitor inability to match its cost structure. If other
airlines are able to recover financial strength, they will be in a better position to take
advantage of cost reduction initiatives and hedging activity, reducing Southwest's
competitive advantages. Due to rising fuel and maintenance hikes (also encountered by
competitors), operating expenses are likely to see additional increases. And labor costs
are going to increase with Southwest's new union contract. Consequently, there will be
greater need to enhance Southwest's differentiated features. Especially with JetBlue's
value proposition, it is increasingly important to seek new customer-oriented and
technology-driven procedural improvements and to find unique ways to build customer
loyalty. In addition, Southwest should take a look at weaknesses (excesses) in the asset
base to improve its return on assets and search for inventive ways to reduce rising fuel,
maintenance, and fee expenditures.
To achieve enduring strategic competitiveness against its rivals, the company
needs to make its best estimation of what the industry will look like in 5 years and in 10
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years. It should constantly monitor the general, industry, and competitive environments
to anticipate and react to threatening trends as well as to identify long-term opportunities.
This assessment includes determining the strategies that other competitors are expected to
use for competitive survival. The destinations and resources of JetBlue, in particular,
should be watched to anticipate the rival's competitive actions.
Growth. Southwest has successfully managed its growth over the years,
expanding by adding aircraft and flight destinations across states and regions. It has
integrated acquired companies to gain access to new destinations and found compatible
partners to pursue growth in natural markets. Still focused primarily on domestic
expansion, the company has immediate plans to net an increase of nine destinations.
Additional growth options are outlined in the grid below.
Growth Options Pros
Managed
Expands upon successful,
Domestic
profitable strategy
Growth
Acquisitions
Quick access to markets
Expands market power
and position (scope)
Opportunities emerge as
new entrants fail and
major airlines scale back

Complimentary
Horizontal
Strategic
Alliances

International
Expansion

Access to international
markets - new passengers
and sources of revenue
Cooperative strategy has
strong focus on creating
value
Opportunity for strategic
alignment and shared
resources
Low cost of expansion
Strategic flexibility
NY LaGuardia slots
provide possible link to
foreign destinations
Can leverage successful
domestic core
competencies in natural
markets
Less dependence on
domestic market
Cost advantages

Cons
Mature and competitive market
Limited domestic growth
Revenue and profit constraints
Uncertain value of acquisition targets'
assets and human resources
Uncertain fit with business strategy and
corporate culture
Low strategic flexibility
Requires substantial financing (debt)
Legal and regulatory requirements
Integration issues - synergies can be
elusive
Limited control over partner behavior
Potential to harm image
Potential incompatibility and conflict
Uncertainty of attaining trust
Cultural differences can interfere with
cooperation and communication
Allies are aiming to gain share of same
market(s)
Risk of partner opportunistic behavior
Management challenges
Compromise strategy and business
model - need primary airports and
possibly different aircraft for overseas
flights
Highly competitive global market
Different market conditions - many
competitive alliances
Uncertain cultural fit (corporate and
social)
Political and economic risks

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economies of scale

Increased management complexity

Based on the competitive and internal analyses above, Southwest is doing well
against ailing competitors. It seems likely that market failures will occur, and the
company needs to be ready to take advantage of appealing growth opportunities which fit
within its strategic framework.
To launch services beyond the U.S. also requires opportunistic posturing. Growth
through acquisitions is preferred to the use of a cooperative strategy so that Southwest
can maintain control of its strategy and image. However, the ability to expand using an
acquisition approach depends upon finding candidates for purchase which have valuable
assets, an acceptable debt level, and a cultural and strategic fit with Southwest. The
ability to perform adequate due diligence, understand legal and regulatory nuances, fund
the purchase without overextending debt, and successfully integrate the business to
achieve synergies is critical to pursuing this strategy. Where expected outcomes do not
exceed expected costs, Southwest should seek compatible partners (such as Volaris) to
quickly access international markets.
Strategic Leadership
Selection of new leadership from within the firm's management pool is preferred
when the firm is performing well and desires to remain committed to the company's
existing vision, mission, strategy, and culture. The unspoken promise of advancement
opportunities within the firm serves to motivate the workforce and contributes to low
employee turnover. The retention of valuable knowledge within the company is
important for sustaining strong performance.
Gary Kelly has moved into the top leadership role at Southwest Airlines. 22 years
with the company have imparted a vast amount of experience with the firm's winning
strategy, industry conditions, services, markets, technologies, and operating systems.
Rising through the financial arm of the company, he has been responsible for Southwest's
use of fuel hedging to guide its recent success. His financial background is well-suited to
the needs of the position because of the fiscal considerations important to Southwest's
strategic competitiveness.
Kelly is equipped to effectively manage the company's resource portfolio, exploit
and maintain its core competencies, and sustain Southwest's valuable organizational
culture. It will, however, be important for him to:

give proper consideration to changes in the competitive landscape and their

implications for adjustments to strategic direction,

develop human and social capital within the company to maximize strategic
success,

promote the use of ethical business practices to avoid the pitfalls of cutting
corners to save costs, and

encourage internal innovation to discover new ways to lower costs and

enhance consumer satisfaction.
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EXHIBIT I.

EXHIBIT II.

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EXHIBIT III.

EXHIBIT IV.

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EXHIBIT V.

EXHIBIT VI.

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