CASE26 Southwest

7/18/2019 CASE26 Southwest

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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 achievedsteady 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 hies, and ac!uisition activity aresufficient to overcome looming challenges in the industry.

What are the ey industry conditions which render profits elusive for airlines"

#oes Southwest Airlines have a durable competitive advantage"

#o recent issues $such as safety violations and a labor union dispute% signal

inherent weanesses at Southwest or demonstrate the company&s strength at

handling threatening situations as they emerge"

'ow can Southwest achieve long(term strategic competitiveness against its rivals"

What strategy $or strategies% should the company use to continue its growth"

Is )ary *elly the right person to head up Southwest Airlines at this time"

ANALYSIS

Industry Environment

+he commercial airline industry has eperienced significant consolidation since

its inception over three decades ago. +he maret for air travel is highly competitive andis characteri-ed by etremely low customer loyalty. rice and destination are significant

decision factors in the traveler&s selection of an airline. /arious initiatives to build

loyalty, such as reward programs, have not been effective.

0ommercial airline banruptcies have become common in the U.S. and are

indicative of the difficulties facing domestic air travel service providers. +he followingfactors continue to eert downward pressure on the profitability of industry participants.

o 'igh operating costs

o Increasing fuel costs

o 0onsumer pressure for low prices

o #ecreased business travel, due to corporate budget cuts in the soft

economy

o Increased costs associated with satisfying safety and security

regulations

0ompeting for maret control against si major U.S. firms, Southwest is the

industry&s low(cost leader. 1ew entrants have been unable to successfully compete on the

Southwest Airlines ( 2



Southwest Airlines

basis of cost, with the eception of 3th(place rival, 4et5lue. 6ajor airlines, recogni-ing

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 aggressivelyretracting their scope (( attempting to operate with fewer aircraft, employees, and flights

to restore profitability.

Competitor Analysis

+o determine actions which could yield strategic competitiveness against its

biggest rivals, Southwest must first evaluate their strengths and weanesses and then

remain continually alert to new conditions and opportunities in the maretplace. +hetable below summarily compares the company to its top three mainstream competitors

and its sole low(cost competitor. 0harts which illustrate revenue and employee

distribution in the industry and evaluate performance along margin, return, and debt(to(e!uity measures are located in 7hibits I through /I at the end of the case notes.

Southwest JetBlue American Delta UnitedRoute Strategy Pt-to-Pt Pt-to-Pt Hub-Spoke Hub-Spoke Hub-Spoke

Business Strategy Low Cost Low Cost Different'n Different'n Different'n

Market Share 131! "#! 1"3! 1$1! 11#!

Re%enue &in i((ions)

Passenger *+,"$ *.,/3/ *.#,$# *11,0#3 *10,31$

reight *"#" *.#/ *.,.3# *1, *1,0./

2ota( *+,0/1 *.,0". *..,+3 *13,30 *.#,1"3

1. Month Re%enue rowth 0#! .#3! 1/! na na

u(( 2ie 4p(oyees 3",3$0 1#,.1+ 0,## ,#"" "",0/1

Re%enue per 4p(oyee *.0/,0"# *.$0,1#+ *./0,."/ *.".,/$+ *""+,##+

5perating Profit Margin 0#! +! ".! /#! 1!

Pre-2a6 Profit Margin 1#$! 1"! ..! 3+! 3!

7et Profit Margin /! #/! ..! ."! .#!

Return on 8ssets +/! 10! "+1! -10#! 1$$!

Return on 49uity "3! #3! 1$! 1.! 1/!

2ota( Debt:49uity 1". ""# +$ ..1 +#.

+he biggest airline company in terms of maret share is #elta, but Southwest has

a respectable share compared to the top three airlines. And the low(cost leader is over

three times the si-e of 4et5lue. $8efer to 7hibit I in the case.%

American and United generate the lion&s share of the industry&s revenues. Along

with #elta, the top 9 airlines generate about 2:; of revenues outside of passenger travel$freight and other%. 7ven though Southwest&s revenues eceed 4et5lue&s by a factor of

9.<, the smaller discount airline grew at a remarable =:.9; in =::3. $8efer to 7hibit I

at the end of the case notes.%

Southwest Airlines ( =



Southwest Airlines

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 worforce. 5ecause labor costs have a significant impact

on operating performance, this puts the company at a distinct disadvantage. $8efer to

7hibits II and III at the end of the case notes.%

Southwest&s operating, pre(ta, and net profit margins eceed each of the othercompetitors& margins in this analysis. >perating profit margin is =<; higher than its

nearest rival, #elta. +his performance measure is an indicator of operating strength. +he

fact that the company&s pre(ta profit eceeds 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

maes substantially more as a percentage of revenues than any other airline. $8efer to

7hibit I/ at the end of the case notes.%

A high return on assets highlights the firm&s ability to avoid ecess capacity andservice outages. American&s return on assets is so much higher than the industry&s that it

appears to be an anomaly. 6ore 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 #elta

is losing money on its capital investments. 8eturn on e!uity is less than =; throughoutthe industry. 'owever, Southwest leads the pac with a ?.9; 8o7, giving the company&s

shareholders the best return on investment in the airline industry. And with @; of its

common stoc being held by employee shareholders, the company is not only pleasing public investors but is also building worforce satisfaction in support of the company&s

strong wor culture. $8efer to 7hibit / at the end of the case notes.%

+he debt(to(e!uity ratio is a measure of borrowed funds relative to funds sourced

by shareholders. Southwest has traditionally held a low level of debt. 0onse!uently, thecompany&s #7 8atio of 2.?= is significantly lower than its competitors&. >f this group,#elta comes closest to Southwest&s performance at =.=2. >n the other hand, American is

debt(heavy at a disturbing B.3<. United also maintains dangerously high debt financing

with a #7 ratio of B.:=. In the middle, 4et5lue has borrowed ?.? times the amount ofe!uity to finance its growth. $8efer to 7hibit /I at the end of the case notes.%

As Southwest&s only low(cost $or value% competitor, 4et5lue has an e!ually(

advantageous point(to(point route structure. With <= destinations in 2B states, the rival is

gaining on Southwest&s C? destinations in the same number of states. It is evident from

Southwest&s stronger performance record $revenue, maret share, etc.% that the company

has greater penetration in the cities where it operates or is serving more lucrativedestinations than the smaller competitor. Where Southwest is a no(frills low(cost airline

with an emphasis on service and a laid(bac culture, 4et5lue augments its low costapproach by using service and style to add value. Flights outside the continental U.S. for

both airlines are focused on South and 0entral America, but 4et5lue also flies to the

0aribbean. Southwest&s activity beyond the U.S. is conducted through the use of strategic partners, such as West4et and /olaris. Again, if not necessarily a panic point, 4et5lue&s

=:.9; revenue growth in =::3 should certainly have Southwest&s attention.




Southwest Airlines

inan!ial Analysis

As discussed above, Southwest has superior financial performance over its

competitors in terms of critical margin, debt, and return indicators. +rends for the

company&s income statement items are furnished below. +hey indicate solid revenue

growth, managed labor costs, and an improvement to non(operating epenses which yielda significant increase in net income. 'owever, fuel, maintenance, and fees are growing at

a rate disproportionate to revenue growth and are negatively affecting operating profitmargin. In the D>therD >ther 7penses category, it is assumed that hedging gains are

responsible for turning a lower operating income into higher pre(ta and net incomes.

2006 2007 % Change

Operating e!enue

Passenger *0,$# *+,"$ 01!

reight 13" 13# -3#!

5ther .#. .$" 3/!

Total $9,086 $9,861 8.5%

Operating "#penses Labor *3,#. *3,.13 3!

ue( .,130 .,3/ 10/!

Maintenan;e "/0 /1/ 31/!

8ir;raft Renta(s 10 1/ -13!

ees "+ /# 131!

Depre; < 8orti= 1 $0!

5ther 1,3./ 1,"3" 01!

Total $8,152 $9,070 11.3%

O$"A&'( &'CO)" *+,- *7+. /.1,%

Other "#penses

>nterest 46pense *1.0 *11+ -$#!

Capita(i=e? >nterest &1) &#) -.#! >nterest >n;oe &0") &"") -"$/!

5ther 11 &.+.) -.+3"!

Total $144 ($267) -285.4%

$re/a# &ncome *7+0 *.03 ,,1+%

Pro%ision for 2a6es .+1 "13 "1+!

'" &'CO)" *-++ *6- 2+1,%

7et >n;oe per Share *#/3 *#0 3"+!

7>:Share, Di(ute? *#/1 *#0" 3$$!

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.

8esources. Amongst Southwest&s tangible resources are operating systems which

enable !uic turnaround and efficiency, a training center for flight crews, andtechnological advancements which improve customer processes, enhance customer

conveniences, and serve to improve the airport eperience for travelers. While the

Southwest Airlines ( ?



Southwest Airlines

company has achieved first mover advantages for its technological innovations, many of

these improvements are now common industry(wide practices. Ironically and

unepectedly, online booing $while immensely convenient for customers% has ended upincreasing buyer bargaining power and eerting downward pressure on ticet prices.

Intangible resources at Southwest include its human resource practices $such asthe company&s Dno layoffD policy%, its reputation for high customer satisfaction $based

upon the company&s on(time, baggage handling, and low customer complaint records%,and its remarable corporate culture $which is actively preserved by e!uipping a

corporate culture committee to carry out this important responsibility%. +hrough

mareting efforts to increase differentiation (( such as D!uiryD humorous advertising and

a Dno feesD policy (( the company has carved an unconventional and si-eable niche out ofthe airline industry.

0apabilities. Southwest&s abilities to maintain low costs, punctuality, and a

satisfied worforce are the foundation of the company&s success. A continuous focus on

overhead cost(cutting practices is strengthened by the company&s standardi-ed fleet, fuelhedging capabilities, and innovative approaches to heighten engine performance for

reduced fuel consumption. Southwest&s on(time performance surpasses its competitors by

half. 5y using a point(to(point service to simplify turnaround and secondary airports to

avoid congestion, the companyEs goals at punctuality are supported by an integratedoperational structure. In addition, Southwest&s employee and management practices have

established the company&s notable reputation as a desirable place to wor, minimi-ed

employee turnover, and contributed to its ability to provide outstanding customer servicefor air travelers.

0ore 0ompetencies. >utlined below are Southwest Airline&s core competencies

and an eplanation of how they provide the company with a competitive advantage.

> Fleet Standardi-ation

For other airlines to tae advantage of this practice would re!uire

replacement of their largest capital assets. +he amount of time it would

tae to rotate non(standard e!uipment out of the fleet without incurring aloss on the assets etends to the life of their current aircrafts. And

investments in new aircraft would have a harmful affect on competitors&

8oA.

> Fuel 'edging

+his activity re!uires cash to eecute, and Southwest&s struggling, debt(ridden competitors have limited financial resources. 1o other competitor

has hedged fuel for the years =::B and =:2: $with the eception of Alasa

Air which has just a <; crude oil hedge for =::B%. +he company&s

hedging activity at the end of =::@ has secured a fuel cost advantage forSouthwest for the net five years. +his cannot be matched by competitors.

For fuel hedging to remain an available strategy, the firm must retain its

position of financial strength.

Southwest Airlines ( <



Southwest Airlines

> Fuel 0onsumption 8eductions

Although other competitors can devise measures for innovatively

improving engine performance to reduce fuel coverage $they can evenimitate Southwest&s blended winglets and 7coower engine washing%,

unless they attain financial security, their ability to pursue such

investments is disabled.

> oint(to(oint Service

With the eception of 4et5lue&s similar flight structure, all other

competitors in the industry use a hub(and(spoe system, which introducescompleities that contribute to travel delays and weaened on(time

performance. 0hanging to point(to(point service, while not impossible, is

a massive undertaing that would affect rivals throughout their entirerange of operations. +herefore, it is unliely 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.

6ore flight slots and terminals can be ac!uired at lower rates, whichenables 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 accordingto Southwest&s financial reports, this cost is increasing. )ate allocations

by destination are thoughtfully selected, closely managed, and do not

change over fre!uently. Again, while a change from primary to secondaryairports is possible, the difficulty implementing the change and the

distraction to major airline operations are liely to impede such changes

for the sae of possible improvements to punctuality.

> 0orporate 0ulture

At this juncture, it would be especially difficult for competitors toestablish a corporate culture which matches the effectiveness of

Southwest&s. lagued by financial issues, lay(offs, banruptcies, and other

cost(cutting measures, getting ahead of the curve on employee satisfaction

would be an enormous undertaing and would tae years to achieve

desired results.

Sustainable 0ompetitive Advantage. In these ways, Southwest is uni!uely

!ualified to better serve its customers. +he company&s competitive advantages are

durable because they provide value, are uncommon, and although in some ways aresubstitutable, would be etremely costly and disruptive to imitate.

6anagement Issues. 8ecent safety and labor issues have introduced newchallenges for Southwest&s management to handle.

Southwest Airlines ( C



Southwest Airlines

>ver 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 theoccurrence of such incidents, and pursuit of ethical practices eceeding legal epectations

can demonstrate the importance placed on consumer safety above all other

considerations.

+he labor union dispute was also incidental. 'owever, the long(term impact toemployee relations and Southwest&s corporate culture remains to be seen. 6ost

importantly, the effect on internal cooperative spirit and customer satisfaction levels will

determine whether the company&s culture has been weaened.

+he company&s ability to effectively address both the safety and labor problems

demonstrates the strength of Southwest&s managerial capabilities. +hese issues werehandled !uicly and decisively with minimal damage. While these incidents are not

indicative of inherent company weanesses, they do reveal how !uicly company

strengths can be compromised. Additional problems in safety and labor relations wouldsignal that more fundamental problems are at the root of these occurrences.

STRATE"Y

ong(term 0ompetitiveness. #espite lower revenue, flight volume, and ticetsales 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 eisting domestic conditions apply financial pressures and limit competitor options,Southwest can tae advantage of its own fiscal stability to strengthen customer

relationships, further reduce fuel costs, and grow the business. 5ecause other airlines

may substantially boost revenues by raising ticet prices and applying new fees for previously(complimentary services, there may be only a temporary window of

opportunity for Southwest to emphasi-e its customer orientation and use the company&s

Dno feesD stance to maimi-e its bond with the consumer.

+he 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 taeadvantage of cost reduction initiatives and hedging activity, reducing Southwest&s

competitive advantages. #ue to rising fuel and maintenance hies $also encountered by

competitors%, operating epenses are liely to see additional increases. And labor costsare going to increase with Southwest&s new union contract. 0onse!uently, there will be

greater need to enhance Southwest&s differentiated features. 7specially with 4et5lue&svalue proposition, it is increasingly important to see new customer(oriented andtechnology(driven procedural improvements and to find uni!ue ways to build customer

loyalty. In addition, Southwest should tae a loo at weanesses $ecesses% in the asset

base to improve its return on assets and search for inventive ways to reduce rising fuel,maintenance, and fee ependitures.

+o achieve enduring strategic competitiveness against its rivals, the companyneeds to mae its best estimation of what the industry will loo lie in < years and in 2:




Southwest Airlines

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.

+his assessment includes determining the strategies that other competitors are epected touse for competitive survival. +he destinations and resources of 4et5lue, in particular,

should be watched to anticipate the rival&s competitive actions.

)rowth. Southwest has successfully managed its growth over the years,

epanding by adding aircraft and flight destinations across states and regions. It hasintegrated ac!uired companies to gain access to new destinations and found compatible

partners to pursue growth in natural marets. Still focused primarily on domestic

epansion, the company has immediate plans to net an increase of nine destinations.

Additional growth options are outlined in the grid below.

"rowth Options #ros Cons

6anaged#omestic

)rowth

• 7pands upon successful, profitable strategy

• 6ature and competitive maret• imited domestic growth

• 8evenue and profit constraints

Ac!uisitions • Guic access to marets• 7pands maret power

and position $scope%

• >pportunities emerge as

new entrants fail andmajor airlines scale bac

• Uncertain value of ac!uisition targets&assets and human resources

• Uncertain fit with business strategy and

corporate culture• ow strategic fleibility• 8e!uires substantial financing $debt%

• egal and regulatory re!uirements

• Integration issues ( synergies can beelusive

0omplimentary

'ori-ontalStrategic

Alliances

• Access to international

marets ( new passengersand sources of revenue

• 0ooperative strategy has

strong focus on creatingvalue

• >pportunity for strategic

alignment and shared

resources• ow cost of epansion

• Strategic fleibility

• imited control over partner behavior

•

otential to harm image• otential incompatibility and conflict

• Uncertainty of attaining trust

• 0ultural differences can interfere withcooperation and communication

• Allies are aiming to gain share of same

maret$s%• 8is of partner opportunistic behavior • 6anagement challenges

International

7pansion

• 1H a)uardia slots

provide possible lin toforeign destinations

• 0an leverage successful

domestic corecompetencies in natural

marets

• ess dependence ondomestic maret

• 0ost advantages (

• 0ompromise strategy and business

model ( need primary airports and possibly different aircraft for overseas

flights• 'ighly competitive global maret• #ifferent maret conditions ( many

competitive alliances

• Uncertain cultural fit $corporate andsocial%

• olitical and economic riss

Southwest Airlines ( @



Southwest Airlines

economies of scale • Increased management compleity

5ased on the competitive and internal analyses above, Southwest is doing well

against ailing competitors. It seems liely that maret failures will occur, and the

company needs to be ready to tae advantage of appealing growth opportunities which fit

within its strategic framewor.

+o launch services beyond the U.S. also re!uires opportunistic posturing. )rowth

through ac!uisitions is preferred to the use of a cooperative strategy so that Southwest

can maintain control of its strategy and image. 'owever, the ability to epand using an

ac!uisition approach depends upon finding candidates for purchase which have valuableassets, an acceptable debt level, and a cultural and strategic fit with Southwest. +he

ability to perform ade!uate due diligence, understand legal and regulatory nuances, fund

the purchase without overetending debt, and successfully integrate the business toachieve synergies is critical to pursuing this strategy. Where epected outcomes do not

eceed epected costs, Southwest should see compatible partners $such as /olaris% to

!uicly access international marets.

Strate$i! 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&seisting vision, mission, strategy, and culture. +he unspoen promise of advancement

opportunities within the firm serves to motivate the worforce and contributes to low

employee turnover. +he retention of valuable nowledge within the company isimportant for sustaining strong performance.

)ary *elly has moved into the top leadership role at Southwest Airlines. == years

with the company have imparted a vast amount of eperience with the firm&s winningstrategy, industry conditions, services, marets, technologies, and operating systems.

8ising through the financial arm of the company, he has been responsible for Southwest&suse of fuel hedging to guide its recent success. 'is financial bacground is well(suited to

the needs of the position because of the fiscal considerations important to Southwest&s

strategic competitiveness.

*elly is e!uipped to effectively manage the company&s resource portfolio, eploit

and maintain its core competencies, and sustain Southwest&s valuable organi-ationalculture. 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 maimi-e strategicsuccess,

– 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.

Southwest Airlines ( B



Southwest Airlines

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CASE26 Southwest

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