Despite fuel prices, Southwest Airlines still feels the ‘LUV’

November 4, 2011  

By Natalie Posgate

An elephant remains in the room for all major U.S. airlines this year. It’s a monetary threat to business – a leech that is slowly sucking and threatening to leave some airline companies lifeless the longer it lingers.

It’s the omen of the increasing fuel prices.

The not-so promising economy isn’t much help to the problem, either. Even Ben Bernanke has acknowledged that we’re quite possibly headed toward another recession – which isn’t positive for the demand for air travel. Barron’s recently reported that changes in demand and prices of jet fuel may cost the airline industry $54 billion this year – a sharp raise from 2010’s reported $39 billion.

While all airlines are suffering from high fuel prices, Southwest Airlines Co. appears to be doing its homework about how to survive in the long run. Through its savvy revenue-building tactics and the “so far, so good” acquisition of AirTran Holdings, Inc., Southwest is trying to increase its profitability in the future.

Since its 1971 inception, Southwest has never had a layoff or pay cut. Founded by Herb Kelleher and Rollin King, the Dallas-based company began as an intra-Texas airline, providing flights to Houston, Dallas and San Antonio. Today, Southwest flies to 72 cities in 37 states. In 2010, it reached its 38th year of profitability.

The 2011 second-quarter results reflected a hurdle, however: Southwest reported a 43 percent decrease in operating income, to $207 million from last year’s second quarter of $363 million. The decline in profit resulted from a 40 percent increase in operating expenses.

Ryan Martinez, the manager of investor relations for Southwest, had only one explanation for the 40 percent increase: high fuel prices.

“The No. 1 threat to our earnings is energy prices,” Martinez said. “In the first 30 years of our existence, crude oil traded around $20 a barrel. The last decade, we’ve seen prices as high as $150 a barrel. It’s a tremendous shift in our cost structure.”

During a conference call about Southwest’s second-quarter earnings, Laura Wright, the airline’s senior vice president of finance and chief financial officer, emphasized the drastic difference between fuel prices for 2010 and 2011.

“Looking back just one year, if we would have paid second-quarter 2010 economic fuel prices in the second quarter of this year, we would have seen a fuel expense reduction of about $420 million,” Wright said.

Southwest had to raise its ticket prices at least seven times this year as a result of high fuel prices. Martinez said that raising fares was painful for the company since it is known for being an affordable airline by offering low fares and providing services such as baggage checking for free.

“We’re a low-cost airline; we pride ourselves in becoming a good value,” Martinez said. “We don’t want to nickel and dime customers for what should be free.”

So in order to produce more revenue while avoiding forcing its customers to pay more, Southwest created two new fare classes: Business Select and Early Bird. Martinez said that the new fares are great strategies because when customers purchase them they address common customer complaints such as non-assigned seating while giving customers the option to pay more for the additional benefits. For example, customers who purchase a Business Select fare are among the first 15 passengers to board the plane, and also receive more frequent flier miles and a free alcoholic drink. This fare generates about $100 million a year in revenue, and so far this year, the Early Bird fare – which permits passengers to automatically be checked in 24 hours before their flight – has generated between $120 million and $130 million.

In addition to adding new fare classes, Southwest has significantly reduced costs through fuel hedging and fuel conservation. Through fuel hedging – a method that Southwest has been using for many years—the airline is able to lock in 50 percent to 80 percent of its yearly supply of fuel for a fixed cost that lies somewhere between the peak high and peak low price per barrel of crude oil. Actions for fuel conservation include measures such as retiring older aircraft for more fuel-efficient aircraft. Martinez said that each aircraft swap gains 8 percent in fuel efficiency. The company has also made simple adjustments like channeling air conditioning from the airport versus burning fuel running the engine to generate electricity when a plane is on a break between flights and boarding passengers.

Southwest is also in the process of working with the Federal Aviation Administration to integrate custom flight routes that stray away from the required navigation performance (RNP) that all airlines currently must abide by. Martinez said that the difference between RNP and Southwest’s proposed custom routes is like the difference between driving around the city with a roadmap versus a GPS. Southwest’s proposed methods (the GPS approach) can save up to 2 percent in fuel per flight. Martinez said that the initiative is still under way and it will take a while for the FAA to fully approve it.

The cost-cut tactics have even trickled down to the average Southwest employee. Elizabeth Robison, a graduate student at the University of North Texas who recently accepted a full-time position in the human resources department after a summer internship at Southwest, explained some of the money-saving methods that her office executed this summer.

“We did every little thing to help save the company money,” said Robison, the new employment coordinator in Southwest’s human resources department. “If it was buying less office supplies or bringing water from home or using recycled cups. Whatever you could do to save the money we did, and everyone did it with the love in their hearts.”

Martinez noted that the new fare classes and cost-cutting tactics are still not enough to offset the high fuel prices in order to generate profit growth, so that’s where the May 2 acquisition of AirTran comes into play – for now and for two or three years down the road when the full integration is completed.

Acquiring another company can be an unprofitable undertaking, but Martinez said that AirTran was the perfect fit for Southwest.

“The purpose of buying AirTran is to take its network and apply our management choices,” he said. “AirTran is a very lean airline, has a low cost DNA and great employees who fly to really great places where ours just want to go.”

AirTran will expand Southwest’s market by giving it access to international flights and more slot-controlled markets (like New York’s LaGuardia Airport: an airport that is so busy that airlines have to buy slots in the terminals to obtain flights). Southwest will also gain a presence in Hartsfield-Jackson Atlanta International Airport – one of the busiest airports in the U.S.

Martinez said that the acquisition itself has been very smooth so far because AirTran was the only airline in the U.S. that had a cost structure similar to or even a little smaller than Southwest’s. Plus, AirTran and Southwest both use Boeing 737 aircraft, which is a huge money saver in the acquisition since Southwest will not have to buy planes to replace AirTran’s. All Southwest has to do is repaint AirTran’s planes red and blue, maybe add a few more seats, and then they will be Southwest planes.

The acquisition came at the right time, Martinez said, since current economic conditions don’t allow Southwest to organically expand by purchasing more planes and flying to more cities. He said that before Southwest can resume organic growth, it needs to regain its 2010 net income level – which may not happen in 2012 since fuel prices will most likely remain high.

“By far right now for 2012 our biggest threat is fuel,” Martinez said. “Our decision to not grow is 100 percent driven by these record-high energy prices. Even in that environment, our acquisition has allowed us to expand our company by 25 percent. When things get better, we’ll return to organic growth and start crossing the lines and connecting the dots. We’ll be positioned on all other sides as a much bigger company, a financially strong company and airline – all while our competitors continue to shrink.”

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