South west Airline" 2002

case twenty-eigh
Andrew c. Inkpen Valerie DeGroot Arturo Wagner Chee Wee Tan
Thunderbird
September 11 thrust the airline industry into economic chaos, resulting in layoffs, bankruptcies, and the prospect of a tenuous future. On September 22, 2001, President Bush signed into law the Air Transportation Safety and System Stabilization Act. The Stabilization Act provided up to $5 billion in cash grants and $10 billion in loan guaranteesto qualifying US airlines to compensate for direct and incremental losses.Immediately after the terrorist acts, most major carriers announced significant service reduc tions,grounded aircraft, and furloughed employees.At Southwest Airlines (Southwest), there was no loss of pay for employees from layoffs, furloughs, or unpaid leaves. By September 18, 2001, Southwest was operating its pre-September 11 flight schedulewith 100% job security. Because Southwest had the strongestbalance sheet and the highest credit rating in the US airline industry, the company was able to avoid the severe cash flow problems experienced by its competitors. According to the Southwest2001 annual report: Southwest was well poised, financially, to withstand the potentially devastating hammer blow of September II. Why? Becausefor several decades our leadership philoso phy has been: we manage in good times so that our Com pany and our Peoplecan be job secure and prosper through bad times.... Once again, after September 11, our philos ophy of managing in good times so as to do well in bad times proved a marvelous prophylactic for our Employeesand our Shareholders.

THE

US

AIRLINE

INDUSTRY

Copyright 2002 Thunderbird, The American Graduate School of Interna tional Management. All rights reserved. This case was prepared by Professor AndrewC. Inkpen and Valerie OeGroot, with research assistance from Arturo Wagnerand Chee Wee Tan, for the purpose of classroom discussion only, and notto indicate either effective or ineffective management.

The nature of the US commercial airline industry was permanently altered in October 1978 when President Jimmy Carter signed the Airline Deregulation Act. Before deregulation, the Civil Aeronautics Board regu lated airline route entry and exit, passenger fares, merg ers and acquisitions, and airline rates of return. Typi cally, two or three carriers provided service in a given market, although there were routes covered by only one carrier. Cost increases were passed along to customers and price competition was almost non-existent. The air lines operated as if there were only two market seg ments: those who could afford to fly, and those who couldn't. Deregulation sent airline fares tumbling and allowed many new firms to enter the market. The finan cial impact on both established and new airlines was enormous. The fuel crisis of 1979 and the air traffic con trollers' strike in 1981 contributed to the industry's diffi culties, as did the severe recession that hit the US during the early 1980s.During the first decade of deregulation, more than 150 carriers, many of them start-up airlines, collapsed into bankruptcy. Eight of the 11major airlines dominating the industry in 1978 ended up filing for bankruptcy, merging with other carriers, or simply dis appearing from the radar screen. Collectively, the indus try made enough money during this period to buy two Boeing 747s1 (Exhibit 1). The three major carriers that survived intact-Delta, United, and American-ended up with 80% of all domestic US air traffic and 67% of trans-Atlantic business.? Competition and lower fares led to greatly expanded demand for airline travel. By the mid-1990s, the airlines were having trouble meeting this demand. Travel increased from 200 million travelers in 1974 to 500 million in 1995, yet only five new runways were

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built during this time period. During the 1980s, many airlines acquired significant new debt in efforts to ser vice the increased travel demand. Long-term debt-to capitalization ratios rose dramatically: Eastern's went from 62% to 473%, TWA's went from 62% to 115%, and Continental's went from 62% to 96%. In contrast, United and Delta maintained their debt ratios at less than 60%, and American Airlines' ratio dropped to 34%. Despite the financial problems experienced by many airlines started after deregulation, new firms con tinued to enter the market. Between 1992 and 1995, 69 new airlines were certified by the FAA. Most of these airlines competed with limited route structures and lower fares than the major airlines. The new low-fare airlines created a second tier of service providers that saved consumers billions of dollars annually and pro vided service in markets abandoned or ignored by major carriers. One such start-up was Kiwi Airlines, founded by former employees of the defunct Eastern and Pan Am airlines. Kiwi was funded largely by employees. Pilots paid $50,000 apiece to get jobs, and other employ ees paid $5,000. In 1999, Kiwi went bankrupt and liqui dated its assets. At its peak in the mid-1990s, Kiwi had 1,200 employees, leased 15 jets, and flew 65 flights daily. Although deregulation fostered competition and the growth of new airlines, it also created a regional dis parity in ticket prices and adversely affected service to small and remote communities. Airline workers gener ally suffered, with inflation-adjusted average employee wages falling from $42,928 in 1978 to $37,985 in 1988. About 20,000 airline industry employees were laid off in the early 1980s, while productivity of the remaining employees rose 43% during the same period. In a vari ety of cases, bankruptcy filings were used to diminish the role of unions and reduce unionized wages.
INDUSTRY ECONOMICS

About 80% of airline operating costs were fixed or semi-variable. The only true variable costs were travel agency commissions, food costs, and ticketing fees. The operating costs of an airline flight depended primarily on the distance traveled, not the number of passengers on board. For example, the crew and ground staff sizes weredetermined by the type of aircraft, not the passen ger load. Therefore, once an airline established its route structure, most of its operating costs were fixed. Because of this high fixed-cost structure, the airlines developed sophisticated software tools to maximize capacity utilization, known as load factor. Load factor was calculated by dividing RPM (revenue passenger miles-the number of passengers carried multiplied by the distance flown) by ASM (available seat miles-the number of seats available for sale multiplied by the dis tance flown).

On each flight by one of the major airlines (exclud ing Southwest and the low-fare carriers), there were typically a dozen categories of fares. The airlines ana lyzed historical travel patterns on individual routes to determine how many seats to sell at each fare level. All of the major airlines used this type of analysis and flex ible pricing practice, known as a "yield management" system. These systems enabled the airlines to manage their seat inventories and the prices paid for those seats. The objective was to sell more seats on each flight at higher yields (total passenger yield was passenger rev enue from scheduled operations divided by scheduled RPMs). The higher the ticket price, the better the yield. Although reducing operating costs was a high pri ority for the airlines, the nature of the cost structure limited cost reduction opportunities. Fuel costs (15.6% of total operating costs at Southwest in 2001) were largely beyond the control of the airlines, and many of the larger airlines' restrictive union agreements limited labor flexibility. The airline industry's extremely high fixed costs made it one of the worst net profit margin performers when measured against other industries. Airlines were far outpaced in profitability by industries such as banks, health care, automobile manufacturing, consumer products, and publishing. In the early I990s, most airlines sharply lowered their new aircraft orders to avoid taking on more debt. At the end of June 1990, US airlines had outstanding orders to buy 2,748 aircraft. At the end of June 1996, orders had fallen to I, II J.3 (A new Boeing 737 cost about $28 million.) By 1999, the global airline industry had improved substantially, and orders rose 2,700. After September 11,2001, both Boeing and Air to about bus reported substantially reduced orders, although the industry showed signs of a revival in early 2002. To manage their route structures, all of the major airlines (except Southwest) maintained their operations around a "hub-and-spoke" network. The spokes fed passengers from outlying points into a central airport the hub-where passengers could travel to additional hubs or their final destination. For example, to fly from Phoenix to Boston on Northwest Airlines, a typical route would involve a flight from Phoenix to North west's Detroit hub. The passenger would then take a second flight from Detroit to Boston. Establishing a major hub in a city like Chicago or Atlanta required an investment of as much as $150 mil lion for gate acquisition and terminal construction. Although hubs created inconveniences for travelers, hub systems were an efficient means of distributing services across a wide network. The major airlines were very pro tective of their so-called "fortress" hubs and used the hubs to control various local markets. For example, Northwest handled about 80% of Detroit's passengers

383

and occupied nearly the entire new Detroit terminal that opened in February 2002. And, Northwest's deal with the local government assured that it would be the only airline that could have a hub in Detroit. When South west entered the Detroit market, the only available gates were already leased by Northwest. Northwest subleased gates to Southwest at rates 18 times higher than North west's costs. Southwest eventually withdrew from Detroit, and then re-entered, one of only four markets Southwest had abandoned in its history (San Francisco, Denver, and Beaumont, Texas, were the other three).
RECENT AIRLINE PERFORMANCE INDUSTRY

FUTURE

PRESSURES

ON THE

INDUSTRY

In addition to the difficult revenue environment for air lines in 2002, the industry was faced with several other issues: 1. Security. The airlines needed increased war risk insurance, and passenger security costs were expected to rise. 2. Customer dissatisfaction with airline service. Service problems were leading some to call for reregulation of airline competitive practices. 3. Labor costs. Although the average salary per airline employee from 1987 to 1996 rose at a rate faster than the increase in the CPI index (4.4% increasein labor costs compared with a 3.7% CPI increase over the same period), in recent years labor costs were up less than a percentage point. However, pressure from labor was expected to increase. 4. Aircraft maintenance. The aging of the general air craft population meant higher maintenance costs and eventual aircraft replacement. The introduc tion of stricter government regulations for older planes placed new burdens on operators of older aircraft. 5. Debt servicing. The airline industry's debt load greatly exceeded US industry averages. 6. Fuel costs. Long-term jet fuel cost was uncertain. In 1997, the average price per gallon of fuel was $.62. In 1999, the average price was $.53, and in 2001, $.71. 7. Air-traffic delays. Increased air-traffic control delays caused by higher travel demand and related airport congestion were expected to negatively influence airlines' profitability.

US airlines suffered a combined loss of $13 billion from 1990 to 1994 (Exhibit 1).4 High debt levels plagued the industry during this period. In 1994, the earnings pic ture began to change with the industry as a whole reducing its losses to $278 million.> Overall expansion and health returned to the industry by 1995, and in 1997and 1998, virtually all US carriers hit record profit levels.Together, the US major airlines made $4.9 billion in net profit in 1998, down from 1997's record of $5.2 billion. After profitable years in 1999 and 2000, the eight major US airlines had a combined loss for the first quarter 2001, the first since 1993. After September II, 2001, the US domestic and global industries were dev astated, leading to the bankruptcies of many airlines, such as SwissAir, Sabena (Belgium), Canada 3000, and Ansett (Australia). America West Airlines was forced to seek a government-backed loan through the federal Sta bilization Act. Exhibits 2, 3, and 4 provide comparative data for the major airlines.

.
(

n a S
T

Airline
American America West Continental Delta Northwest Airlines ~

Load Factor (%)

69.4 71.9 72.8 69.1 74.3
68.0

Break Even
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58.9

Above/Below BE
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57.3

Southwest Airlines
384 TWA United US Airways
sis Division.

66.1 70.8 68.9

82.8 94.7 85.3

84.0 89.4 7.2

Source: Airline Quarterly Financial Review, Fourth Quarter 2001, Department of Transportation

Office of Aviation Analysis, Economic and Financial Analy

Ranklngs"
American United Delta

2000 Company

% Market

Share

1998 Company Rankings

Delta United American Northwest US Airways Continental Southwest TWA America West Others Total

% Market

Share

Northwest Continental US Airways Southwest America West

24.0 19.7 18.0 12.4 10.0 7.1 6.4 2.9 100.0

1985 Company Rankings

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% Market

Share

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* Department

of Transportation

http://www.activemedia-guide.comftotalusairline

Sources: Department of Transportation and Standard & Poor's, cited by Industry Surveys, February 1, 1996, and "World Airlines: A year in review," Interavia Business& Technology. June 1999, Publisher: Aerospace Media.

SOUTHWEST AIRLINES

BACKGROUND

In 1966, Herb Kelleher was practicing law in San Anto nio when a client named Rollin King proposed starting a short-haul airline similar to California-based Pacific Southwest Airlines. The airline would fly the "Golden Triangle"of Houston, Dallas, and San Antonio, and by

staying within Texas, avoid federal regulations. Kelleher and King incorporated a company, raised initial capi tal, and filed for regulatory approval from the Texas Aeronautics Commission. Unfortunately, the other Texas-based airlines, namely Braniff, Continental, and Trans Texas (later called Texas International), opposed the idea and waged a battle to prohibit Southwest from flying. Kelleher argued the company's case before the Texas Supreme Court, which ruled in Southwest's favor. The US Supreme Court refused to hear an appeal filed by the other airlines. In late 1970, it looked as if the company could begin flying. Southwest began building a management team, and the purchase of three surplus Boeing 737s was negotiated. Meanwhile, Braniff and Texas Interna tional continued their efforts to prevent Southwest from flying. The underwriters of Southwest's initial public stock offering withdrew, and a restraining order against the company was obtained two days before its sched uled inaugural flight. Kelleher again argued his com pany's case before the Texas Supreme Court, which ruled in Southwest's favor a second time, lifting the restraining order. Southwest Airlines began flying the next day, June 18, 1971.6 When Southwest began flying to three Texas cities, the firm had three aircraft and 25 employees. Initial flights were out of Dallas' older Love Field airport and Houston's Hobby Airport, both of which were closer to

per Available Seat Mile Data Airline

American* America West* Continental Delta Northwest Southwest United US Airways
*2000 figures Source: Annual Reports, company Web sites.

EXHIBIT

Cost/ASM. Op. Rev.!ASM. 4th Otr, 2001 4th Qtr. 2001

10.38 8.50 9.58 10.14 9.78
7.54

10.17 8.04 8.98 9.39 9.17

8.57

12.00 12.46

9.80 9.86

downtown than the major international airports. Flam boyant from the beginning, original flights were staffed by flight attendants in hot pants. By 1996, the flight attendant uniform had evolved to khakis and polo shirts. The "Luv" theme was a staple of the airline from the outset and became the company's ticker symbol on Wall Street. Southwest management quickly discovered that there were two types of travelers: convenience, time oriented business travelers, and price-sensitive leisure travelers. To cater to both groups, Southwest developed a two-tiered pricing structure. In 1972, Southwest was charging $20 to fly between Houston, Dallas, and San Antonio, undercutting the $28 fares of the other carri ers. After an experiment with $10 fares, Southwest decided to sell seats on weekdays until 7:00 p.m. for $26 and after 7:00 p.m. and on weekends for $13.1 In response, in January 1973, Braniff Airlines began charging $13 for its Dallas-Houston Hobby flights. This resulted in one of Southwest's most famous ads, which had the caption "Nobody's going to shoot Southwest out of the sky for a lousy $13." Southwest offered trav elers the opportunity to pay $13 or $26 and receive a free bottle of liquor. More than 75% of the passengers chose the $26 fare, and Southwest became the largest distributor of Chivas Regal scotch whiskey in Texas. In 1975, Braniff abandoned the Dallas-Houston Hobby route. When Southwest entered the Cleveland market, the unrestricted one-way fare between Cleveland and Chicago was $310 on other carriers; Southwest's fare was $59.8 One of Southwest's problems was convincing passengers that its low fares were not just introductory promotions but regular fares. SOUTHWEST OPERATIONS Although Southwest grew to one of the largest airlines in the United States, the firm did not deviate from its initial focus: primarily short-haul (less than 500 miles), point-to-point flights, a fleet consisting only of Boeing 737s, high frequency flights, low fares, and no interna tional flights. In 2001, the average Southwest one-way fare was $84. The average Southwest aircraft trip length was 531 miles with an average duration of about one hour and 35 minutes. This was up from 462 in 1999 and 394 in 1996. Southwest had about 2,800 flights per day serving 58 cities. Each plane flew about eight flights daily, almost twice the industry average. Planes were used an average of 12 hours a day, compared with the industry's 8.6 hour-per-day average. Southwest's cost per available seat mile was the lowest in the industry (Exhibit 4) and the average age of its fleet was eight years, the lowest for

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the major carriers. Southwest also had the best safety record in the airline business. Southwest was the only large airline to operate without major hubs, although cities such as Phoenix, Houston, and Dallas were increasingly becoming important transit points for Southwest trips. For exam ple, daily departures from Phoenix, Southwest's busiest airport, increased to 184 in 2002. Point-to-point service provided maximum convenience for passengers who wanted to fly between two cities, but insufficient demand could make such nonstop flights economically unfeasible. For that reason, the hub-and-spoke approach was generally assumed to generate cost sav ings for airlines through operational efficiencies. How ever, Southwest saw it another way: hub-and-spoke arrangements resulted in planes spending more time on the ground waiting for customers to arrive from con necting points. Turnaround time-the time it takes to unload a waiting plane and load it for the next flight-was about 15 minutes for Southwest, compared with the industry average of 45 minutes. This time savings was accom plished with a gate crew 50% smaller than other air lines. Pilots sometimes helped unload bags when sched ules were tight. Flight attendants regularly assisted in the cleanup of airplanes between flights. Relative to the other major airlines, Southwest had a "no frills" approach to services: reserved seating was not offered and meals were not served. Customers were handed numbered or color-coded boarding passes based upon their check-in order. Seating was first come, first served. As a cost-saving measure, the color-coded passes were reusable. As to why the airline did not have assigned seating, Kelleher explained: "It used to be we only had about four people on the whole plane, so the idea of assigned seats just made people laugh. Now the reason is you can turn the airplanes quicker at the gate. And if you can turn an airplane quicker, you can have it fly more routes each day. That generates more rev enue, so you can offer lower fares."? Unlike some of the major carriers, Southwest rarely offered delayed customers a hotel room or long distance telephone calls. Southwest did not use a com puterized reservation system, preferring to have travel agents and customers book flights through its reserva tion center or vending machines in airports. Southwest was the first national carrier to sell seats from an Inter net site. In 2001, 46% of Southwest tickets were booked online. The company estimated that the online ticketing cost was $1 per booking and $6-8 with a travel agent. Southwest was also one of the first airlines to use tick etless travel, first offering the service on January 31, 1995. Southwest was the only airline with a frequent

flyer program based on the number of flights taken by a passenger, not miles flown. Over the years, Southwest's choice of markets resulted in significant growth in air travel at those loca tions. In Texas, traffic between the Rio Grande Valley (Harlingen) and the Golden Triangle grew from 123,000 to 325,000 within 11 months of Southwest entering the market. to Within a year of Southwest's arrival, the Oakland-Burbank route became the 25th largest pas senger market, up from 179th. The Chicago-Louisville market tripled in size 30 days after Southwest began fly ing that route. Southwest was the dominant carrier in a number of cities, ranking first in market share in more than 50% of the largest US city-pair markets. Exhibit 5 shows a comparison of Southwest in 1971 and 2002.
SOUTHWEST'S PERFORMANCE

Southwest bucked the airline industry trend by earning a profit in 29 consecutive years (see Exhibit 6 for South west financial performance). Southwest was the only major US airline in 1990, 1991, and 1992 to make both net and operating profits. Even taking into account the losses in its first two years of operations, the company averaged more than 12% annual return on investment. As of February 2002, Southwest's lO-year average return to shareholders was 23.6%. Southwest has ranked number one in fewest customer complaints for the last 11 consecutive years as published in the Depart ment of Transportation's Air Travel Consumer Report.

Southwest ranked second among companies across all industry groups, and first in the airline industry, in For tune magazine's 2002 America's Most Admired Compa nies list. Southwest accomplished its enviable record by challenging accepted norms and setting competitive thresholds for the other airlines to emulate. The com pany had established numerous new industry standards. Southwest flew more passengers per employee than any other major airline, while at the same time having the fewest number of employees per aircraft. Southwest maintained a debt-to-equity ratio much lower than the industry average and was one of the few airlines in the world with an investment grade credit rating. Southwest had a fleet of 355 737s in 2002, up from 106 in 1990 and 75 in 1987. Of the total fleet, 256 air craft were owned and the remainder leased. At the end of 2001, Southwest was committed to 132 orders for the 737-700 aircraft.

HERB

KELLEH ER

Herb Kelleher was CEO of Southwest from 1981 to 2001. In 2001, at age 71, Kelleher stepped down as CEO but remained Chairman. Kelleher's leadership style combined flamboyance, fun, and a fresh, unique per spective. Kelleher played Big Daddy-O in one of the company videos, appeared as Elvis Presley in in-flight magazine advertisements, and earned the nickname the

1971
Size of fleet Number of employees Number of passengers carried Number of cities served Number of trips flown Total operating revenues Net income (losses) Stockholders' equity 108,554 3 6,051 2,133,000 (3,753,000) 3,318,000 4 195

1999
306 29,005 52.6 million 55 602,578* 4,164,000,000* 433,400,000*

April. 2002
355 64.6 million 58 940,426** 5,555,174,000** 511,147,000**

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*199S Figures **2001 Figures Sources:Nuts: Southwest Airlines' CrazyRecipefor Businessand PersonalSuccess,K. Freibergand J. Freiberg,1996, Austin,TX, Bard Press,p. 326; Haovers Online; Bureau of Transportation statistics at www.bts.gov/programs/oaiS; outhwest Airlines Fact Sheet at www.southwest.com/about_swalpresS/factsheet.htm l.; 2001 Annual Report.

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