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For 43 consecutive years, Southwest Airlines has made money, making it by far the most consistently profitable U.S. carrier.
But while there’s no indication Southwest’s streak will end, some analysts are expressing frustration, saying the airline could earn more if stopped clinging to strategies that worked best decades ago.
Southwest has grown markedly since the 1970s, morphing from a small, quirky, Texas-centric airline into the nation’s largest domestic carrier. Even in the past 10 years, change has come fast, with the airline focused mostly at the largest U.S. airports, such as New York LaGuardia, Philadelphia, and Los Angeles, rather than at the outlying airports like Manchester, New Hampshire that it once preferred. Southwest is even adding international routes, mostly to Mexico and the Caribbean.
Though its paint job and route structure have changed, Southwest remains at its heart Herb Kelleher’s airline. Now 85, Kelleher was one of Southwest’s founders, and he led the airline in some form from the mid-1960s, before its first flight, until to 2008, when he retired as chairman. Kelleher ensured Southwest would succeed its way — by levying few fees, having no hubs, and prioritizing its customers and employees, along with shareholders.
But times change, and several analysts are aggressively questioning why Southwest has refused to follow its competitors in instituting new revenue-producing schemes. Southwest’s competitors have added fees or raised prices for nearly all extras, from checked baggage to advanced seat assignments to ticket changes. Travelers don’t like the extra charges, but there’s little indication they’re avoiding American, Delta and United, all of which keep reporting major profits.
Southwest is making big money, too. It earned $820 million in net income in the second quarter, with an operating margin of 23.7 percent. But like every other airline, Southwest says business is not as strong as a year or two ago. Analysts hate it when airlines report lower revenues, and they usually recommend carriers take strong actions to respond. But Southwest has made fewer tweaks to satisfy investors than other U.S. airlines.
Several analysts seem to suggest the airline is too enamored with its past success, asking why CEO Gary Kelly, a Kelleher acolyte who joined the company in 1986, has been so protective of the airline’s brand. Many believe Southwest would not lose customers if it more aggressively chased revenue or slashed flights during slow periods to better match capacity with demand.
“The impression that investors have is that your priorities at the moment might be somewhat out of order,” J.P. Morgan analyst Jamie Baker said on Southwest’s July earnings call. “The impression is that passengers come first, then labor unions, and then shareholders. And that’s certainly fine when all is right with the world, and it certainly worked well under Herb. But during a time of industry crisis, and I would suggest that’s what current revenue trends imply, most companies would consider revisiting their sort of priority order, at least in the short run.”
Kelly was not amused, suggesting Southwest would stick with what has worked.
“We care about our people and then in turn we care about our customers,” Kelly said. “It is a virtuous cycle. To think that you can simply ignore that and say, ‘We’re only going to focus on the shareholders,’ doesn’t work. It’s not sustainable.”
Resistance to Fees
Many airlines have copied Southwest to build low-fare, low-cost carriers, including Canada’s WestJet Airlines and JetBlue Airways.
Like Southwest, both started with single aircraft type – the Boeing 737 for WestJet and the Airbus A320 for JetBlue – and each is fiercely protective of its brand and operating model.
More than Southwest, however, both airlines have evolved. Each brought in new aircraft types, and both recently have added a premium cabin — JetBlue, with a lie-flat business class for longer flights, and WestJet with premium economy.
Analysts don’t expect Southwest to add a new aircraft or business class, but they do look to WestJet and JetBlue to prove how a low-cost airline can add fees without harming its brand.
Bag fees are the best example. Both WestJet and JetBlue waited several years before charging for luggage, with executives fearing fees would alienate core customers. Both eventually relented — WestJet in late 2014, and JetBlue last year.
Travelers complained, but they got used to the fees. And quickly, both airlines had a new and lucrative revenue source. JetBlue executives had predicted customers might check fewer bags to avoid the fees, but even that did not happen.
“It has not had a dramatic change, or the change we had expected, as far as customer behavior,” Marty St. George, JetBlue’s executive vice president for commercial and planning, told analysts after the airline added its fees, assessed on the cheapest tickets. WestJet CEO Gregg Saretsky told investors in 2014 his carrier’s rollout had “gone flawlessly.”
Southwest remains a holdout. It argues that, as the largest North American carrier without bag fees, it has a competitive advantage, and it has built an advertising campaign around its fee policy. It believes customers seek out Southwest because it gives them free bags.
“We’re the only carrier that doesn’t nickel and dime with bag fees, change fees, so we offer a tremendous value,” Kelly said last year.
Still, Kelly’s thesis is not easy to prove, and some analysts suspect passengers would not bolt if Southwest mimicked JetBlue and WestJet. At Southwest’s investor day in June, J.P. Morgan’s Baker begged Kelly to test bag fees on some routes to see if customers revolt.
“What would be harm to the brand of doing your own … experiment?” Baker asked.
Not long after that exchange, Baker downgraded Southwest’s stock to neutral. “Like JetBlue under prior management, Southwest continues to resist certain industry efforts aimed at improving revenue,” he wrote in a research note.
To be sure, Southwest’s approach has its defenders, as the company’s brand has considerable goodwill among customers.
“I don’t think there’s anything that pisses people off more than these damn fees,” said Kent Gourdin, director of of the Global Logistics and Transportation Program at the College of Charleston. “I just think that customers don’t understand them and they seem unfair. I think that may be a good strategy for them.”
Southwest eventually may change its fee policy — even Kelly has said the airline might “evolve” on some positions — but Richard D. Gritta, a professor at the University of Portland’s Pamplin School of Business, said the airline will only shift when it is sure it is making the right decision.
“One thing about Kelly is he always expands very cautiously. Some people might say too cautiously,” Gritta said. “But I still wouldn’t sell Southwest short. Kelly knows what he is doing.”
Like most of its competitors, Southwest has said passenger demand has fallen slightly recently, with fewer business travelers buying lucrative last-minute tickets.
When demand lags, airlines typically have two choices. They can lower fares to fill seats, or they can operate fewer flights to better match supply with demand. In recent months, American, United, and Delta generally have implemented both approaches, and analysts have generally approved.
But while Southwest is discounting, it has refused to reduce its flying for late 2016. The airline’s rationale is simple. It says when it sells tickets — and promises customers it will fly a route — it intends to operate the flight. Rather than tweaking its schedule whenever it wants, Southwest generally only makes changes to its schedule a few times per year.
Southwest is now working on its 2017 schedule, and while it may make cuts for next year, it has said it is too late to reduce 2016 flying.
“We’ve not been able to model a scenario where it was profit positive for us to do that,” Kelly said on the July earnings call. “In dealing with these incremental capacity choices, we think that actually would be harmful to Southwest in the near term as opposed to helpful.”
But what’s good for customers and the airline’s operation is not necessarily cheered by investment analysts, many of whom wonder why Southwest doesn’t follow the pack.
“For a company that is facing its first year-over-year margin decline in 13 quarters, we and the market were hoping for a more tangible response, [such as] capacity cuts,” Deutsche Bank’s Michael Linenberg wrote in July.
Meanwhile, Wolfe Research’s Hunter Keay criticized Southwest in July for its lack of “urgency in this area,” saying the airline’s unwillingness to reduce short-term capacity “is strange and out of touch with investor priorities.”
Still, Gourdin, of the College of Charleston, said he gives Southwest some credit for not cater to analyst whims.
“They seem to be doing something right, so maybe we don’t care what the analysts think,” he said. “The bottom line is the bottom line.”