“South by Southwest”: A Theme of Mistaken Identity; Deception; or the Airline’s New Reality?

Hitchcock’s “North by Northwest” title offered no clue about the movie’s content either. It has even been said that it is an “anomaly and a clue to the absurd, confused plot where no one is who they appear to be.” “South by Southwest” is an anomaly at least from the growth story that has defined its corporate life. But a confused plot – no. It is nothing more than the reality this blogger has been writing and talking about for years. There are simply few profitable route opportunities even for those with very low unit costs. And nobody really wants to acknowledge it.

Three airline earnings calls down. More to go. The general consensus is that the fourth quarter of 2008 would result in deep losses as would the first quarter of 2009 largely due to “hedges gone bad,” as well as the fact that the two quarters define the shoulder season for this industry and the fact that demand in this new world is not fully understood. Jamie Baker, airline analyst with J.P Morgan, went as far as to say to a reporter: "Out of respect for our clients and managements, we do intend to show up for work during earnings season, in the event anything interesting should occur." Baker went on to say, "Our suspicion is that nothing will."

I have agreed with Mr. Baker on many points over the years. But I do not agree that this quarter’s calls are lacking in storylines. Items of interest have emerged from this week’s calls with United, American and Southwest that will prove important as 2009 unfolds. In fact, they may prove to be among the most important stories -- ones that dictate the evolution of the North American marketplace as we know it.

Cost per Available Seat Mile (ex-Fuel)

This year, non-fuel unit costs in a time of decreasing capacity will test management at all airlines. Managing unit costs of any kind, in any network industry, in a shrinking capacity environment challenges the best managers even in the most favorable economic conditions. Between United and American, we heard two very different stories.

United demonstrated excellent non-fuel CASM performance during the quarter, reporting that it will be able to manage 2009 costs at something less than a 3 percent increase. On the other hand, American pointed to sharply higher non-fuel CASM performance as its capacity shrinks further and underperforming pension assets add to the carrier’s numerator. For 2009, its non-fuel CASM is expected to increase more than 7.5 percent.

Yep, it is one thing to talk about managing unit costs at American and United – two carriers that have been forced to rethink many old operating practices as options for cost cutting dwindle. Yet, it is an entirely different thing to think about Southwest sans growth. I’m talking about the “G” word. Growth is the bedrock strategy that arguably has been the single most important component of the company’s ability to build – and maintain – its enviable culture and low unit operating costs. Growth does many things: moves a pilot from the right seat to the left seat; allows a flight attendant to have weekends off; and even masks cost mistakes in the short term.

A Redrawing of the Competitive Landscape?

A Southwest in capacity retreat – albeit only 4 percent worth – is a very different story than the one written between 2002 and 2006 when the carrier grew at the expense of the crippled network carriers. And it is a very different story than the one that sets Southwest apart from the industry’s competitors: its low unit costs, ex labor, ex fuel. Yes, its "hedges gone good" made Southwest nothing more than a "flying trading desk" since 2004, a carrier setting profitability records while on the Airline Growth Hormone (AGH). Now it is time for the airline to be something very different.

I admire Southwest CEO Gary Kelly. I, and others, acknowledge that there is no harder CEO Job in the global industry today because the storybook company must now remake itself just as the network carriers were forced to do. Southwest must undergo surgery as capacity shrinks. And it cannot do cosmetic surgery; it must do invasive surgery.

The Revenue Line

Southwest anticipated that it would have to begin a process of weaning itself off of AGH. Kelly has done what any good CEO would do in fully anticipating that cosmetic surgery was not an option. He and his team focused on the revenue line - and they have delivered good results. Despite Southwest’s dominance in frequency in the markets it serves though, the airline was still pricing itself more than 40 percent less than competitors in common origin-destination markets as early as 2000.

Since that time, Southwest has worked hard to increase fares as its cost advantage was eroded by the restructuring network carriers undertook – a restructuring forced in part by Southwest’s competitive challenge. I predict that Southwest will still be pricing fares well below its competition across its network for years to come. And therein lies the rub.

For a carrier that is so reliant on low unit costs to offset its historic pricing strategy (read: low non-labor unit costs,) a shrinking of capacity only makes the carrier’s job harder. As I have written and lectured, the carrier’s costs will only increase due to structural issues that define the few remaining markets without Southwest or low-cost carrier competition.

Tables Turning?

Much is being written about fares on the decline. While I am not happy to hear this, the economic headwinds and the need to manage revenue in the shoulder season probably drive pricing actions – even with significantly less capacity. So, let’s think about this from a different point of view.

For the past 15 years, Southwest has largely dictated pricing actions in the US domestic market. Yes, up until the late 1990s, the actions were mostly predicated on the carrier’s limited geographic presence. But today it can be said that Southwest is at least virtually present (including highway access) in US markets that comprise 95+ percent of domestic demand.

Southwest absolutely needs to raise fares – or find other revenue. The carrier can now be said to have a cost disadvantage - particularly its labor costs. The other carriers in Southwest markets can cross-subsidize their base fares with ancillary fees -- fees that Southwest has said it will not charge. My guess is that the network carriers are now setting the base fare price and are more than happy to decrease base fares to keep a non-hedged Southwest in detox as it gets treatment for AGH and the fact that it is no longer a flying trading desk.

Just Another Airline?

Of course, Southwest is anything but just another airline. But it is about to have to deal for the first time with issues that other airlines have struggled with for two decades, in many cases contributing to the undoing of their respective cultures. This is particularly true of carriers that had weaned themselves off of AGH in the late 1980’s, even when AMR’s-revered CEO Bob Crandall was preaching “time of day” service was the only answer to tomorrow’s success.

How does Southwest tell its workers that it cannot afford increases in its union contracts? Can it generate enough revenue to close its historic pricing gap? Can it even consider pulling out of markets that are economically challenging given its long track record of staying? Can Southwest be a US domestic player alone? Can it be only a US provider for international revenue sources? Can it actually reduce costs and restructure its operations without layoffs or other changes that threaten the culture it has built?

Concluding Thoughts

I have been on the other side of Southwest issues for years. So with all due respect to Mr. Baker, I think there is a hell of a story to come from the earnings announcements. A shrinking Southwest is a big part of that story– one that has the potential to reset the many arguments that have been used to demonstrate US domestic competition. In fact, it potentially resets many myths surrounding the US’s most luved carrier.

Finally, maybe finally, the story will read that the network carriers are responsible for driving down fares and promoting competition as capacity goes “South by Southwest”. How do you think Jim “Hell No”berstar and the Fear Mongers will feel about that?

Much more to come.