Study Questions for Southwest Airlines
1. What are Southwest's key competitive advantages? How would you quantify them?
2. How sustainable are Southwest's advantages? Where are they most and least vulnerable to imitation or leapfrogging by competitors?
3. What strategic recommendations would you make to Southwest? How should they respond to new competitors?

Southwest Airlines

As 1998 neared a close, Southwest Airlines was ready to celebrate yet another successful year. The Company had passed more than 25 years of consecutive profitability. This achievement was even more remarkable given the turbulent cycles which had caused every other major airline to have multiple years of steep losses during that same period. Southwest Airlines was heralded for more than its financial performance, though. For the seventh straight year in 1997, the Company had the best customer satisfaction record among all major airlines according to Department of Transportation records. The Company had been acknowledged for its employee relations as well. Fortune magazine recognized Southwest as the best company to work for in the United States. The impact of Southwest Airlines on the airline industry as a whole was undeniable. Both major established and new startup carriers sought to emulate Southwest’s practices from aircraft operations to employee relations to its low-cost fares. Despite its impressive accomplishments, Southwest faced challenges in maintaining its outstanding performance. Both major airlines such as USAir, Delta, and United and new startups were targeting the short-haul market where Southwest excelled.

Another potential problem facing Southwest involved a change in U.S. tax law. A change in the tax structure of air travel taxes was expected to have a disproportionate impact on short-haul carriers. The Taxpayer Relief Act of 1997 altered the 10 percent federal excise tax on domestic tickets. The new structure decreased the tax rate to 8 percent in 1998 and then 7.5% in 1999. However, the new structure also included a segment tax of $2 per flight segment that was scheduled to gradually increase to $3 per segment by 2002. A Lehman Brother’s estimate anticipated a 33 percent rise in Southwest’s tax burden in 1998. Southwest responded to the new tax rates by increasing its fares $1 to $2 to cover the segment tax.

Several questions faced Southwest Airlines: Could it continue to sustain its low-cost advantage as existing airlines created what amounted to new airlines and new entrants entered the industry with much lower labor costs? How should it respond to these new competitors? And, what opportunities among the many available to the airline, should it pursue?

The U.S. Airline Industry

The U.S. Airline industry was appoximately an $80 billion industry in 1997 (see Exhibit 1). Approximately 75 percent of airline revenue was derived from domestic passengers with less than 25 percent coming from international travel. After four years of record losses in the early 1990s, the industry had enjoyed profitability from 1994-97 culminating with more than $6 billion in 1997 operating income. Most saw excellent prospects for the industry with FAA forecasts anticipating a 4.8 percent over the next few years (see Exhibit 2.

Regulation

Federal law required the following to be certified by the FAA: all commercialized aircraft; equipment used for planes flown in the U.S.; maintenance shops intended for carrier use; and personnel who work on, fly, or manage planes. Airlines were classified on three scales: the type of service they offered, annual revenues, and the type of aircraft they employed. Major airlines included only those airlines earning revenues of $1 billion, or more, annually in scheduled service. They generally provide national, and in some cases, worldwide service. Ten major airlines in 1998 offered passenger service including: Alaska, America West, American, Continental, Delta, Northwest, Southwest, TWA, United, and US Airways. Major airlines were required to maintain a fitness certification establishing that the carrier had the financing and management in place to provide scheduled service with large aircraft (61 or more seats and a payload of 18,000 pounds). Major airlines were also required to qualify for an operating certificate issued by the FAA which spells out requirements regarding training, and aircraft maintenance programs.

The second class of carriers, national airline earned annual revenues between $100 million and $1 billion. Most served designated regions of the country. A few provided long-haul and international service. Like the major airlines, they operated medium and large sized jets. Listed as national carriers were Aloha, American Trans Air, Emery, Evergreen, Hawaiian, Midwest Express, and Polar airlines.

Regional served a single region of the country and their smaller communities. Since deregulation, regionals had been the fastest growing and most profitable segment in the industry. Regional carriers were subdivided into large, medium, and small. Revenues for large carriers were between $20 and $100 million. Most regional aircraft seated more than 60 passengers, held a fitness certificate, and complied with FAA operating requirements. Medium carriers were simply on a smaller revenue scale of less than $20 million. Small were often called commuters. Revenues were not specified, and aircraft were less than 30 seats. They were exempt from FAA operating requirements, and operated under different FAA regulations.

For much of its history the airline industry had been among the most regulated of all industries. Prior to the 1978 deregulation of the industry, the Civil Aeronautics Board (CAB) resembled a public utility mandating the routes each airline would fly and determining what prices they would charge. The airline industry continued to be regulated after 1978 with regard to safety, labor, operating procedures, aircraft standards, emission levels and noise standards. Though limited in scope, deregulation profoundly changed the U.S. airline industry. Carriers were allowed to set their own prices and were granted much greater freedom in determining what routes they would fly. Deregulation also opened the door to new entrants. The time from deregulation until 1994 was plagued with cyclical downturns. Large losses, mergers, and several airline bankruptcies resulted in increased concentration. The period from 1994 to 1998 had been one of relative stability and profitability for the major airlines.

Hub and Spoke Systems

Along with deregulation came the increased development of a hub and spoke network which existed on only a limited basis before 1978. Hubs are strategically located airports used as transfer points for passengers traveling from one region to another region surrounding the hub. All major airlines except for Southwest Airlines operated hub and spoke systems (see Exhibit 5). The hub and spoke system was designed to enable airlines to service more markets with the same sized fleet. Hub and spoke systems allowed airlines to service more cities with fewer planes. A hub with six spoke cities, for example, could be served by six planes flying round trips to the hub city. The same seven cities would require 21 planes if only direct, point-to-point routes were used. While efficient in the number of planes required to service a set of cities, hub and spoke systems required two-stage flights for trips where a hub was neither the origin or destination.

Hubs also required higher fixed costs in a number of areas. Airlines scheduled a number of flights arriving within minutes of each other so that once grounded, passengers on those flights could transfer to aircraft that would transport them to their desired destinations. To work effectively, hubs required a large number of ground personnel to transfer baggage, assist passengers, and complete other tasks required before take-off. Unit costs were driven upward by the additional ground personnel required to service a hub’s peak periods. Another problem was that workers were often idle between the banks of incoming flights. Bad weather at a hub presented yet another obstacle. Delays at one hub had the potential to disrupt an airline’s entire domestic route system. Such disruptions often resulted in numerous delays and re-routed planes.

In opposition to the hub and spoke network, the point-to-point system transferred passengers from point A to B. The point-to-point system resulted in faster turnaround times. Turnaround times of 20 minutes were not uncommon for point-to-point systems, as opposed to averages of 45-60 minutes for hubs.

The airline industry had a history of intense periods of price competition. So intense were the fare wars of 1990-93 that the industry lost $12.7 billion, more than it had made in all the time since Orville and Wilbur Wright. Yields, which were the passenger revenue divided by revenue passenger miles (RPM) were just over 13 cents per mile in 1997, slightly down from 13.2 cents in 1996. Some analysts observed greater price stability in 1996-97. Start-up discount airlines such as ValuJet and Kiwi had, because of losses, scaled back growth and avoided fare wars where possible. Fares stabilized considerably after 1993.

Industry Capacity and Entry

Capacity was an important factor in industry performance. Industry analysts measured capacity in available seat miles (ASMs) and utilization of capacity by an indicator labeled load factor. ASMs equaled the number of aricraft miles flown multiplied by the number of seats available for passenger use. Load factor equaled the proportion of aircraft seating capacity that was actually sold. ASMs had grown by only 3.5% in 1997 and 3.4% in 1996. At the same time demand, measured by revenue passenger miles, increased by 5.5% in 1997 and 7% in 1996. Other factors that deterred price competition were frequent flier programs and the consolidation of hub positions for some airlines. The result was that travelers were less likely to shop for the best fares between different airlines than to simply find the best fare on their preferred carrier.

Several airlines such as Reno, Kiwi, ValuJet, and Western Pacific had entered the airline industry in the 1990s. Major airlines such as United, Delta, and Continental had all initiated new "airlines within an airline." Most of the new entrants sought to mimic the low cost approach that Southwest had used so successfully. Aircraft were readily available. Though, for example, a state-of-the-art Boeing 737-700 cost approximately $40 to 45 million, used aircraft were available either for lease or purchase for only a fraction of the price of a new plane. New airlines faced significant obstacles, however. Typically start-up airlines were at a disadvantage in competing with the major airlines because they could not afford nor obtain gate space at major airports during the peak times. Peak times were essential to attracting the lucrative business travel market. The importance of peak gate times was illustrated by a 1997 United Airlines’ survey showing that just 9% of their business class passengers contributed to 44% of their revenue. Start-up airlines were thus relegated to using gates controlled by major airlines at off-peak times or to finding space in satelite airports.

Air Travelers

Air travelers were typically segmented into two groups: business and leisure travelers. Business travelers, who accounted for approximately 40 percent enplanements, were historically less price sensitive than leisure travelers. They often traveled on much shorter notice than leisure travelers. Thus, they did not qualify for the discounted rates offered by many airlines for advance ticket purchases. Since the cost of travel for most business travelers was assumed by their employers, they often were indifferent to price differences. Many business travelers were also members of frequent flyer programs. These programs allowed travelers to earn credit for each mile flown. Accumulated credits could be redeemed for free travel. The effect of such programs was to induce frequent travelers to be less price sensitive and prefer one airline over others even in the face of small to moderate fare differences. Price sensitivity among business travelers, however, was increasing. Many companies were encouraging employees to reduce air fares by flying coach rather than first class fares and by encouraging them to stretch trips over Saturday’s to qualify for the steep discounts offered by most airlines for travelers staying over a Saturday. Advances in information technology presented an alternative to air travel for business people. Many companies had acquired video conferencing capabilities to reduce the need for travel for their employees. E-mail, telephone conferencing, and faxes all allowed for instant communication. While it was clear that information technology provided a substitute for air travel, no reliable estimate of the impact of these technologies on air travel had been completed.

Unlike business travelers, leisure travelers were highly price sensitive. Most planned their travel well in advance and shopped for the best fare prices. In many instances, leisure air travel was contingent on finding suitable low fares. Otherwise, potential air passengers either traveled by other means or skipped a particular trip altogether. Ground transportation was the most significant alternative for air travel. For short-haul flights, cars were the most viable substitutes. In some parts of the U.S., trains were a viable substitute for air travel. Because leisure travel was usually discretionary, it was sensitive to changes in disposable income. Not surprisingly, the strong economic years of the mid 1990s had been coupled with strong demand for leisure air travel. To attract the price-sensitive leisure traveler, airlines advertised deeply discounted fares. However, most passengers were unable to take advantage of the most steeply discounted fares. By law, carriers did not have to offer more than 10% of the seats on a flight at a discount rate. Fares were complex. On any given flight, passengers were likely to have booked the same flight under as many as a dozen different fares depending on when, and how close to departure time their flight was booked. American Airlines attempted to simplify fare structures in 1992 with a simplified, four-tiered pricing system. When other carriers did not follow American in adopting the simplified fare structure, American abandoned it.

Labor

Labor costs pressures were one of the primary concerns of most airlines. Labor accounted for 31% of total industry costs but were substantially higher for the major airlines. All of the major airlines had unionized workforces. Pilots, flight attendants, and mechanics were all represented by different unions. The recent profitability of the major carriers had created more militancy on the part of unions to raise wages. American Airlines pilots waged a brief strike in 1997 and Northwest pilots had done the same in September, 1998. Recent collective bargaining agreements had also brought larger pay increases than had occurred in the industry for several years. American pilots gained a 9 percent increase over five years, United pilots and mechanics agreed to a 10 percent raise over two years, and United flight attendants obtained a 36 percent raise over 10 years. The recent aggressiveness of unions was expected to continue because of the industry’s profitability and due to increases in productivity. Two key measures of labor productivity, ASMs per worker and revenue per worker, had increased at compound annual rates of 3.7 and 6.3 percent respectively between 1991 and 1996.

Southwest Airlines History

In 1971, businessman Rollin King and attorney Herb Kelleher had a vision to start a different kind of airline. Under the direction of President Lamar Muse, Southwest Airlines, with 4 planes and 195 hot-pant and knee-high booted employees, took its first flights with service between Dallas, Houston, and San Antonio. The first year was not a profitable one. With 6,051 flights and 108,554 passengers; they had a net loss of $3,318,000. Southwest managed to turn a profit in only its second year.

Herb Kelleher, who in 1982 took over as President, Chief Executive Officer, and Chairman of the Board, of Southwest Airlines has been hailed as one of the nation’s most effective and charismatic CEOs. He had an open door policy with all levels of employees, and had been known to load baggage on holidays. The chain-smoking Kelleher was also regarded as highly unconventional. He once settled a difference over advertising with a competitor with an arm-wrestling match.

Southwest Airline’s Strategy

Southwest Airlines took considerable pride in being the low fare airline. The Company’s annual report empasized the benefits of Southwest’s low cost achievments.

The People of Southwest are Freedom Fighters, ensuring affordable fares are available to as many people as possible. As business people, our Employees understand how low fares are critical in our shorthaul market niche. Since we are primarily a shorthaul carrier, low fares are essential. With an average aircraft trip length of 425 miles, ground transportation has always been our most significant competitor. Therefore, we must charge low fares, every seat, every flight, every day, regardless of what our airline competitors charge.

Our pledge to our Customers has worked. We have developed a reputation as the low fare policeman in the industry, THE Low Fare Airline. Customers think of us when they think of low fares and depend on us to keep fares low. We are committed to continue that tradition.

The results are remarkable. Through Southwest service, communities achieve economic freedom when it comes to airfares. The number of travelers expands by three- and four-fold after Southwest enters a market and slashes fares. This is especially true in shorthaul markets where ground transportation is a viable option. In many cases, people just weren’t traveling at all. That changes once Southwest enters the market.

Southwest focused on short-haul travelers where average flight time was about an hour. It sought to achieve low costs through streamlining services in areas such as ticketing, seating, and serving food to keep costs low. Rather than use a hub and spoke system, Southwest was the only major airline to rely on a point-to-point route structure. At the end of 1997, Southwest serviced 52 cities (see Exhibit *). From among those those 52 cities, Southwest chose city-pairs that had the potential to generate substantial traffic for both business and leisure travelers. Southwest enjoyed, on average, a 60 to 65 percent market share in the city-pairs it served and ranked first in market share in 80 to 85 percent of those city pairs. Southwest also reported that it ranked first or second in customers boarded at a majority of the airports it served. The benefits of having Southwest serve a city were widely recognized. The airline received over 100 requests from cities requesting service from Southwest in 1997 alone. Southwest’s plans for expansion for 1998, however, included only two cities. To some extent, expansion plans were limited to a 6 to 7 percent increase in capacity for 1998 due to Boeing’s production delays and a tight aircraft market.

Southwest Airlines’ Operations

In 1998, Southwest had the lowest operating costs of all the major airlines, but its advantage had narrowed at least slightly in the 1990s. Five years earlier, Southwest had enjoyed a 1.9 cent cost per ASM advantage over American, 2.41, 2.57, 3.8 cents edge over Delta, United, and USAir respectively. Only America West and Continental, who had entered into Chapter 11 proceedings and sharply reduced labor costs through tough renegotiated labor agreements, were within 1.5 cents cost per mile of Southwest. Delta, Alaska, and Northwest had all drawn within 1.5 cents per mile of Southwest in costs by 1997 while America West actually had operating costs per ASM slightly below Southwest.

Labor

The largest cost of operating an airline was labor. Labor accounted for 31 percent of Southwest’s operating expenses in 1997 or 2.26 cents per mile. This was considerably lower than major competitors such as Delta (39%) and United (48%). Like the other major airlines, Southwest workforce was mostly unionized. Approximately 84 percent of Southwest’s employees belonged to a union. Unlike many of their competitors, though, Southwest had enjoyed exceptionally good labor relations. One example of the exceptional cooperation between management and labor was the innovative agreement that Southwest reached with its pilots. In 1995, the pilots, who were represented by Southwest Airlines Pilots' Association, reached a l0-year agreement that linked pilots' financial rewards to the economic success of the company. It allowed the union to cancel the pact after the first five years. In lieu of traditional wage increases during the first five years, pilots were to receive bonus payments based upon the carrier's profitability (years of payment were 1995,'97 and '99), and 1.4 million shares in annual stock options. The association contract included no pay raises, substituting 1995, '97, and '99 bonuses based on company profits. If the contract were retained beyond the first five years, pilots would receive annual wage increases of 3%, and additional compensation based upon Southwest's profitability. The company had never been the target of a strike. In late 1997, Southwest agreed to a new contract with its flight attendants who were represented by the Transport Workers Union of America. While other negotiations were on the horizon, such as those with the customer service workers reservation sales agents, none were expected to be highly contentious.

All of Southwest’s 25,175 employees were granted the option to puchase Southwest stock. Depending upon the grant, these options required terms of ten years of continued employment from the date of the grant, or ten years from the date exercisable. Options became vested, and fully exercisable at the end of three, five, or ten years.

Fuel Costs

After labor, fuel costs were the second largest cost component for airlines. Fuel and oil expenses were 15% of operating expenses in 1997 compared to 12% for Delta. Southwest, along with other airlines, benefited from a dramatic frop in fuel prices over the 1997-98 period. Average fuel cost per gallon for Southwest was $.6246.

Ticketing

Ticketing was another area where Southwest was able to realize cost savings. Southwest was the first of the major carriers to offer electronic ticketing (e-tickets). Electronic ticketing costs $1 per ticket compared to estimated $8 for paper tickets. Much of that difference was in labor costs. Besides labor costs, E-tickets also helped Southwest economize on commissions to travel agents. Passenger traffic commissions accounted for only 5 percent of Southwest’s operating expenses compared to 8 percent for Delta and United Airlines. By 1998, other major airlines had introduced electronic ticketing. Southwest, however, with over 60 percent of its passengers flying on e-tickets, still issued a far greater proportion of tickets electronically than other major airlines such as Delta who had reached 24 percent by mid 1998.

Aircraft

In contrast to its competitors, Southwest used only Boeing 737s in its flights (see Exhibit *). Using only 737s lowered maintenance, training, and inventory costs. Boeing was the launch customer for the Boeing 737-700, receiving its first in December, 1997. The –700 was considered more fuel efficient, less maintenance intensive, and had a lower capital outlay than the 737-300. Southwest was scheduled to receive 22 –700s in 1998. Eight older 737-200s were scheduled for retirement in 1998. While Southwest was dependent on Boeing for the delivery of new 737s, the company was prepared to purchase existing 737s from other sources if they were available at reasonable prices.

Aircraft Operations

Southwest planes spent more time in the air than their competitors. The average turnaround time necessary to unload passengers and baggage from one flight and load the passengers and baggage for the next was only 20 minutes compared to an industry average of 45 minutes. This allowed Southwest to operate with 35 fewer aircraft than if its turnaround time had been at the industry average. It also allowed them to use significantly fewer gates for the same amount of traffic. The short turnaround times combined with the short-haul flights allowed Southwest planes to make more flights than its competitors. The average Southwest plane made 3079 departures in 1996 compared to 2086 for its next highest competitor, America West. The planes used by Delta (1,723), United (1,392), and American (1,226) flew far fewer flights.

Another aspect of flight operations was Southwest’s policy of no food service during flights. Instead, the airline served only drinks and snacks. One estimate suggested that this saved Southwest $3.73 per passenger in food costs in addition to any fixed costs associated with food services.

Maintenance costs (Outsourced engine maintenance to G.E. Engine Services – 10 year contract. Southwest paid G.E. a rate per flight hour for G.E. to perform virtually all engine maintenance.)

Airports

Southwest choice of airports differed from other major airlines. In some large cities, Southwest operated mostly out of smaller secondary or satellite airports such as Dallas Love Field, Houston Hobby, Chicago Midway, Oakland, Burbank, Ft. Lauderdale, Providence, and Baltimore). Focusing on satellite airports reduced costs because gates were less expensive. It also also helped on-time performance because these airports were typically less congested than hub airports. Even where Southwest did operate out of hub airports, it did not seek premium gate locations. For example, in Delta’s hub in Salt Lake City, Southwest occupied the most remote and difficult to get to gates at a cost of $57.00 per sq. ft compared to the $68.50 per sq. ft costs that Delta incurred. In 1997, Soutwest operated out of 52 airports; flew 2300 flights per day; which accounted for 44 departures per airport.

Pricing

Southwest was regarded as the industry leader in pricing. One indication of Southwest’s low prices was that when they entered a new market, airline ticket prices sometimes fall by as much as 50% to 70%. These fare reductions also led to dramatic increases in passenger traffic. It was not unusual for traffic on a city-pair route to increase by more than 100% once Southwest entered a market. Southwest's advertising exploits their pricing strategy. Their ads focus on them being the low-fare leader, as well as the "fun airline. Southwest’s lower operating costs allowed them to maintain a profit with lower load factors than its larger competitors. For example, Southwest’s 61.2% load factor in the second quarter of 1998 was 8.6% above its break even level of 52.6% while Delta’s higher load factor of 68.7% was only 6.5% above break even. Delta, American, Northwest, United, Continental, USAir, America West, and Alaska all had breakeven loads between 62% and 68%.

Southwest had enjoyed the benefits resulting from higher fares across the industry. Several regional airlines had increased fares. The Wall Street Journal reported that even smaller regional carriers who competed on the basis of no-frills and low fares had increased their prices. When discount airlines raised prices, major airlines often responded with fare increases based on the belief that there should be an appropriate spread between frills and no-frills service. Although Southwest has raised their prices, they had been significantly below the average price hike for no-frill airlines.

Customer Service

Despite its achievements as a low cost airline, Southwest had also accumulated an impressive record of customer service. Five consecutive years, from 1992 to 1996, Southwest earned the "Triple Crown" for best baggage handling, fewest customer complaints, and best on time performance of all major airlines according to Department of Transportation statistics. Some industry critics pointed out, however, that these statistical achievements were at least partly due to Southwest’s short-haul strategy and location in mostly warm weather markets. Short-haul flights had fewer bags handled per passenger mile. Warm weather destinations reduced the number of flight delays due to poor weather. And, , according to this argument, complaints went down because of fewer baggage problems and flight delays. Other studies, however, including a Money magazine survey had rated Southwest as best among all major airlines on service.

Human Resources and Culture

Southwest’s human resource practices were highly regarded. The Company was recognized by Fortune magazine as the best place to work in the United States. Every new employee — from pilot to customer service rep to mechanic to sales person — received training in the firm’s "You, Southwest, and Success" (YSS) program. The YSS program was a day-long class designed to teach new employees about Southwest’s commitment to and reputation for customer service.

The culture of Southwest was another area that set it apart from other airlines and was viewd as a model to emulate by firms in many industries. The Company adopted LUV as its stock exchanges symbol to represent not only its home at Dallas Love Field but also its theme of customer and employee relationships. The airline’s annual report declared that Southwest had a culture, "that values efficiency, hard work, innovation, and simplicity. Our people have the will and the desire to to produce low costs. That’s how the low cost producer keeps finding ways to reduce costs further." This cultural commitment to low costs was credited not only with various process innovations but also day-to-day advantages in aspects such as fast turnaround of planes. Southwest established a culture committee in the early 1990s. The committee’s mission was to regularly visits all sectors of the company promoting the original history and spirit of the airline. Herb Kelleher believed that linking human spirit and personal performance to training and corporate vision was the key to success in highly competitive industries. The corporate philosophy was "Bring your personality and your sense of humor to work."

Fun was another term often associated with Southwest’s culture. Southwest flight attendants were well known for their friendly informality. It was not uncommon for Southwest employees to inject humor into even the most mundane activities: the pre-flight safety announcement. One flight attendant gave the following rendition of the safety instructions on a Dallas to San Diego flight:

If I could have your attention for a few moments, we sure would love to point out those safety features. If you haven’t been in an automobile since 1965, the proper way to fastensyour seat belt is to slide the flat end into the buckle. To unfasten, lift up on the buckle and it will release. …

FAA regulations require passenger compliance with all lighted passenger information signs, posted placards, and crew member instructions regarding seat belts and no smoking. In other words do exactly what we say!

Speaking of smoking, there’s never any smoking aboard our flights. You know what happens if we catch you smoking here at Southwest, don’t you? You’ll be asked to step out onto our wing and enjoy our feature movie presentation, Gone with the Wind. There is never any smoking, even in the lavatories.

Finally, although we never anticipate a change in cabin pressure, should one occur, four oxygen masks will magically appear overhead. Immediately stop screaming, please deposit a quarter, and unlike President Clinton, you must inhale! If you’re seated next to a child or traveling with someone who is acting like a small child, secure yourself first and then assist him or her. Please continue wearing the mask until otherwise notified by a uniformed crew member—yes, believe it or not, these are uniforms! And, we do need to tell you that the bag does not inflate, but you still are receiving oxygen. Sit back, relax and enjoy a one-hour flight to San Diego on the best airline in the universe— Southwest. Southwest Airlines is determined to offer Positively Outrageous Service to customers.

 

New Low-Cost Competitors

Some viewed the greatest potential threat to Southwest Airlines as new low-cost entrants to the industry. Some of these start-ups were initiated by major airlines such as Delta Express, U.S.Airway’s Metro Jet and Shuttle by United. These units sought to replicate Southwest’s short-haul routes, low cost practices, and fares. Other entrants — such as Reno, Kiwi, Western Pacific, and ValuJet — were completely new airlines. As with the major airlines’ low-cost start-ups, these new entrants sought to replicate the Southwest model of a low-cost airline by adopting a philosophy of cheap fares and no frills. The new startups typically enjoyed the advantage of less unionized workforces. This gave them a potential advantage over Southwest on labor costs.

The ValuJet crash in 1996 affected the prospects of possible airline start-ups. Smaller airlines experienced a sharp reduction in passengers following the accident. Over time passengers returned to the newer discount airlines when large fare differences were offered. New government policies also made it more difficult to start a new airline following the ValuJet crash. The FAA increased its scrutiny of start-ups. This scrutiny took the form of more complete reviews of maintenance, safety, and recordkeeping procedures. The new procedures doubled the time needed to acquire FAA approval to operate a new airline. The FAA also placed limits on the number of aircraft new airlines were able to operate. These limits were based on a carrier’s financial and managerial resources.

ValueJet’s traffic did not fully recover when it resumed operations following the crash. The airline operated at only 55% capacity compared to 65% before the accident. Largely because of this lackluster performance, in 1997 ValuJet merged with and adopted the name of AirTran Airways.

Perhaps the greatest threat among the new startups was Metro Jet, a subsidiary of US Airlines. Metro Jet was predominantly in the East and Southeast. Metro Jet’s strategy was simply, "We match Southwest." The entire operational structure of MetroJet was explicitly patterned after Southwest along with fares, schedules, and customer incentives.

Southwest responded to MetroJet by rallying its employees. First, Southwest commenced a "war day" where employees declared war on Metro Jet. Southwest employees decorated their offices with army surplus netting and paraphernalia. All employees were invited to wear army fatigues to work on war day. Since Metro Jet expressed an intention to match any Southwest price, Southwest decided to emphasize customer service in its "war" with MetroJet. Southwest employees were asked to write two or three thank you letters to passengers who chose Southwest over Metro Jet on identical routes. These letters were then passed out at the end of the flight, thanking the passengers for flying with Southwest.

Another effort by a major airline to move into the low-fare, short-haul segment of the industry was undertaken by United Airlines. Begun in 1994, Shuttle by United was an effort by United Airlines to create an airline within an airline. At its inception, Shuttle flew 184 flights per day between eight West Coast city-pairs. While widely viewed as a threat to Southwest, Shuttle’s early head-to-head efforts against Southwest had met with some setbacks. In Southwest strongholds such as Oakland and the San Diego-Sacramento market, Shuttle had not fared well. In response, Shuttle re-focused its operations around its Los Angeles and San Francisco hubs. By late 1996, Shuttle overlapped only about 6-7 percent of Southwest’s capacity, down from 13% earlier. According to estimates, Shuttle’s costs were approximately 50 cents higher per ASM than Southwest’s, but they were also able to command slightly higher fares. More of Shuttle’s passengers were business travelers (approximately 80 percent earned frequent flier miles), which allowed them to sustain slightly higher fares than Southwest. United had indicated that it might expand Shuttle to other areas of the country, but it had not discussed any specific areas or timetable for doing so.

Other regional competitors, such as America West, sought to avoid direct competition with Southwest. Instead of overlapping flights with Southwest flights, America West chose to service routes that were typically longer than Southwest routes but still offered low fares and no-frills, so as not to compete with the other major airlines.

As Southwest continues to expand, competition becomes stronger and stronger. Recently, many airlines have taken Metro Jet’s position of matching fares whenever Southwest expands into their territory. Another aspect of increased competition is the presence of stronger, well-established regional discount airlines.

One startup, Wester Pacific closely modeled its operations after Southwest. Founded by Edward Beauvais, who earlier was a co-founder of America West, Western Pacific was financed with $28 million in addition to $48 million raised in an initial public offering. Based in Colorado Springs, it used only Boeing 737-300s to simplify aircraft operations. Flights included no reserved seats and no meal service. While Western Pacific sought to emulate Southwest, it was intent on avoiding head-to-head competition.

Exhibits

Exhibit 3: FAA Forecasts of Industry Demand (Not Available)

Exhibit 6: Southwest Airlines Performance Summary

SELECTED CONSOLIDATED FINANCIAL DATA ⁽¹⁾

(IN THOUSANDS EXCEPT PER SHARE AMOUNTS)