Southwest Airlines facing unprecedented pressure … for Southwest


For more than three decades, Southwest Airlines has been the star of the airline business, with nonstop growth, an unprecedented string of profits and a culture that transcended the industry’s notoriously bitter labor relations.

But as it flies into 2009, the Dallas-based discount carrier is under pressure as never before:

Southwest lost $176 million during the second half of last year, its first two unprofitable quarters in a row.

The airline is retreating for the first time, cutting flights and slowing its flow of new airplanes after years of steady expansion.

A vaunted fuel-hedging program, which gave Southwest a significant advantage over rivals, turned negative when the price of oil plunged, costing Southwest hundreds of millions of dollars.

Renowned for its low costs, Southwest is facing rising expenses as it downsizes.

Investors are clearly worried. Shares of Southwest have fallen by about 40 percent during the past three months, including an 18 percent one-day drop — the largest in the company’s history — the day after it reported its fourth-quarter earnings.

That’s more than double the decline of the Amex airline index, which tracks large airlines’ stocks, during the same period.

“Southwest is in the midst of a transformation right now, and that means some real challenges,” said airline consultant Stuart Klaskin of Klaskin, Kushner & Co.

In a recent report, airline analyst Jamie Baker of JPMorgan called Southwest “competitively neutered.”

Tom Parsons, chief executive of Arlington-based, said Southwest is discounting fares for spring travel more steeply than in past years.

“I haven’t seen sales like this at this time of year since 9-11,” Parsons said. “You know what that means? It means their bookings look really bad.”

But Chief Executive Gary Kelly says it would be a mistake to count the airline out.

“We are very, very well-prepared for some really tough times, and that’s when our low-fare brand and our people have historically really excelled,” Kelly said in a recent conference call with analysts and reporters.

With plans to begin a North American low-fare alliance with two other airlines, an intense focus on business travelers and strategic moves such as new service at LaGuardia Airport in New York, some industry observers say Southwest is the airline to watch in 2009.

“I really think Southwest is going to be the big story this year,” Klaskin said.

‘Coming to kill us’

For much of the past decade, Southwest was considered the most formidable competitor in the industry, and its entry into new markets terrified entrenched rivals.

In 2004, when the airline announced an expansion into Philadelphia, the chief executive of US Airways, which operated a hub there, warned employees in usually blunt terms.

“Southwest is coming to Philadelphia in May,” David Siegel said in an Internet broadcast. “They’re coming for one reason. They’re coming to kill us.”

One of the most powerful weapons in Southwest’s arsenal was its fuel hedges — contracts that allow the airline to buy most of its fuel at prices set in advance.

During the second quarter of last year, for example, Southwest paid, on average, $2.19 per gallon while Fort Worth-based American Airlines paid $3.17 per gallon.

Few competing airlines had hedging programs as strong as Southwest’s, and thus the airline had a distinct advantage that let it keep its fares lower than its rivals’.

When competitors matched Southwest fares — which they often did to hold onto market share — they would lose money on their flights while Southwest remained profitable.

That advantage was erased in the fall when oil prices plunged as the global economy weakened. Southwest found itself buying fuel at higher than market prices, and the value of its portfolio of hedge contracts plunged.

The oil-price decline also wreaked havoc with the airline’s finances, requiring it to post collateral to cover future losses and write down the value of its hedges.

The airline quickly announced a plan to unwind its fuel hedges this year so they cover just 10 percent of fuel purchases. While that will let Southwest pay less for fuel, it will also increase its vulnerability to swings in oil prices.

Most importantly, it means that Southwest won’t have an edge over most of its competitors on the price of jet fuel.

But executives said the airline hasn’t given up its hedging program and is ready to start locking in prices if oil rebounds.

“We have not changed our fundamental philosophy,” Chief Financial Officer Laura Wright said.

Expansion grounded

Another casualty of the grim economic environment has been Southwest’s steady growth, once a driving force in its success.

During the past 10 years, the number of seats available on every mile of Southwest’s network more than doubled. And the number of paying passengers on the airline soared from about 53 million in 1998 to 89 million last year, when Southwest carried more passengers than any other U.S. airline.

But growth flattened during the fourth quarter of last year, and Kelly said Southwest will shrink by more than 4 percent in 2009. Any growth plans are suspended indefinitely.

As it shrinks, it faces more pressure to cut costs or risk declines in its operating margins.

Analyst Baker said that he “would not be surprised” to see Southwest’s costs rise by as much as 8 percent this year, not including fuel, “and even that may prove optimistic.”

The airline’s costs related to airports, aircraft maintenance and labor are also rising. And new contracts that award raises to mechanics and pilots could add to the pressure over the next few years.

Kelly said he has no plans to lay off employees. But he wouldn’t rule out using voluntary buyouts or early retirements to reduce Southwest’s work force if necessary.

Road to recovery?

Despite the difficulties with fuel and other costs, Southwest has made significant progress in bringing in money. During the fourth quarter, operating revenues were up nearly 10 percent despite the economic downturn.

And Kelly is adding several tools that he hopes will keep his airline at high altitudes despite the new challenges:

Luring business fliers: The airline launched business-select fares, which enable early boarding and include a free drink and other perks for a higher price. The new fares brought in $75 million in extra revenue last year.

International service: Southwest is teaming up with Canadian airline WestJet and Mexican carrier Volaris to create the first international low-fare airline alliance. The deal will allow Southwest to book passengers to cities in Canada and Mexico by transferring them onto partner airlines.

Strategic schedule: While it pares flights, Southwest is moving some resources into new cities that it hopes will attract more revenue. Service begins in March in Minneapolis/St. Paul, and the airline hopes to begin service to LaGuardia Airport in New York as well.

Currently Southwest’s only New York-area service is to Islip Airport on Long Island, so service to LaGuardia would be a big draw for business travelers.

Bulked-up balance sheet: The airline has bolstered its finances in recent months, drawing $400 million from a revolving credit facility, raising $400 million through a loan and collecting $173 million in an aircraft sale-leaseback deal.

The airline has $1.8 billion in its coffers to help cushion any additional losses.

Moneymaking perks: Southwest is revamping its Rapid Rewards frequent-flier program to make it more attractive to business travelers and hopes to offer in-flight wireless Internet access for a fee in the months ahead.

“We’ve got a very in- tense focus to transform the airline that you’re very familiar with,” Kelly said. “So I think we’re undertaking the next three years from a very strong position.”