CASE 4 Southwest Airlines Flying High with Low Costs Southwest Airlines sent its first flights alo! in 1971. A!er almost 45 years, Southwest was so successful that the company was considered, in many ways, the crown jewel of the airline industry. The organization had achieved the longest continuous stretch of profitability in the history of the airline industry and was consistently ranked in the top 10 on Fortune’s list of “Most Admired Companies,” a list that spanned all industries. Southwest’s executives liked to say that they strove toward a triple bottom-line of People, Planet, and Performance. In 2015, Southwest was on strong financial ground, despite the fact that the prior 15 years had been some of the most difficult in aviation history. The airline industry had been hurt by the 9/11 terrorist attacks and the Great Recession of 2008–2009. Although 2009 had been a dif- ficult year for the company, Southwest had still managed to eke out a positive net income of $99 million. The company’s performance improved in the subsequent years, with net income rising above $400 million and revenues increasing from $10.3 billion in 2009 to more than $17 billion in 2012 (see Exhibits 1 through 3). Southwest achieved its strong financial performance in large part by having a high load factor, the airline industry’s measure of the percentage of seats that are filled on an airline’s flights. In 2010, Southwest hit the highest load factor in its history: 79.3 percent. Following its successful “Bags Fly Free” ad campaign, Southwest also saw its domestic market share increase by almost 2 percent. Southwest was known for high levels of both customer service and employee satisfaction. In 2013, Southwest not only rated as the top airline in a Consumer Reports survey of passengers1 but also reigned at the top of the US Department of Transportation’s customer satisfaction rankings. By 2015, with the benefit of lower fuel costs, it achieved record profits of $4.1 billion. Overall, Southwest had an enviable record of performance. The US Airline Industry The airline industry is critical to the health of the US economy. Airlines provide 11 million jobs in the United States and are responsible for five cents of every dollar of the US gross domestic product (GDP). For every 100 airline jobs that exist, 388 more jobs are supported outside of the airline industry.2 A key turning point in airline history was the deregulation of the industry in 1978. Before deregulation, the Civil Aeronautics Board regulated all passenger fares, which meant the price was the same for each flight between two cities. The board also regulated industry entrances and exits; mergers and acquisitions; and even airlines’ rates of return. Typically, any given market had only a few airlines, and price competition was essentially nonexistent. Following deregulation, numerous new entrants moved into both established and unserved markets, and fare prices began to drop quickly. The average passenger fare in 1978 was about 8.49 cents per mile. In 2009, that price, adjusted for inflation, had decreased C-41 case04SouthwestAirlines.indd 41 11/8/19 6:15 PM C-42 Southwest Airlines EXHIBIT 1 Southwest Airlines Selected Financial & Operating Figures Financial Data: 2015 2013 2011 (In Millions except per share) Total Operating Revenues: 19,820 17,699 15,658 Operating Expenses: Salaries, wages, and benefits 6,383 5,305 4,371 Fuel and oil 3,616 5,763 5,644 Maintenance materials and repairs 1,005 1,080 955 Aircra! rentals 238 361 308 Landing fees and other rentals 1,166 1,103 959 Depreciation and amortization 1,015 867 715 Other operating expenses 2,242 86 1,879 Total Operating Expenses: 15,704 16,421 14,965 Operating Income: 4,116 1,278 693 Net Income: 2,181 754 178 Net income per share, basic 3.30 1.06 0.23 Total assets at period-end 21,312 19,345 18,068 Long-term obligations at period-end 2,541 2,191 3,107 Stockholders’ equity at period-end 7,358 7,336 6,877 Operating Data: Revenue passengers carried 118,171,211 108,075,976 103,973,759 Enplaned passengers 144,574,882 133,155,030 127,551,012 Revenue passenger miles (RPMs) (000s) 117,499,879 104,348,216 97,582,530 Available seat miles (ASMs) (000s) 140,501,409 130,344,072 120,578,736 Load factor (1) 83.6% 80.1% 80.9% Average aircra! stage length (miles) 750 703 679 Trips flown 1,267,358 1,312,785 1,317,977 Average passenger fare 154.85 154.72 141.90 Passenger revenue yield per RPM 15.57¢ 16.02¢ 15.12¢ Operating revenue yield per ASM 13.98¢ 13.58¢ 12.99¢ Operating expenses per ASM 11.18¢ 12.60¢ 12.41¢ Fulltime equivalent Employees at period-end 49,583 44,831 45,392 Aircra! in service at period-end (2) 704 680 698 (1) Revenue passenger miles divided by available seat miles (2) Includes leased aircra! Source: Southwest Airlines Annual Reports. 56 percent.3 As prices declined for passengers, however, more than 150 airlines went bankrupt, and eight of the 11 major airlines went bankrupt, merged, or closed. The airline industry’s profit margins are some of the lowest in the world (see Exhibits 4 and 5). Airlines paid considerable attention to reducing their operating costs, but their con- trol over those costs was severely limited. In particular, labor costs represented the largest percentage of an airline’s costs, but union agreements limited labor flexibility. The sizes of the crew and ground sta# were typically proportional to the size of the aircra! they served. Other case04SouthwestAirlines.indd 42 11/8/19 6:15 PM The US Airline Industry C-43 EXHIBIT 2 Southwest Airlines Balance Sheet As of December 31 . 2015 2013 2011 2009 Current Assets: (In Millions) Cash and cash equivalents 1,583 1,355 829 1,114 Short-term investments 1,468 1,797 2,315 1,479 Accounts and other receivables 474 419 299 169 Inventories of parts and supplies, at cost 311 467 401 221 Deferred income taxes 2,490 168 263 291 Prepaid expenses and other current assets 188 250 238 84 Total current assets 4,024 4,456 4,345 3,358 Property and equipment, at cost: Flight equipment 19,462 16,937 15,542 13,719 Ground property and equipment 3,219 2,666 2,423 1,922 Deposits on flight equipment purchase contracts 1,089 764 456 247 24,685 20,820 18,421 15,888 Less allowance for depreciation and amortization 9,084 7,431 6,294 5,254 15,601 13,389 12,127 10,634 Other assets 717 530 626 277 21,312 19,345 18,068 14,269 Current Liabilities: Accounts payable 1,188 1,247 1,057 732 Accrued liabilities 2,591 1,229 996 729 Air tra#ic liability 2,990 2,571 1,836 1,044 Current maturities of long-term debt 637 629 644 190 Total current liabilities 7,406 5,676 4,533 2,695 Long-term debt less current maturities 2,541 2,191 3,107 3,325 Deferred income taxes 2,490 2,934 2,566 2,200 Deferred gains from sale and leaseback of aircra! 43 65 75 102 Other noncurrent liabilities 760 771 910 493 Stockholders’ Equity: Common stock, $1.00 par value 808 808 808 808 Capital in excess of par value 1,374 1,231 1,222 1,216 Retained earnings 9,409 6,431 5,395 4,971 Accumulated other comprehensive income –1,051 –3 –224 –578 Treasury stock, at cost: –3,182 –1,131 –324 –963 Total stockholders’ equity 7,358 7,336 6,877 5,454 Source: Southwest Airlines Annual Reports. operating costs were primarily determined by the distance traveled and not by the number of passengers boarded. Most airlines—notably Delta, American, and United—used a hub-and-spoke system to coordinate flights, which meant that they funneled the majority of their tra#ic through “hub” airports. Hub-and-spoke (HS) systems were designed to help airlines maximize their load factors, meaning they helped keep planes full going into and out of a hub airport. case04SouthwestAirlines.indd 43 11/8/19 6:15 PM C-44 Southwest Airlines EXHIBIT 3 US Domestic Airline Total Operating Revenues (In millions) American America Continental Delta Northwest Southwest United US JetBlue Alaska West Airways 2015 33,581 — — 40,816 — 19,820 37,864 7,504 6,416 5,594 2013 25,760 — — 37,818 — 17,699 38,287 14,936 5,442 5,151 2012 24,825 — — 36,917 — 16,411 37,160 14,121 4,982 4,650 2011 23,958 — 16,175 35,316 — 13,655 21,155 13,341 4,509 4,310 2010 22,151 — 14,011 31,894 — 12,104 19,682 12,196 3,781 3,427 2009 19,898 — 12,361 18,047 10,863 10,350 16,359 10,781 3,287 3,006 2008 23,696 — 15,033 20,973 14,096 11,023 20,237 12,459 3,390 3,221 2007 22,833 2737 14,105 19,239 12,735 9,861 20,049 9,318 2,843 3,070 2006 22,493 3770 13,010 17,339 12,555 9,086 19,334 8,076 2,363 2,693 2005 20,657 3397 11,108 16,112 12,316 7,584 17,304 7,212 1,703 2,416 2004 18,608 2482 9,851 15,154 11,266 6,530 15,701 7,073 1,266 2,241 2003 17,403 2223 7,333 14,203 9,184 5,937 13,395 6,762 998 2,027 2002 15,871 2021 7,353 12,410 9,152 5,522 13,916 6,915 635 1,832 2001 15,639 2035 7,972 13,211 9,592 5,555 16,087 8,253 320 1,763 2000 18,117 2309 9,129 15,321 10,957 5,650 19,331 9,181 105 1,760 1999 16,090 2164 8,024 14,901 9,868 4,736 17,967 8,460 — 1,696 1998 16,299 1983 7,299 14,630 8,707 4,164 17,518 8,556 — 1,581 1997 15,856 1887 6,361 14,204 9,984 3,817 17,335 8,501 — 1,457 1996 15,136 1752 5,487 13,318 9,751 3,407 16,317 7,704 — 1,307 Note: US Airways and America West started to report combined on-time data in January 2006 and combined tra#ic and financial data in October 2007 following their 2005 merger announcement.