Southwest Airlines Waging War in Philly

Company Case 9 Southwest Airlines: Waging War in Philly

BAT TLE STATIONS! In March 2004, US Airways CEO David Siegel addressed his employees via a Webcast. Theyre coming for one reason: Theyre coming to kill us. They beat us on the West Coast, they beat us in Baltimore, but if they beat us in Philadelphia, they are going to kill us. Siegel exhorted his employees on, emphasiz- ing that US Airways had to repel Southwest Airlines when the no-frills carrier began operations at the Philadelphia International Airport in Mayor die.

On Sunday, May 9, 2004, at 5:05 A.M. (yes, A.M.), leisure passengers and some thrift-minded business people lined up to secure seats on Southwests 7 A.M. flight from Philadelphia to Chicagoits inaugural flight from the new market. Other pas- sengers scurried to get in line for a flight to Orlando. And why not? One family of six indicated it bought tickets for $49 each way, or $98 round trip. An equivalent round-trip ticket on US Airways would have cost $200.

Southwest employees, dressed in golf shirts and khaki pants or shorts, had decorated the ticket counters with lavender, red, and gold balloons and hustled to assist the throng of passengers. As the crowd blew noisemakers and hurled confetti, Herb Kelleher, Southwests quirky CEO, shouted, I hereby declare Philadelphia free from the tyranny of high fares! At 6:59 A.M., Southwest flight 741 departed for Chicago.

WAR ON! Was Southwests entry into the Philadelphia market worth all this fuss? After all, US Airways was firmly entrenched in Philadelphia, the nations eighth-largest market, offering more than 375 flights per day and controlling two-thirds of the air- ports 120 gates. Further, in 2004, little Southwest served a to- tal of 58 cities and 59 airports in 30 states and was offering only 14 flights a day from Philly out of only two gates. And until its entry into Philadelphia, Southwest had a history of entering smaller, less expensive, more where it didnt pose a direct threat to the major airlines like US Airways. Did Southwest really have a chance?

Southwest was used to that question. In 1971, when Kelleher and a partner concocted a business plan on a cocktail napkin, most people didnt give Southwest much chance. Its strategy completely countered the industrys conventional wisdom. Southwests planes flew from point-to-point rather than using the hub-and-spoke pattern that is the backbone of the major air- lines. This allowed more flexibility to move planes around based on demand. Southwest served no meals, only snacks. It did not charge passengers a fee to change same-fare tickets. It had no as- signed seats. It had no electronic entertainment, relying on comic flight attendants to entertain passengers. The airline did not offer a retirement plan; rather, it offered its employees a profit-sharing plan. Because of all this, Southwest had much lower costs than its competitors and was able to crush the competition with low fares.

For 32 years, Southwest achieved unbelievable success by sticking to this basic no-frills, low-price strategy. Since it began operations in 1972, it was the only airline to post a profit every year. In 2003, just prior to taking the plunge in Philly, the com- pany earned $442 millionmore than all the other U.S. airlines combined. In the three prior years, Southwest had earned $1.2 billion, while its competitors lost a combined $22 billion. In May 2003, for the first time, Southwest boarded more do- mestic customers than any other airline. From 1972 through 2002, Southwest had the nations best-performing stockgrow- ing at a compound annual rate of 26 percent over the period. Moreover, whereas competing airlines laid off thousands of workers following the September 11 tragedy, Southwest didnt lay off a single employee. In 2004, its cost per average seat mile (CASMthe cost of flying one seat one mile) was 8.09 cents, as compared with between 9.42 to 11.18 for the big carriers.

THE MAJORS: LOW ON AMMUNITION In the early 2000s, the major (or legacy) airlines, such as US Airways, Delta, United, American, and Continental, faced three major problems. First, little Southwest was no longer little. Second, other airlines, such as JetBlue, AirTran, ATA, and Virgin Atlantic, had adopted Southwest-like strategies. In fact, JetBlue and America West had CASMs of 5.90 and 7.72 cents, respectively. In 1990, discount airlines flew on just 159 of the nations top 1,000 routes. By 2004, that number had risen to 754. As a result, the majors, who had always believed they could earn a 30 percent price premium, were finding it hard to get a 10 per- cent premium, if that. Third, and most importantly, the major air- lines had high cost structures that were difficult to change. They had more long-service employees who earned higher pay and re- ceived expensive pension and health benefits. Many had unions, which worked hard to protect employee pay and benefits.

AT TACK AND COUNTER AT TACK US Airways had experienced Southwests attacks before. In the late 1980s, Southwest entered the California market, where US Airways had a 58 percent market share on its routes. By the mid- 90s, Southwest had forced US Airways to abandon those routes. On the Oakland-to-Burbank route, average one-way fares fell from $104 to just $42 and traffic tripled. In the early 90s, Southwest entered Baltimore Washington International Airport, where US Airways had a significant hub and a 55 percent mar- ket share. By 2004, US Airways had only 4.9 percent of BWI traffic, with Southwest ranking number one at 47 percent.

Knowing it was in for a fight in Philly, US Airways reluc- tantly started to make changes. In preparation for Southwests ar- rival, it began to reshape its image as a high-fare, uncooperative carrier. It spread out its scheduling to reduce congestion and the resulting delays and started using two seldom-used runways to reduce bottlenecks. The company also lowered fares to match Southwests and dropped its requirement for a Saturday-night stayover on discounted flights. USAirways also began some new promotion tactics. It launched local TV spots on popular shows to promote free massages, movie tickets, pizza, and flowers.

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On the other side, Southwest knew that Philadelphia posed a big challenge. Philadelphia International was one of the biggest airports it had ever attempted to enter. And with US Airways strong presence, it was also one of the most heavily guarded. Finally, the airport was known for its delays, conges- tion, bureaucracy, and baggage snafus, making Southwests strategy of 20-minute turnarounds very difficult.

Therefore, Southwest unveiled a new promotion plan for Philly. Ditching its , the airline held focus groups with local travelers to get their ideas on how it should promote its servicea first for Southwest. As a result, the airline developed a more intense ad campaign and assigned 50 percent more employees to the airport than it typi- cally had for other launches. Southwest also recruited volun- teers to stand on local street corners handing out free inflatable airline hats, luggage tags, and antenna toppers. The airline used billboards, TV, and radio to trumpet the accessibility of its low fares as well as its generous frequent flier program.

Two short years after Southwest began service to Philadelphia, the market took on a dramatically different look. Southwest had boosted daily nonstop flights from 14 to 53. It had added service to 11 new cities and quadrupled its number of gates from two to eight, with its eye on four more. The number of Southwest employees in Philly approached 200, a huge in- crease over its postlaunch total of less than 30.

But the external impact of Southwests first two years in Philadelphia was a classic example of what has come to be known as the Southwest effecta phenomenon in which all carriers fares drop and more people fly. In Philadelphia, the in- tense competition brought on by Southwests arrival caused air- fares on some routes to drop by as much as 70 percent. In 2005, airline passenger traffic for Philadelphia International was up 15 percent over 2004. The airport attributed much of that in- crease to Southwest. In all, by the end of 2005, Southwest had captured 10 percent of total passenger traffic. In turn, US Airways share fell about five percentage points.

Just as US Airways was absorbing Southwests blows in Philadelphia, the underdog airline struck again. In May of 2005, Southwest started service to Pittsburgh, another major US Airways hub. Shortly thereafter, Southwest announced that it would also soon enter Charlotte, North Carolina, US Airways last stronghold.

THE END OF AN ER A? Today, although it appears that Southwest is on cloud nine, many factors are forcing the nations most profitable air carrier to change its flight plans. First, the best-known discount airline has more competition than ever before. Upstarts such as Frontier, AirTran, and JetBlue are doing very well with Southwests model. And they are trumping Southwests low fares by adding amenities such as free TV and XM satellite radio at each seat.

Even the legacy carriers are now in better positions to take on Southwests lower fares. All of the major airlines have ruth- lessly slashed costs, mostly in the areas of wages and pensions. Some, like US Airways, have used bankruptcy to force steep union concessions. In fact, Southwest now has some of the highest paid employees in the industry.

At the same time that competition is becoming leaner and meaner, Southwests cost structure is actually on the rise. Because Southwest already has such a lean cost structure, it has much less room for improvement. For example, travel agent commissions have been at zero for some time (Southwest doesnt work through agents). Sixty-five percent of Southwest customers already buy their tickets online, minimizing its call center expense. And Southwest is quickly losing another of its traditional cost advan- tages. For years, through some smartly negotiated fuel-hedging contracts, Southwest has enjoyed fuel prices far below those paid by the rest of the industry. But with those contracts expiring, Southwest paid 47 percent more for jet fuel in 2006 than it did in 2005. For others, the cost increase was much less.

Although Southwest still holds a cost advantage over the major carriers, the gap is narrowing. Southwests CASM for 2006 was 8.8 cents, up 17 percent from 7.5 cents four years ear- lier. With the cost structure of the big airlines decreasing, Southwests cost advantage has narrowed from 42 percent to 31 percent. With the momentum on both sides, this gap could soon be as little as 20 percent.

As these factors have quickly turned the tables on Southwest, some analysts are questioning the companys current strategic di- rection. Slowly, Southwest is becoming what its competitors used to be, says industry consultant Steven Casley. Serving congested hub airports, linking with rivals through code-sharing, and hunting the big boys on their own turf are all things that Southwest would previously have never considered.

But Gary Kelly, Southwests new CEO, defends the com- panys actions. Hey, I can admit it, our competitors are getting better, says Kelly. Sure, we have an enormous cost advantage. Sure, were the most efficient. The problem is, I just dont see how that can be indefinitely sustained without some sacrifice. Kelly has his eye on change, in the areas of both cost and rev- enue. Although costs are already low at Southwest, the low-cost carrier is doing all that it can on that front. But the revenue side poses some greater potential.

In 2006, Southwest raised ticket prices, boosting average fares by 11.4 percent over 2005. But fares can only go up so much before customers stop jumping on board. So Kelly is con- sidering many tactics that Southwest long avoided. Some of the possibilities include an assigned seating system and an in-flight entertainment system. By 2009, Southwest will be booking in- ternational flights through ATA Airlines. And in another first, Southwest has begun selling tickets through third-party distri- bution agents Galileo and Sabre Holdings.

When asked if he was worried about Southwest losing its competitive advantage, Mr. Kelly responded confidently:

We know people shop first for fares, and weve got the fares. [But] ultimately, our industry is a customer-service business, and we have the best people to provide that spe- cial customer service . . . thats our core advantage. Since the U.S. Department of Transportation began collecting and publishing operating statistics, weve excelled at on- time performance, baggage handling, fewest complaints, and fewest canceled flights. Besides, were still the low- cost producer and the low-fare leader in the United States. We have no intention of conceding that position.

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By almost any measure, Southwest is still the healthiest air- line in the business. However, that might be like saying its the least sick patient in the hospital. As the industry as a whole has suffered in the post-September 11th world, Southwests 2005 earnings of $313 million were half of what the company made in 2000. The airlines stock prices continue to hover somewhere between $11 and $14 a share, more than 30 percent below 2001 levels. As the other patients get better, Southwest can only hope that its future initiatives will be the new medicine that it needs.

Questions for Discussion

1. How do Southwests marketing objectives and its marketing-mix strategy affect its pricing decisions?

2. Discuss factors that have affected the nature of costs in the airline industry since the year 2000. How have these factors affected pricing decisions?

3. How do the nature of the airline market and the demand for airline service affect Southwests decisions?

4. What general pricing approaches have airlines pursued?

5. Do you think that Southwest will be able to continue to maintain a competitive advantage based on price? What will happen if others carriers match the low-price leader?

Sources: Melanie Trottman, As Competition Rebounds, Southwest Faces Squeeze, Wall Street Journal, June 27, 2007; Southwest Airlines Adds Sales Outlet, Wall Street Journal, May 17, 2007; Chris Walsh, A Philadelphia Success Story: Southwests Quick Growth in City Shows Its Potential in Denver, Rocky Mountain News, December 30, 2005; Susan Warren, Keeping Ahead of the Pack, Wall Street Journal, December 19, 2005; Barney Gimbel, Southwests New Flight Plan, Fortune, May 16, 2005, accessed at www.money.cnn.com; Let the Battle Begin, Air Transport World, May 2004, p. 9; Micheline Maynard, Southwest Comes Calling, and a Race Begins, New York Times, May 10, 2004; Melanie Trottman, Destination: Philadelphia, Wall Street Journal, May 4, 2004; Andy Serwer and Kate Bonamici, Southwest Airlines: The Hottest Thing in the Sky, Fortune, March 8, 2004, p. 86.

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