We’ve got a guest post today looking at Southwest in Atlanta. As I wrote before, I like the way Southwest is handling the merger from an operational perspective, but will it work out financially? Here’s one take. Do you agree?
For more than a decade, the conventional wisdom has been that the legacy carriers are ultimately doomed and that Southwest Airlines will take over the world – or at least its air transportation needs. Nowhere was that supposed to be more true than in Philadelphia, a market Southwest entered in 2004, fully expecting to take over the hub operations of a dying US Airways. 
But a funny thing happened on the road to this inevitable victory: US Airways fought back, and it is now Southwest that is in retreat in the City of Brotherly Love.
Philadelphia, however, is only a skirmish compared to what’s ahead. A much bigger battle is looming in Atlanta, where Southwest’s acquisition of AirTran has put the airline on a collision course with Delta Air Lines. As in Philadelphia, Southwest enters this market with high expectations. But as explained below, it is by no means inevitable that Southwest will thrive in Atlanta. If it does not, the era of Southwest’s industry ascendancy will end, and the U.S. legacy carriers – with their home turf secured – may enjoy a far more stable future . . . until the next major challenger rises to the occasion.
To understand why Southwest might disappoint in Atlanta, we need to look at what happened in Philadelphia. Last month, Southwest quietly revealed that it was pulling out of 4 additional short and medium haul Philadelphia markets, and reducing frequencies on other routes. This brought to 11 the number of Philadelphia routes that Southwest has entered and subsequently exited in Philadelphia. Aviation Consultant Mike Boyd has provided the data which explains the reason for this pullback. Quite simply, Southwest was getting its butt kicked.
On the soon-to-be-terminated Philadelphia-Pittsburgh route – a classic short-haul, business-oriented market (in other words, a “perfect” Southwest route) – Southwest’s load factor was 20 points less than that of US Airways. And on the tickets it did sell, it got 11% less for them. In the even more important Philadelphia-Boston market, where Southwest is reducing service but not yet exiting, the results look even worse. There, US Airways has an almost 30 point load factor advantage and an astonishing 40% yield premium over Southwest.
The only conclusion that can be drawn from these results is that Philadelphia fliers, especially the business travelers who buy higher-priced tickets, have preferred to stick with US Airways rather than give their business to Southwest. There are many reasons to believe the same could be true in Atlanta. Why? First, as has been demonstrated repeatedly, it is very difficult to make money playing second-fiddle at a major hub airport. Delta is gargantuan compared to AirTran in Atlanta – approximately three times the size of its smaller rival, with a global reach, a massive entrenched frequent flyer program, and a corresponding ability to schedule far more frequencies between city pairs to allow travelers to fly exactly when it is most convenient for them.
Of course, these are the same hurdles that AirTran had to overcome to build its presence in the Atlanta market in the first place. But it did so at a time when AirTran’s unit costs were much lower than Delta’s. Back in 2004, AirTran’s CEO claimed he could fly a passenger for 35% less than it cost Delta looking at stage length-adjusted unit costs. It is difficult to know what cost advantage Southwest will have over Delta, but it is certainly far smaller than 35% considering Delta’s costs have come down while Southwest’s climbed since 2004. And AirTran’s incredibly low cost structure will likely climb to Southwest levels very quickly as the merger progresses.
Even with its significant cost-advantage, it is not as if AirTran has truly thrived in Atlanta. “Survived” is a more accurate description. Where it competes head-to-head, Delta has shown revenue premiums of 30 percent or more (remarkably similar to US Airways’ premium over Southwest in Philadelphia). Lower revenues and lower costs have generally enabled AirTran to eke out tiny profits. Last year, for example, AirTran made $38 million. And so far this year, AirTran has apparently been modestly unprofitable, even as all the legacy carriers (except American) have made money.
To produce even this break-even level of financial performance (assuming oil prices do not decline), Southwest is going to have to significantly boost unit revenue from the current AirTran network. For while the combined airlines will undoubtedly have some cost-saving synergies, the 800-lb gorilla in the closet is going to be the expense of bringing AirTran’s relatively low paid workforce up to Southwest’s best-in-industry wages. For example, a Southwest pilot now makes about $260 an hour. An AirTran pilot makes about $100 less.
Boosting these revenues may not be easy for Southwest. First, it plans to give up checked-baggage and change fees, putting it at a significant revenue disadvantage to Delta — which can charge the same base fares and still collect this additional ancillary revenue. Southwest will also be eliminating some of the in-flight perks valued by AirTran’s business customers: a separate business class cabin and seat assignments. Southwest may also face push-back from its new frequent flyer program which can be far less generous than AirTran’s, especially for passengers buying discounted tickets.
Finally – and unlike in Philadelphia – there are virtually no under-served Atlanta markets for Southwest to stimulate with its famous low fares (which are now a lot higher than they used to be, but still cheaper than what legacy carriers typically charge when they don’t face competition). AirTran already flies to nearly all of the places Atlanta travelers want to go. So if Southwest is going to make money in Atlanta, it is going to have to do it largely on the routes AirTran already serves.
Bottom line: Atlanta will be a challenging environment for Southwest. Failure may have been an option in Philadelphia, but it is not an option in Atlanta. Unless Southwest rises to these challenges, what we think we know about our domestic aviation industry is again about to change.
Wayne Rutman is an independent airline analyst and investor in Wilmington, DE. He can be reached at waynerutman@yahoo.com.
