Just imagine this. You’re running Southwest Airlines, trying hard to fight off Elliott Investment Management’s desire to fire you and your board chair. It says you’ve missed out on a ton of revenue opportunities, and it’s time to change. What’s the last thing you want to see? Probably a miss on your revenue guidance.
So it was last week — the last week of this very quarter — when Southwest announced that its Q2 revenue guidance was too rosy. Instead of unit revenue being down 1.5 to 3.5 percent year-over-year, it’s going to be down 4.0 to 4.5 percent. Woof.
What exactly is going on here? Is a wave of revenue weakness hitting the industry? After all, American revised its guidance downward just a few weeks ago. If we see Delta and United miss their guidance — something that probably won’t happen — then I’ll believe it’s an industry issue. But for now, this appears to be a Texas flu with two distinct variants.
With American, it’s hard to know what exactly went wrong in the forecasting process, but when the airline fired its Chief Commercial Officer at the same time it lowered guidance, it would certainly point to internal problems as being the main culprit.
At Southwest, the airline explains this as being a very specific problem of internal mismanagement of the revenue management system. Specifically, in the SEC filing, Southwest said this:
The reduction in the Company’s RASM expectations was driven primarily by complexities in adapting its revenue management to current booking patterns in this dynamic environment.
The airline isn’t saying more than that yet, so let’s talk about what that probably means.
Back in April 2023, it was announced that Southwest had fully switched to use Amadeus’s Network Revenue Management (NRM) solution for all of its revenue management. Southwest made the decision to really put all its eggs in the Amadeus basket, already using the Amadeus Altea passenger service system and Sky suite for network planning optimization. This is probably a good thing since I’m assuming this is what the RM department looked like before.
Southwest had actually been using multiple systems for awhile, testing them to see which would be the best option for the airline. In the Amadeus press release, Southwest Chief Commercial Officer Ryan Green was quoted as saying this about the company’s decision:
We directly observed revenue uplift from the Network Revenue Management product through an extensive multi-year production pilot. Following these results, we are excited to announce the selection of Amadeus as our next generation revenue management system provider. We have completed the full cutover to NRM three months earlier than our original plan thanks to the strong partnership between the Southwest and Amadeus Revenue Management teams.
This wasn’t just changing RM providers, but rather it was a change in philosophy. Instead of managing the network using a leg-based system, it switched to an origin and destination (O&D)-based system. That is no small task.
In a traditional leg-based system, it’s all about managing demand on a specific flight. Let’s pretend you’re managing Southwest 355 from Long Beach to Phoenix today. You have 143 seats on the 737-700, and Southwest no longer really overbooks, so assume your goal was to sell 143 seats.
The idea is to sell as many high fares as you can, and then you want to fill in the rest of the seats with lower fares. That’s backwards, of course, since you have to sell the lower fares first. So you have to guess how many of the high fares you can sell closer to departure and hold back seats while selling lower-priced ones in advance. Airlines have more than a dozen different fare buckets which the revenue management system opens and closes. Analysts watch the flights to make sure demand is developing as expected. They will tweak models and adjust numbers if they see a need.
But with an O&D-based system, it gets more sophisticated. There are some people flying from Long Beach to Phoenix, but there are also people going from San Jose to Phoenix or from Long Beach to San Antonio, Omaha, Tampa… you name it. They’re all flying on the same leg from Long Beach to Phoenix, but they are paying wildly different fares depending upon where they are flying.
I don’t want to get into too much detail, but this is far more complex, and it requires a mindset change for analysts to handle this. As one long-time consultant, Tom Bacon, explains in a blog post:
When airlines change from leg-based revenue management to O&D revenue management, they face a huge change management task. The change is not just deployment of a more sophisticated RM system that promises more revenue. The new system represents multiple wholesale changes, including implications for the organizational structure, for recruiting and training, for accountability, for performance metrics, and for executive interaction. Many airlines fail to gain the benefits of O&D RM because they do not properly address some of the critical associated requirements.
Without knowing any more detail from the airline, this is what appears to have happened at Southwest. A system that was supposed to improve revenue performance has not done it. That doesn’t mean it’s the system’s fault. As Ryan said in that quote, the testing phase brought better revenue performance. Further, there were consultants-a-plenty to help with this project along the way. So it’s likely more of an issue about how Southwest has built up and trained its team to do the job.
The good news is it’s fixable. The question now is how quickly Southwest can turn the ship around and get it producing better revenue results. My guess is that we’ll hear more about this on the airline’s earnings call later this month.
