Southwest shows it is still an LCC at heart

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In the years since its founding as an intra-Texas low-cost carrier (LCC) in 1967, Southwest Airlines has grown into the second largest U.S. airline as measured by the capacity of its domestic route network.

But though many have long since stopped viewing Southwest as an LCC, analysts say that the airline’s approach to dealing with weakening industry demand over the remainder of this year reveals that its business model is still influenced by its low-cost roots.

“In the broadest sense of all, Southwest is still an LCC, and LCCs win more with cost advantages than with revenue advantages,” said Seth Kaplan, managing partner of the newsletter Airline Weekly.

Each of the four major U.S. carriers — United, American and Delta along with Southwest — reported softening demand during earnings calls last month. Southwest, for example, projects that its unit revenue, defined as how much money it makes per seat for every mile it flies, will be down 3% to 4% this quarter compared with a year earlier.

The carriers attribute the softening market to a more competitive fare environment for close-in bookings and to weak corporate-travel demand.

For legacy carriers United, American and Delta, difficulties in the transatlantic market, in large part related to foreign currency weakness and to the fallout from Brexit, are other causes of concern. Southwest does not fly to Europe, though it does serve Latin America.

In response to softening demand, each of the Big Three announced plans to curtail capacity growth for the remainder of this year.

Reducing growth doesn’t make sense to this year’s bottom line, Southwest CEO Gary Kelly said during the carrier’s second-quarter earnings call on July 21.

“We’ve not been able to model a scenario where it was profit positive for us to do that,” he said.

Southwest’s approach sparked a sharp question during the call from UBS Securities stock analyst Darryl Genovesi, who noted that capacity cuts from the legacy carriers will likely help Southwest. Why, Genovesi asked, is Southwest resistive to coordinating with its main competitors on capacity and pricing, at least to the extent that such things could be done without violating antitrust laws?

“With Southwest having grown to be as large a player as it is in the industry today, isn’t it kind of required that, overall, the industry is healthy in order for Southwest to be healthy?” Genovesi asked.

Kelly, in what was likely a well-advised effort to avoid any issues related to antitrust laws, declined to answer the question.

Kaplan, though, said that Southwest simply has a different decision matrix than the legacy carriers when it comes to capacity expansion.

He said that as a general rule, legacy carriers have higher cost structures than LCCs due to less favorable union contracts and more expensive offerings such as fancy airport lounges and differentiated products, including business-class cabins. Because their costs are higher, such airlines tend to react to weakened demand by reducing capacity in an effort to cut costs and drive ticket prices higher.

In contrast, LCCs have much lower overhead than their legacy competitors. So their key to higher profitability is to create additional efficiencies through route expansion. More routes mean lower gate fees on average and more efficient use of aircraft, for example. Because overhead is lower, LCCs can expand longer than legacy airlines in a weakened fare environment.

That difference is evident in the current rate of expansion of various U.S. airlines. While the Big Three are adding just a point or two of capacity this year, the ultra-low-cost carriers Spirit and Allegiant increased their available seat miles by 24.7% and 16.9% respectively through the second quarter. The LCC JetBlue, meanwhile, said it anticipates growth of 8% to 9.5% for the full year, though it, like the Big Three, did reduce planned capacity growth by .75% in June.

Southwest’s growth rate this year of 5% to 6% falls in between the LCCs and legacies, reflecting what both Kaplan and airline industry analyst Bob Mann of RW Mann and Co. say is its status, both in pricing and overhead: somewhere between the LCC it was two decades ago and the legacy carriers with which it is now on par with regard to the size of their domestic networks.

Because Southwest is now bridging that gap, it still competes a bit more directly for route space with the upstart airlines than do American, United and Delta.

“There’s a smaller difference between Southwest and the irritants who want to grow rapidly,” Mann said.

Kaplan added, “In terms of capacity, it is always a little more important for Southwest to grow than it is for Delta, American and United.”

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