Southwest Destiny?

SOUTHWEST DESTINY?

Amid talk of mergers by the majors and government focus on competition, the low-fare carrier grows unchecked

By Darryl Jenkins, Director, The Aviation Institute, George Washington University

October 2000

A study released by George Washington University Aviation Institute director Darryl Jenkins looks at potential airline mergers and concludes that one player, Southwest, is being overlooked in the process. Here’s an edited transcript of the report.

In May of 2000, United Airlines and US Airways announced plans to merge, triggering extensive public and regulatory comment about the future of the industry — much of it revolving around fears of less competition, higher prices, and reduced service. The most commonly voiced concern is that the merger and subsequent consolidation will result in three airlines dominating.
This paper examines the airline industry from an economic perspective: the current competitive state of affairs, the likely consequences of industry consolidation, and the potential future of U.S. commercial aviation, whether or not the merger takes place.

The conclusions:
1) The biggest danger from industry consolidation is the risk that regulators and government officials may be distracted by merger issues and put important infrastructure and traffic control issues on the back burner. An outdated air traffic control system and a shortage of runways and airport gates provide one of the most likely scenarios for limiting competition and creating higher prices due to congestion.
2) Under any realistic scenario, there will be at least four big carriers of domestic traffic.
3) The most compeling story of the skies is Southwest Airlines, whose growth has been under-recognized by regulators and lawmakers, and under-reported by the media. With up to 290 Boeing 737 planes on order, Southwest will match Delta Airlines as the largest carrier of domestic traffic within five years, and undoubtedly will (become) America’s biggest domestic carrier.
4) There is almost no believable turn of events that could derail Southwest’s expansion.
Airline competition will take on different characteristics than in the previous decades of deregulation. Doom-and-gloom predictions about the future of the industry are almost certainly wrong, because the marketplace is so diverse -- and the state of competition so healthy -- that there are few scenarios that would result in less competition over the next 5-10 years.
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Scenario: Three large major airlines develop; other competition disappears. I consider this least likely.
Under this scenario, Southwest and other low-fare contenders cease to exist and we have what Congress supposedly fears most: three large carriers with no low-cost competition.
Each of these carriers has a large network, and they compete against each other for virtually every city pair. Under today’s robust economic conditions, the planes are full and the carriers are fat and happy. If the economy remains at 3-4 percent real growth, then prices will remain constant. If it is in the 5 and above range, this will put additional disposable income in consumers’ pockets, which will increase load factors, putting pressure on airlines to increase prices. These are the economic pressures that could raise prices.
But what happens when the economy slips from outstanding to merely good? Load factors drop back to the high 60 percent range, meaning that seats are available on virtually every airline on every flight (except peak routes during peak hours). Each airline has more planes than ever, each airline has hefty debt service. The result, confounding the pundits, is a battle of the giants.
Likelihood: Low.
* * *
Scenario: Mergers produce three network airlines (United/US Airways, American/Northwest and Delta/Continen-tal). But other airlines continue to thrive. As politicians, pundits, and analysts look toward the future of airlines during the summer of 2000, the prediction of a Big Three airline market is the flavor du jour. I think this scenario is more likely than the first – but it doesn’t go far enough.
United needs US Airways to become a truly national carrier. American wants Northwest to obtain the Asia-Pacific presence that it desperately needs. And if Delta merges with Continental, it gains a strong New York metro presence with Continen-tal’s hub in Newark. That also would help feed its flights to Europe from JFK airport.
As the three network carriers emerge and stimulate traffic in small and mid-size communities, new competitors begin to discover new sources of growth. Among these entrants is a familiar name, Southwest, which already has over 400 current flight connections from almost 60 cities. Because Southwest has the most immediately available resources, it moves into these markets rapidly. Southwest’s crowns in the Midwest become Minneapolis-St. Paul and St. Louis.
Most people do not realize that Southwest is already the number-two carrier of domestic air passengers (behind Delta). It uses its St. Louis and Chicago-Midway hubs for East-West connecting routes and its new quasi-hub in Allentown, PA, to capture a large share of short-haul traffic on the East Coast. It becomes possible to reach virtually any metropolitan area in the U.S. on Southwest with only one connection — and, lo and behold, Southwest has become the fourth network carrier.
Soon the fare war is system-wide. After each airline has lost millions, fares finally stabilize at a lower level, providing some profits, and an uneasy cease-fire takes hold.
The fare war is bad news for some small airlines. Those with high costs like Vanguard and Pro Air (which had little chance of long-term survival anyway) fade into the sunset. Frontier, AirTran, ATA, Midwest Express, Spirit, DC Air and some others survive because their costs are low enough to operate in a low-fare environment. DC Air – created as a spinoff to serve Washington Reagan National Airport after the United/US Airways merger – begins to expand. DC Air buys a new fleet of planes and uses its gates at Washington Reagan National to fly all over the East Coast.
Nonetheless, these smaller carriers begin their own consolidation, primarily for defensive purposes. They begin pressuring politicians and regulators for greater access to gates and takeoff/landing slots, which will require expansion of airports. This triggers "talk wars" across the nation, as "not in my backyard" citizens try to block construction.
Once the dust settles (literally and metaphorically) the result is more competition from big airlines and once-small airlines that have metamorphosed into larger airlines.
Assumptions: This scenario of cutthroat competition is a direct result of the mergers being approved. History tells us that when the major airlines enter new markets against other majors, there is always bloodletting. For unexplained reasons, neither regulators nor politicians currently consider South-west to be a "major" airline, and regularly ignore its plans for growth and the subsequent effect on the industry. This is one of the most amusing non-events in Washington.
* * *
Scenario: United and US Airways merge, and immediately try to drive Southwest out of business by lowering prices.
This scenario is irresistible to the media because of its "David vs. Goliath" implications. Unfortunately for Holly-wood, it’s highly unlikely.
* * *
Scenario: The same three major network carriers emerge, joined by two major low-cost carriers: Southwest, and a fresh face: JetBlue.
Spurred on by the competitive thrust of Southwest into areas where it had previously planned its own expansion, start-up carrier JetBlue uses creative financing to buy more new planes from Airbus. The result: On the East Coast, JetBlue and Southwest fight for every available passenger, and at the end of five years, carry a big chunk of domestic short-haul traffic.
What does this do to the major airlines? The length of their average flight segment increases and they concentrate on longer-haul and international traffic.
As demand grows, the East Coast runs into capacity constraints. BWI and Dulles airports become the dominant low-cost carrier hubs. Newark and the other New York airports also exceed capacity, leaving Southwest’s outpost on Long Island as the only area network with room to expand.
Southwest begins to look for additional cities on the East Coast to serve, such as Allentown, PA. Southwest also decides to use some of its fleet for international traffic, beginning with Canada and Mexico, including prime leisure spots like Cancun.
Consequently, cities like Hartford emerge as new mini-hubs because they are the only airports with the ability to add flights. Atlantic Coast Airlines, with its existing connections to two major airlines and a fleet of regional jets, takes advantage of the situation and begins flying into more communities. The result is a low-cost competitor offering high levels of convenience, especially for suburban areas.
Assumptions: The advantage of this scenario, in the realism department, is that it doesn’t matter whether the big network airlines do, or don’t, merge. Southwest and JetBlue are likely to expand on the East Coast regardless of what the other carriers do, and change the face of competition. The capacity problem will be the defining problem on the East Coast.
* * *
Scenario: An economic downturn reduces passenger traffic at the same time OPEC hikes oil prices, making jet fuel more expensive.
It is the early 1990’s all over again: a slumping economy combined with a spike in oil prices. The effects on the nation’s karma are profound as members of Generations X and Y — who have never seen a recession —encounter layoffs for the first time.
Recreational travel and four-day ski weekends disappear, and the airlines (whether the Big 7, the Big 4, the Big 3 or the Little 15, depending on merger outcomes) cut fares desperately to attract passengers, losing money.
Older planes like 727s are retired. So are turboprops, which are fuel-efficient but otherwise costly to operate, resulting in a loss of service to smaller cities. The big network carriers are hurt, but survive, because they have large cash reserves. JetBlue and Southwest suffer less because their costs are so low; at worst, they postpone delivery of a few planes. US Airways, with its high costs, old planes, and lack of regional jets, is hit hardest.
Assumptions: For those of us who have observed the airline business for many years, this is potentially a very real scenario.
* * *
Scenario: Smaller national airlines emerge – and merge – to join the fray.
Assumptions: I believe, and so do many other observers, that this rise-of-the-small-airlines scenario will happen sooner or later. The big question in this particular scenario is when is America West going to grow up and begin to act as an adult airline?
* * *
Scenario: The merger does not go through, leaving US Airways on its own.
The result: a weakened US Airways. It limps along (much like TWA does today, as a regional carrier that flies a couple of international routes) or runs into a cash crunch in the next recession and closes its doors.
Assumptions: As US Airways retreats ... some smaller communities that currently receive air service solely because they feed US Airways hubs are likely to lose service entirely. This gloomy scenario for a stand-alone US Airways is highly realistic.
* * *
Scenario: The merger does not go through, and US Airways eventually goes out of business.
Likelihood: US Airways has been fortunate to have survived this long. The robust economy has saved it for the time being, and the airline is sitting on a pile of cash. However, US Airways still lacks a long-term viable strategy and its costs are very high.
* * *
Scenario: Any and all mergers are approved, but Congress decides to let overseas airlines join the fray by entering the U.S. marketplace.
The result is that U.S. and foreign airlines operate freely in all countries. U.S. airlines thrive in Europe because they are much more efficient. A few foreign carriers also find happiness in U.S. markets
Assumptions: This scenario is unlikely because of opposition from U.S. unions, the State Department, and European governments.
* * *
Scenario: Southwest becomes the largest carrier of domestic traffic.
I believe this scenario is the most likely outcome for America’s airline industry in the next decade.
* * *
Scenario: Gridlock
If the nation’s airways and skies become so crowded that we cannot put enough planes in the air to satisfy demand, the result will be gridlock. If gridlock occurs, the only mechanism that can reduce demand to match supply will be pricing.

The ’Southwest Effect’

• People are willing to drive to an airport up to two hours away to save money on a Southwest flight — automobiles, in effect, become a "feeder" for Southwest, allowing it to create virtual hubs.
• Southwest serves, in essence, over 90 percent of the domestic population.
• Southwest’s revenues and profits are steadily increasing. Its operating margin of 21.5 percent in the second quarter of 2000 was its best since 1980, according to Merrill Lynch. The company raised its fares four times since the second quarter of 1999 and still achieved a load factor of almost 75 percent in the most recent quarter.
• Southwest’s planned growth of 8 to 12 percent annually is likely to continue, given its recent plane purchases (in the next 10 years, the size of Southwest’s fleet will double, with up to 290 new planes on order). As its network expands to include more major metropolitan areas, the ability of long-haul passengers to fly on Southwest for their entire trip will increase.
• Southwest will enter one or more new major markets annually for the next five years (and) will dominate short-haul traffic on the East Coast, with plenty of feeder traffic into the Midwest and West Coast.

Player to Watch: JetBlue

As if competition from Southwest were not enough, the majors also must look over their shoulders at JetBlue. Although a new startup, it has the advantages of adequate gate space at New York’s JFK and a pipeline to brand new planes from Airbus. If JetBlue can avoid the pitfalls that often plague start-up airlines, it could quickly become a factor along the East Coast and beyond.
JetBlue seems to be doing a good job of selecting routes and filling planes and is in the strongest financial shape of any start-up airline. It also is flying into regions that will result in head-to-head competition with US Airways — ominous news for that airline if its merger with United is not approved.