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Historical Background of Southwest Airlines

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Southwest Airlines Co. (NYSE: LUV) is a major U.S. airline, the world's largest low-cost carrier, headquartered in Dallas, Texas. The airline was established in 1967 by Herb Kelleher and adopted its current name (Southwest Airlines) in 1971. The airline has more than 52,000 employees as of July 2016 and operates more than 3,900 departures a day during peak travel season. As of 2014, it carried the most domestic passengers of any U.S. airline. As of July 2016, Southwest Airlines has scheduled services to 98 destinations in the United States and seven additional countries with service to three airports in Cuba expected to begin later this year, subject to governmental approvals. Southwest Airlines has used only Boeing 737s, except for the period from 1979 to 1987 when it leased some Boeing 727s from Banff International Airways. As of January 2016, southwest is the largest operator of the Boeing 737 worldwide, with over 700 in service, each averaging six flights per day

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Assessment of All Content

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Southwest paid US $60.5 million in stock and cash for Muse Air when Muse was on the verge of collapse in 1985. After completing the acquisition, Southwest renamed Muse Air Tran Star Airlines. Tran Star became a wholly owned subsidiary of Southwest and operated as an independent airline. Unwilling to compete in a fare war against Frank Lorenzo's Texas Air, Southwest eventually sold Tran Star’s assets to Lorenzo in August 1987.

Economic conditions, fair prices, changes in demographics, terrorism, and outbreaks of deadly disease, all have a direct and significant impact on airline carriers and demand for air travel.  The terrorist attacks of 2001 where the beginning of one of the most challenging periods for airlines.  The attacks caused economic uncertainty, downsizing of airline employees, and flight shutdowns as demand and passenger traffic decreased. With the industry in an already weakened financial state, following the 9/11 terrorist attack, passenger traffic decreased by 5.9% year-over-year in 2001 and 1.4% in 2002, forcing airlines to cut capacity by 2.8% in 2001 and 3.9% in 2002.  Domestic airline revenues decreased from $130.2 billion in 2000 to $107.1 billion, and airlines reported losses which totaled $57.7 billion between 2000 and 2005.

Economic growth and stability is another significant demand driver of air travel. A strong economy means there is more disposable income to spend on leisure and business air travel.  A weak economy, results in higher rates of unemployment, and notably less disposable income to spend on leisure and business travel. The nature of the airline industry makes it highly susceptible to economic downturns.  The failure of major financial institutions in 2008 led to a global financial crisis which drastically impacted air travel.  Just as U.S. airline carriers were starring to achieve normal profits, following the 2001 terrorist attacks, soring oil prices and the global financial crisis resulted in revenue losses of $26.4 billion between 2008 and 2009  From 2008-2009, premium travel decreased 25%, economy travel fell 9%, and revenues fell by 14%.

Although Southwest Airlines is equally susceptible to these demand trends, the company’s innovative business model and aptitude for increasing per-flight revenue while simultaneously decreasing costs, and its proficiency at accommodating increases in demand has effectively allowed the company to achieve year-over-year revenue growth.  Southwest Airlines point-to-point strategy, the efficiency of its low-fare structure, a no-frills approach to air travel, and a strategic fuel hedging strategy has given the company the ability to increase efficiency by effective reductions in operating and labor costs. In addition, since fuel is among one of the largest expenses for airlines, fluctuating oil prices and a lack of substitute fuel sources can heavily affect profitability if exposure is not hedged. Of the four U.S. major airlines, southwest is the only one who aggressively uses a fuel hedging strategy.

The financial crisis of 2008 also resulted in a major industry consolidation and a reduction in the number of carriers. The economic downturn resulted in a decrease from 11major carriers in 2005 to just six by 2014. Today, the four major airlines in the market, include Delta, United, Southwest, and American Airlines, which account for just under 70% of market share.  Since Southwest’s entry into the airline industry as a low-cost carrier, the company has become a major player.  The company has consistently retained the largest share of airline traffic, with only a slight drop-off in 2016.  As demonstrated by the chart below, Southwest is currently leading the pack among all domestic carriers with a market share of 19.10%.

Legislative mandates aimed at increasing competition in the highly concentrated major U.S. airports required airports above certain concentration thresholds to take distinct measures to ease and inspire new entry and expansion by smaller airlines, primarily by increasing access to airport facilities.  This has made the airline industry much more competitive. While the industry’s capital-intensive nature result in high exit barriers, the barriers to entry on the other hand are low due to liberalization of market access. While entry of new carriers into the market can bode well for consumers as routes are increased and fares are often driven by the entry of low-cost carriers into new markets, which can potentially reduce prices as much as 20%, new carriers entering the market as well as existing airlines expanding services to new markets can considerably intensify competition for Southwest. The airline industry has a relatively small number of carriers, services are identical or differentiated, and ease of entry is rather low, thus based on these characteristics, the U.S. airline industry is an oligopoly.  Furthermore, currently the top four airline carriers have less than 70% of the market share, and the barriers to entry while low due to deregulation, remain difficult due to the capital-intensive nature of the industry.  Because it requires an investment of several billion dollars to purchase or lease aircraft fleets and build out the infrastructure necessary to compete on major profitable routes, new carriers are primarily limited to lower-profit smaller regional routes which may further discourage market entry. Furthermore, the airline industry doesn't meet the four-firm concentration ratio test of 80% or greater market share.