Monday, July 23, 2012

Case Study of Southwest Airlines (July 16, 2012)

Case Study of Southwest Airlines
Michael D. Lavespere
July 16, 2012

Executive Summary
The purpose of this case study is to identify the primary problem and secondary problem facing Southwest Airline and to offer a solution based on detailed market research. The market research contains a situation analysis on the environment, the airline industry, Southwest Airlines, and the current marketing strategies. In addition, Porter’s 5 Forces Model is used to better understand the dynamics and competitive forces in the airline industry. 
Situation Analysis
An analysis of the environmental influences is critical in understanding the landscape of the airline industry in order to address specific marketing or business problems in which airline companies compete. The environmental conditions researched are comprised of economic conditions, cultural and social values, legal, and political influences in the market.
Economic Conditions and trends
The airline industry faced many obstacles during 2011 and early 2012 that decelerated the resilient rebound that was seen in 2010 by airlines. The Japanese earthquake and tsunami, the political uprising in the Middle East which drove up the price of jet fuel, a ‘slow to grow’ U.S. economy coupled with concerns of Greece and Spain has kept many Airline CEO’s concerned. During 2011, many of the major airlines posted a decline in revenue. According to the International Air Transport Association (IATA), airlines are expected to “generate overall profits of $3.5 billion in 2012, down from the estimated $6.9 billion in 2011 and $16 billion in 2010 (Zack Equity Research, 2012). This sharp reduction in expectations is an indication that 2012 could potentially be a very tough year for an already fragile airline industry. The IATA also noted that “fuel is an airline's second largest expense” with labor being the greatest cost (2012). The spike in fuel prices early in 2012 left little room for optimism. However, a short lived decline in prices in Q2 was overshadowed with a recent jump in prices in July 2012. The current price for jet fuel is $2.83 (July 10, 2012) and many analysts are expecting the upward spike to continue (2012, US Energy Information Administration). The price volatility of fuel has always been a challenge for the airline industry and though predictions are for the price of fuel to continue to rise, the airline industry should not panic too soon. The cost of fuel is very unpredictable and the current price (July 10, 2012) is far below the cost 12 months ago of $3.13. The positive outlook on this threat is that it affects all airlines multilaterally, thus it is incumbent on each airline to offset the potential increases in operating cost.
In addition, though fuel prices are considered high, it still remains below the 2008 levels that wounded the airlines industry. “Airlines have already imposed about 10 broad fare increases in 2011” and these increases in fares have not slowed down the rise in consumer travel. This could be an opportunity for airlines to earn higher profits if consumer demand for travel continues to grow despite higher fares (Zack Equity Research, 2012).
Cultural and social values and trends
After the September 11, 2001 attacks on the World Trade Center, air travel declined sharply out of fear of additional terrorist attacks. Although air travel seems to be getting back to pre-911 numbers, it has changed the culture of the world and the cost to airlines. Since 911, increases in operating cost were immediately absorbed by the airline industry for the additional security expenditures that are required in a post-911 world. Fortunately, no further successful attempts have been carried out since that day; however, another similar terrorist attack would cause unconceivable harm on the airline industry and its future.
An emerging international trend that is particularly of interest is the growth of the middle-class in Brazil, Russia, India, and China.  This growth fosters the propensity of international traveling for many new consumers that previously would have been unable to do so.  In addition, the popularity of Facebook, Tweeter, Social Media, and video conferencing appears to not affect the demand for traveling.  Many would argue otherwise; however, it is quite conceivable that these types of mediums reduces separations and encourage traveling in many ways.  Just as email did not exterminate the postal service as many projected, social media will only help the airline industry.
Political / Government
in October 1978, the Airline Deregulation Act was signed into law by President Carter to encourage market entry and competitive pricing.  Since that time, the federal government; specifically, the Department of Transportation (DOT) and the Federal Aviation Administrator (FAA) with numerous directives and regulations from the federal government have vastly and actively regulated the airline industry.  On January 26th, 2012, the latest government mandate is that airline companies must include all taxes and fees while advertising their fares.  Many are concerned that this could potentially harm travel demand due to the “price shock” from consumers who are not familiar with the new law. As a result, the airline industry could see diminishing profits.
Summary of environmental opportunities and threats
The current environmental landscape offers many opportunities to the airline industry. The most promising is the continual expansion of consumer demand for air travel globally. In particular, the increase of middle-class populations in Brazil, Russia, India, and China is bringing new customers to the international traveling market. Moreover, the growth in the social media market over the last couple of years have removed many degrees of separation between people and places and has encouraged many to travel to experience such introductions in ‘real life’. But the current environment also offers threats to the industry that should be anticipated by airline companies. A slow recovering U.S. economy and concerns with Europe’s financial health, coupled with rising fuel prices could thwart the increase in travel demand. Terrorist attacks and natural disasters as floods and earthquakes can also have a global impact on consumer’s demand for air travel and put struggling airlines further into the red. And finally, depending on the nature of further government interference, the effects could be positive or negative.
An analysis of the airline industry is paramount in understanding the specific influences that affect the airline companies within this backdrop. To understand the airline industry, the research will consist of industry structure and classifications, competitive forces using the Porter’s Five Forces model (1979), and other competitive forces specific to the airline industry.
Airline Classification and Structure
Within the airline industry, three distinct business models are deployed by several competing companies. The U.S Department of Transportation (2012) classifies these groups as a network carrier, a low-cost carrier, or a regional carrier. Network carriers use a hub-and-spoke system of air traveling for its passengers. This model uses preferred airports as a transfer point for passengers to connect to a second flight in order to get to their desired location. This model is heavily used by US Airways and Delta. The hub-and-spoke model is beneficial to the company because it helps decreases operating cost and reduces competition in the regional area of the airport. However, this model will typically inconvenience passengers by requiring him/her to take multiple flights in order to get to the intended destination. A low-cost carrier typically specializes in point-to-point flights and does not use a hub-and-spoke model. This benefits the company because it does not have to absorb the cost of managing a hub airport; however, low-cost carriers typically offer fewer flights than a hub-and-spoke airline. The low-cost carrier is appealing to passengers for its cheaper prices and direct flights to intended destinations. The development of this business model has been perfected and profitably for Southwest Airlines. The final business model is the regional. Regional carriers typically service small cities and markets that are not served by the larger network and low-cost carriers; in addition, regional carriers connect these smaller markets to the larger airport hubs.
In addition to classification, the U.S Department of Transportation (2012) also structures airline based on the amount of operating revenue. They are structured in four groups: Major, National, Regional, and Cargo. A major airline (sometimes referred to as international) generates operating revenue of more than $1 billion per year; a national airline generates operating revenue between $100 million to $1 billion, while a regional airline generates operating revenue between $20 million to $100 million annually. The final structure is the cargo airlines, which specialize in the transport of cargo and can be further classified as a major, national, or regional airline depending on operating revenue earned annually (AVJOBS, 2012).
Michael Porter 5 competitive forces
To further understand the airline industry, the Porter Five Competitive forces model will be used to determine the airline industry’s weaknesses and strengths in order to formulate a strategy to gain a competitive advantage, maintain profitability, or further suggested course corrections for Southwest Airlines (Porter, 1980). The 5 competitive forces examined are the competition, potential for new entrants, suppliers, consumers, and substitute products. Harvard Business Review Publishing released a YouTube video of Dr. Michael Porter discussing the airline industry specifically using his 1979 model. His invaluable insight is used throughout this analysis.
Analysis of existing competitors
The airline industry is marked with intense competition that is exclusively on price. For the exception of a few airlines, the market share fight is a bloody landscape of price wars with airline companies displaying a year end loss as their earned trophy in the end. The fundamental cause for this price war is that airlines struggle to find any service and product differentiation. A flight from Houston to Chicago by one airline renders the same result for the passenger as it would with another airline. Granted, there have been futile attempts to offer beverages, food, better seating, and many other amenities to passengers, but these marketing strategies only seem to drive operating cost instead of customer loyalty. As of 2010, the Federal Aviation Administration has awarded an air operator certificate to 190 airline industries to service the U.S—each competing for market share and profitability while hundred’s rest on the defunct airlines list as casualties of strong competition.
Analysis of potential new entrants
Although the airline industry is extremely competitive with very little profitability, new entrants continue to enter the market place. With established airline companies historically showing spurts of mediocre profitability punctuated by long periods of terrible profitability, it is somewhat surprising that new entrants would be a topic worthy of discussing. However, new airline companies are continuing to enter the market place, for example, Baltia Air Lines Inc. is one of the latest entries to dive into the snake pit of the airline industry in 2011.
Analysis of substitute products
With strong competition and threats of new entrants, the concern of substitute products is equally concerning. The service of airline passage is a text book example of a homogeneous product in that US Airways flight and Southwest’s flight are indistinguishable from each other. The end result is that the passenger arrives at their intended destination. This homogeneity only drives customers to substitute one airline for another exclusively on price. More notable is that consumers do have the option of traditional substitute products as automobile, bus, train, etc. However, these other modes of transport typically threaten regional airlines as opposed to the larger major carriers.
Analysis of Suppliers
The airline industry (on a fundamental level) needs three key continuous inputs: Labor, Planes, and Fuel. With any changes or threats in either area can quickly devour profits. The airline supply of airplanes are dominated by Boeing and Airbus, thus there is relatively no competition for prices on airplanes and parts. It also brings an additional threat in that this strong reliance on just two suppliers subjects the airlines to the internal health and direction of Boeing and Airbus. Any failure or disruption (even mild) for either organization would directly impact the airline industry. For example, recently “the U.S. Federal Aviation Administration proposed to fine Boeing Co. $13.6 million, its second-largest penalty ever, for delays in telling airlines how to prevent fuel-tank explosions on 383 aircraft (2012, Bloomberg). This disturbance could potentially affect the operations of airline companies. In addition, the airline industry is highly unionized and if a labor dispute or strike were to ensue, the industry would be devastated. Unlike fuel prices, both airplane manufactures and labor unions can be effectively dealt with to minimize future risk. Fuel prices, however, are unpredictable and extremely volatile. An embargo of gas from the Middle East, as with the 1973 Oil Crisis, could bring many airline companies into bankruptcy overnight.
Analysis of Consumers
The bargaining power of the buyers is indicated in the lack of loyalty. Airline passengers are fickle and price sensitive, yet demand less cancelations, fewer delays, and more amenities at no additional charge. Demands for better customer service by consumers is encouraging an already over regulated industry for more government intervention and mandates. If a customer sees a better price for an airline he/she will quickly take advantage of it. Some would argue that frequently flyer programs have encouraged customer loyalty; however, very little creditable data has been provided to substantiate such claims.
Summary of industry opportunities and threats
The airline industry is one of a few industries that Porter’s 5 competitive forces reveal major threats in all five areas. The existing competition is fierce with low-margins, while ironically new entrants to the market place continuous to replace the bankrupted victims of competition. Boeing and Airbus seem to reap all the profits from the airline market, while the consumer seems to be the only winner in the capitalistic game of competition. Meanwhile, a labor strike could bring the entire airline industry to a halt.
Over the years, Southwest Airlines has been scrutinized from college students to business analysts to near ad nauseam in an attempt to determine how they are able to consistently stay profitable while the competition seems to immerse in the red year over year. Many argue that it is the corporate culture that distinguishes it from the competition, while others claim it is the low-cost strategic model and leadership. Perhaps it is a combination. Perhaps it is none of the above. Regardless of the reasons, Southwest Airlines must find great comfort in that many have struggled to understand the reasons for their success and have been unable to duplicate it—as of yet!
Company Overview
Southwest Airlines entered the airline industry in 1971 with approximately 20 round-trip flights between Dallas, Houston, and San Antonio with three Boeings 737. The first two year[s], Southwest Airlines posted losses and followed it with 39 straight years of profitability. Fast forward to 2012, and Southwest Airlines posted a $178 million net income for 2011[i], over 700 Boeings 737, flying to 35 states (SWA, 2012). As in 1971, Southwest is still considered a low-cost carrier and has consistently been able to compete on cost-cutting measures and customer service. Southwest Airlines ticker is (LUV) and their top competitors are Delta Air Lines (DAL), US Airways (AAMRQ), and JetBlue Airways (JBLU); however, the airline industry fosters competition among all air carriers.
Comparison to Competition
Southwest Airlines does several things that have helped them maintain profitability over the years. First, Southwest flies only one type of plane—the Boeing 737 series. This allows parts, labor, training, and maintenance cost to be optimized and streamlined. Second, true to their nature, Southwest offers point-to-point flying, which bypasses the expensive hub-and-spoke model that network carriers and their competition use. In addition, it also offers direct flights more often to passengers at a cheaper rate. Finally, the modest in-flight service of Southwest has not held back consumers. With no assigned seating, no first class, and no meals included, one would assume this strategy would send customers away. However, Southwest has successfully aligned customer’s expectation for a low cost trip. Passengers are more than willing to make some trade-offs for lower fares. Southwest Airlines grew their domestic market share to 25% in 2011 and has maintained its position as the largest domestic airline based on passengers boarding in the U.S.
Southwest Airlines’ objectives are consistent. It seeks to continue the short-haul approach and point-to-point flights coupled with high employee retention to maintain their customer service at a high level. However, Southwest Airlines’ is also improving business and leisure travel and introducing international services at William P Airport in Houston to meet rising demand. (Boehmer, 2012)
Management philosophy
Former CEO Herb Kelleher, who founded Southwest Airline, was deeply committed to a philosophy of putting employees first. “If they’re happy, satisfied, dedicated, and energetic, they’ll take real good care of the customers. When the customers are happy, they come back. And that makes the shareholders happy” (Magretta, 2002). Southwest employees are among the highest paid in the industry which seemingly contributes to the low turnover rate compared to other airline companies. In addition to ‘putting people first’, the management philosophy has been to manage growth slowly around uncertainties in the market.
Organizational culture
Southwest Airlines has excellent workforce relations with its employees and it goes through astonishing steps to ensure that employees are appreciated and valued. The premise is that employees in return will understand and deliver the management philosophies to grow the company. This dedication was solidified when the CEO, Gary Kelly, began the 2012 annual meeting saying, “My top priority is protecting the job security of our more than 43,000 Employees and nurturing a Culture that excites them to come to work” (Bms, 2012).
Summary of the firm's strengths and weaknesses
Southwest Airlines firm operation strategy is contributed to its focus on the point-to-point model as opposed to the expensive hub-and-spoke model. This has kept the airline profitable while offering direct nonstop flights for approximately 76% of their customers. In addition, the ‘putting people first’ philosophy has translated in great customer services and how employee turnover compared to the industry average. However, these strengths can quickly turn into weakness if not managed properly. First, Southwest Airlines appears to be abandoning the short-haul model that has made them so successful. With the recent strategy to offer international flights out of Hobby airport in Houston Texas, one would argue that this contradicts the core mission of the company. In addition, the short-haul model can easily be replicated for new entry competitors that are not bound by contracts and long-term debt of hub-and-spoke airports. Secondly, Southwest Airlines is heavily unionized with 82% of its employees represented by unions. They have mitigated risk and labor strike avoidance thus far by highly compensating their staff. The escalating labor costs cannot continue and at some point must be addressed. Finally, very few would argue that Southwest Airlines excels at low-cost flights and corporate culture. But, what if competitors learn how to compete with Southwest on cost? What if a competitor can successfully implement a similar culture? What if the concatenation of AirTran employees to the Southwest Airline corporate culture is not successful and causes disruption throughout the organization?
Marketing Strategy & Objectives
In Southwest Airlines One Report™ their marketing strategy is the commitment to the “triple bottom line of Performance, People, and Planet” (2012). To meet the performance objective of profitability, Southwest Airlines plans to expand their route network, continue fuel conservation and hedging, and build on the benefits of the AirTran acquisition. The financial target is a 15% return on invested capital (pre-tax). The strategy for “People” is to nurture the existing corporate culture and to modernize part of the fleet to provide a better interior and customer experience. In addition, the fleet upgrade will help Southwest Airlines meet its commitment of protecting the ‘Planet’ with eco-friendly airplanes.
Analysis of sales and profits
For year ending 2011, Southwest Airlines posted total operating revenues of $15.65 billion with a net income of $178 million. In 2010, Southwest Airlines reported total operating revenues of $12.1 billion with a net income of $459 million and total operating revenues of $10.35 billion with a net income of $99 million in 2009. Over this three year period, fuel expense compared to total operating revenue has increased and salary compared to total operating revenue decreased.
Summary of marketing strategies
The marketing strategy for 2012 is three-fold: (1) increase profitability through expansion, fuel conservation and hedging (2) nurture existing corporate culture and enhance customer experience through modernization of airplanes and (3) continue the path of eco-friendly airplanes.
Situation Analysis Summary and Solutions
The primary problem that Southwest Airlines is facing is the escalating fuel prices which were the largest cost category in 2011. The fuel cost averaged a record $3.19 per gallon in 2011 which was nearly a 35% increase from 2010. Southwest has been somewhat successful in hedging the cost of fuel, but with fuel prices expected to continue to rise over the long term, the benefit of hedging will be diminished. Delta Air Lines recently purchased a refinery from ConocoPhillips to offset the risk of higher jet fuels prices (Mouawad, 2012). This vertical integration type of acquisition will be the future of the airline industry. With the IATA estimating that the airline industry fuel bill will grow an additional $40 billion from 2012, unconventional solutions must be explored.
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Boehmer, J. (2012). United Plans Houston Capacity Cut Amid SW Expansion. Business Travel News, 29(9), 40.
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[i] This includes the impact of purchasing AirTran in May 2011

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