By Acquiring AirTran, Will Southwest Continue to Spread the LUV?

Southwest’s recently announced plan to acquire rival AirTran is nothing new for the industry, but represents a departure for the Dallas-based discount carrier. Plagued by higher fuel prices and capacity issues, airlines in the U.S. have in recent years turned to consolidation as a way to cut costs and remain competitive.

The Southwest-AirTran merger (valued at $3.4 billion when AirTran’s aircraft leases and debt are included) now awaits regulatory approval. The announcement comes hot on the heels of similar deals between Delta and Northwest and, more recently, United and Continental. If the AirTran purchase is approved, Southwest becomes the nation’s fourth largest airline. In addition, the company will start moving further away from its long-running strategy of point-to-point service to second-tier airports. As the airline expands, experts say, the challenge will be retaining its reputation in a sector prone to tumultuous business cycles.

Southwest has grown steadily, thanks to a streamlined service model that employs only one type of aircraft and focuses on smaller airports with lower operating costs. The company has also become known for relatively high employee morale and strong customer service. “Southwest is evolving,” says Wharton business and public policy professor W. Bruce Allen. “The only question is, can they remain Southwest as they get bigger?”

According to Allen, the AirTran acquisition is another step in Southwest’s move toward setting up shop in larger airports in major cities, such as LaGuardia in New York and Ronald Reagan Washington National Airport. Southwest currently has limited presence at those airports because takeoffs and landings there are controlled by the slot system, a government-administered lottery designed to relieve congestion at busy airports. Merging with AirTran also gives Southwest a major position at Atlanta’s Hartsfield-Jackson Atlanta International, the world’s busiest airport and the only major U.S. market not currently served by Southwest.

For decades, Allen notes, Southwest has expanded largely through organic growth in small markets at airports on the fringe of major cities. For example, the company served Boston residents through airports in Rhode Island and New Hampshire. Using smaller, less congested airports allowed Southwest to turn its planes around quickly and keep costs down. Eventually, however, the company ran out of those opportunities and began to expand into major airports. The AirTran merger would give Southwest new or expanded presence in 63 markets including Milwaukee, Orlando and, most importantly, Atlanta. AirTran has a 22% domestic market share at Hartsfield-Jackson airport, with half of its flights originating and terminating there. The acquisition will give Southwest access to new customers by connecting passengers through the Southeast.

In announcing the proposed merger, Southwest leadership estimated that folding AirTran’s operations into its own would cost $300 to $500 million, but that by 2013 the deal would reap $400 million more per year due to cost cutting and more spending by customers. “[Buying AirTran] makes Southwest a truly national low-cost carrier with its footprint,” notes Dan Kasper, an airline analyst with LECG Consulting in Boston. “It can now do pretty much what the legacy networked carriers do, which is take passengers from anyplace in the country to anyplace else.”

Founded in 1971 as a regional air carrier with flights between Dallas, Houston, and San Antonio, Texas, Southwest now carries more passengers than any other low-cost carrier in the world. In 2009, Southwest flew 86 million passengers and had revenues of $10.4 billion. The company, headquartered at Love Field in Dallas, uses the ticker symbol LUV and has 34,726 employees. The company reported net income of $112 million on revenue of $3.17 billion for the second quarter of this year. Southwest was among eight of nine largest U.S. carriers posting a profit in the second quarter (only American Airlines reported a loss).

AirTran’s roots go back to 1992 when it was founded as ValuJet, a low-budget airline based in Atlanta. In 1996, the company faced a safety investigation after one of its planes crashed in the Florida Everglades, killing all 110 aboard. The following year, ValuJet acquired smaller AirTran Airways but took on the AirTran name. Headquartered in Orlando, AirTran has 8,000 employees and carried 23 million passengers last year. The company’s 2009 revenues were $2.34 billion. AirTran made $12.4 million on revenues of $700.6 million in the second quarter of this year.

Elizabeth Bailey, Wharton emeritus professor of business and public policy, says the proposed merger makes sense for both companies. AirTran was probably “delighted” to accept Southwest’s offer on behalf of its shareholders, she says, and Southwest gains new access to passengers in areas where Delta currently has a stronghold. “I think a combined Southwest and AirTran will be a strong competitor. A lot of their routes strengthen each other.” According to estimates by Southwest, only 11.9% of the airline’s current seat distribution is in the Southeast; the merger with AirTran will up that figure to 17.9% and also give a slight boost to seat distribution on the East Coast.

Given its major presence in Atlanta, Delta would appear to be the legacy carrier facing the biggest competitive impact from a Southwest-AirTran merger. But the effect may be minimal, at least in the short term. In a September 28 research note, JP Morgan analyst Jamie Baker wrote that about 10% of Delta’s estimated $2 billion local demand base in Atlanta comes from flights to cities served by Southwest. That amounts to less than 1% of Delta’s overall business. In light of the Southwest-AirTran deal and mergers between Delta and Northwest and United and Continental, observers are also watching for American Airlines to make a similar move. “We don’t believe Southwest-AirTran warrants an immediate competitive response from … [American],” Baker wrote. “We do wonder whether JetBlue, Spirit and Virgin might view their standalone prospects differently today versus this time last week.”

Wharton’s Allen points out that the AirTran acquisition gives Southwest its first international routes — with service to Puerto Rico, Aruba, Mexico and the Bahamas. These new destinations are expected to help boost loyalty to Southwest through its frequent flyer program now that a few more “exotic” locations are available. “Before, you could go to Lubbock if you had enough miles,” he jokes.

Another major change, Allen notes, is that AirTran will bring new types of aircraft into the Southwest fleet. Historically, a key element of Southwest’s business model was keeping operations simple and costs down by flying only one type of airplane, the B737. In a report, Hunter Keay, airline analyst at Stifel Nicolaus Capital Markets in Baltimore, Md., wrote that AirTran operates 87 B717 and 52 B737-700 aircraft. He expects Southwest to fly the planes under its own colors and its own interior seat configuration, eliminating AirTran’s first-class section. According to a Q&A about the merger on Southwest’s website, the company emphasizes plans to continue offering only one seating class and no assigned seating on its planes.

As for Southwest’s signature low prices, Bailey predicts that despite the consolidation on some routes, Southwest will continue to provide discount fares. “There may be some places where both Southwest and AirTran fly that might go up a little bit, but I think it’s going to be good for the consumer overall,” she suggests. In addition, Keay noted in his report that most of the 31 overlapping routes served by both Southwest and AirTran are leisure markets where it is difficult to pass along price increases.

In an interview with The Dallas Morning News published October 3, Southwest CEO Gary Kelly said that the company will continue to keep prices down. “We are a low-fare carrier. That is who we are. That is how we’ve established trust over 40 years,” Kelly told the newspaper, noting that the carrier did not raise prices following past mergers. “We’re not going to change who we are. We’re expanding who we are. We’re taking low fares farther.”

Customers in markets where Southwest previously lacked a presence may see a difference, however. JP Morgan analyst Baker wrote in a research note  that Southwest fares on shorter routes averaged about 30% higher than AirTran’s; for longer routes, Southwest charged about 16% more in terms of yield, or fare collected per passenger per mile. Baker predicted that, once the merger is approved, the costs and fares for all routes will be marked to Southwest levels.

But Todd Sinai, a Wharton real estate and business and public policy professor who has done research on the airline industry, says that even before Southwest enters a market, prices begin to come down as competitors prepare to meet the challenge. Despite consolidation within the market, the arrival of Southwest can lead to lower fares. “Think about places where Delta might have [several] flights and AirTran has one endpoint. If Southwest now has the other endpoint, that can lower fares on the route,” Sinai notes.

Absorbing AirTran

The biggest obstacle for Southwest post-merger will be bringing two different cultures into line, according to Wharton management professor Peter Cappelli. “It will be tricky for Southwest,” he notes. “Southwest’s whole business model is built on a particular approach to managing employees. It’s a big bet they are making that they can swallow AirTran.”

Cappelli says Southwest puts enormous effort into the selection and training of new employees. Based on current operations, Southwest estimates that the combined company would have about 43,000 employees serving more than 100 million customers at 100 different airports (four new airports are expected to be added in 2011.) “Now this is a very different approach, taking thousands of [AirTran] employees, dumping them into the system and hoping it works. It’s a pretty risky move.” Cappelli adds that airline mergers are always difficult because integration has to take place while a carrier continues to carry out complex operations: “You have to fly the planes. There’s not a lot of time to put people through an orientation program.”

Integrating workers in terms of pay and seniority is another challenge. “The big issue that often destroys airline mergers is the seniority scale — particularly for the pilots,” says Cappelli. “You’re going to find that people who are captains will no longer be captains [in the merged company].” Southwest and AirTran cannot even turn to the large legacy airlines that have merged for guidance on this problem. “I don’t know that the legacy carriers have learned anything. They just suffered through it.” Indeed, last month, pilots staged a protest at Philadelphia International Airport complaining that they still do not have a unified labor agreement five years after the merger of U.S. Airways and America West Airlines.

According to Keay’s report, Southwest enjoys good labor relations even though 80% of its workforce is unionized. He says Southwest pilots earn nearly 30% more than AirTran’s pilots, but that Southwest is likely to boost the pay of those coming in from AirTran to comparable levels. Managing seniority issues will be more difficult. Southwest pilots outnumber Air Tran’s pilots by five to one and would want to push AirTran’s pilots to the bottom of the seniority list, creating “a tense situation and potentially disrupting [Southwest's] non-confrontational culture,” according to Keay.

No matter how good a merger looks to top executives on paper, Allen adds, the difficulty is in making it work after the deal goes through. “The reality is that once you get married, you suddenly see dirty laundry you didn’t see when you were dating,” he points out. Southwest has some past experience to draw from — the airline has made smaller acquisitions in the past, acquiring Muse Air in 1985, Morris Air in 1993 and ATA Airlines in 2008. Last year Republic Airways outbid Southwest for Denver-based Frontier Airlines.

While Southwest and AirTran are both considered discount airlines, Cappelli says the two companies do not operate with the same strategies. Southwest relies on simple cost and fare structures, selling one class of tickets with no assigned seating via its own website, while AirTran has more differentiated service, selling tickets via third-party sites like Expedia and Priceline. Southwest charges no reservation change fees or fees for up to two checked bags. AirTran, meanwhile, charges $75 for reservation changes made after a purchase, in addition to a fee of $20 for the first checked bag and $25 for the second. AirTran earned $250 million in fees last year. Kasper says Southwest has done an analysis showing that its “bags fly free” policy has boosted revenues by 1% to 2%. Southwest officials have said that they plan to continue the no-fee policy after the merger.

As discount carriers, Southwest and AirTran compete for some of the same customers, and the rivalry has included skewering each other in recent television commercials. AirTran produced a commercial showing people dressed as cows being herded onto the runway as an AirTran passenger watches from her first class seat while sipping a cocktail. Meanwhile, Southwest ran a commercial featuring pumped up Southwest baggage handlers heckling a rival plane that charged to check bags. The plane’s logo was blurred, but it was identifiable as an AirTran plane.

According to Jay Sorensen, a former airline executive and president of the Wisconsin-based IdeaWorks consulting company, Southwest does not have to unbundle its fees and charge a la carte for services in order to compete effectively against Delta and the other large legacy carriers that have adopted fee-based programs. He says many industries have competitors offering flat fees that survive alongside companies that slice and dice offerings in order to charge customers only for goods and services they find most important.

Blurring the Lines

If the Southwest-AirTran merger wins regulatory approval, it will represent another major consolidation in an industry which tends to experience boom and bust cycles, but has gone through a particularly difficult period following the terror attacks on September 11, 2001, and then the global financial crisis. Many of the nation’s largest airlines, including US Airways, United, Northwest and Delta, spent time in bankruptcy court within the last decade and have now reduced capacity substantially.

Prior to the Southwest-AirTran announcement, Delta acquired Northwest in 2008 to become the world’s largest airline — only to have that title usurped by a merger of United and Continental, a deal that was finalized in September. Allen says that the most recent wave of consolidation among the legacy carriers, along with the Southwest-AirTran combination, may reflect a decision by companies to compete by limiting capacity rather than waging price wars that destroy earnings throughout the entire industry.

Kasper, the airline consultant, says it seems that the industry may have learned its lesson about overexpansion, but history is not in their favor. “I’m going to wait and see what happens,” he notes. “Post 9/11 and with the economic crisis, they’ve looked over the abyss twice now and that has scared the current crop of managers pretty well…. But the question remains, when things pick up as they’re starting to do, will they still keep their eye on the bottom line?’”

According to Bailey, industry consolidation has been underway since airline deregulation began to take effect in the 1970s. “There were an artificially large number of companies. If you think about any other industry, like autos, there are only three big producers in the United States.” She says that in the long run, the market could be served with three to five major carriers where there once were 20. “I’m very pleased to see Southwest is going to strengthen the discount section of the industry because the rest of the industry has been consolidating.”

The Southwest-AirTran deal not only reflects the consolidation trend in the industry, but also a convergence in the market between the low-cost carriers and the large legacy names, Kasper notes. He says that the big carriers are offering stripped down operations, competitive fares and fewer frills than in the past. Meanwhile, Southwest is increasingly able to offer coast-to-coast networks and overseas flights, like the big players. “It’s getting harder in the back of the plane to tell the difference between Southwest and the legacy carriers.”

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