- The Washington Times - Monday, October 30, 2006

Southwest Airlines, the savvy low-cost carrier that became the envy of the industry, is showing signs of losing altitude.

The airline recently reported that its net income plunged 77 percent in the third quarter to $48 million (6 cents per share) compared with $210 million (26 cents) a year earlier.

Southwest blamed the downturn on the dramatic rise in fuel costs this year, a foiled airline bomb plot in August and an overall softening in demand for air travel.

But the problems facing the Dallas carrier are much more deeply rooted, many airline analysts say, and unless the airline makes significant changes to its lauded business model, it faces serious consequences.

“They have huge problems,” said Michael Boyd, a Colorado airline consultant who has studied Southwest for years.

Southwest was able to transform itself from a tiny regional carrier in Texas in the late 1960s into the country’s largest low-cost carrier by adopting a revolutionary business model.

The airline has shunned the traditional practice of establishing airport hubs in favor of flying short and medium-range routes. This “point-to-point” system allows for planes to fly five or six times a day, maximizing employee and airplane productivity.

Another Southwest hallmark has been to fly to medium-size markets and secondary airports in major cities with little competition. Thus, airports such as Midway International in Chicago and Long Island MacArthur Airport outside New York became Southwest staples.

But Southwest’s system appears to have outgrown its usefulness.

“The problem with that model is that when you get too big, like Southwest is right now, it’s not easy to find shorter-haul, high-density markets,” said airline analyst Anthony Tangorra, chief executive of Latitude Transport Advisory. “They’re running out of [markets] that fit their model. As a matter of fact, you could say they’ve run out.”

Southwest has been forced to fly to busier, more competitive airports — such as Philadelphia International, Pittsburgh International, Denver International and Washington Dulles International — to maintain its self-imposed 10 percent annual growth rate.

“They have to go into markets now where, instead of generating traffic with low fares, they’ve got to go in there and claw [passengers] from other carriers,” Mr. Boyd said.

Southwest’s monolithic fleet is another problem, analysts say. The airline flies only Boeing 737 planes — medium-range aircraft that generally are too large or too impractical to fly into smaller regional airports.

“They’re between a rock and hard place because, as it stands today, the real growth nodes are places like Greenville-Spartanburg, like Charleston, S.C., like Shreveport, and they can’t access those places with their planes,” Mr. Boyd said.

With dozens of new 737s on order, Southwest isn’t expected to acquire the smaller planes it would need to serve smaller markets any time soon.

Despite the challenges, many industry watchers expect Southwest to overcome its hurdles by overhauling its business model and reinventing itself.

“They’re getting to be in a pretty tight spot,” Mr. Tangorra said. “But it doesn’t mean they’re going away any time soon, because they still have a very healthy relative cost advantage versus the competition.”

Ray Neidl, an airline analyst with Calyon Securities, says Southwest has plenty of opportunity to expand routes at its existing airports.

“They may run out of places to fly to — maybe by the year 2075,” Mr. Neidl said. “Then they’ll just start expanding to Mexico or the Caribbean.”

Mr. Neidl last week raised his equity rating for Southwest to “add” from “neutral,” and predicted the airline will meet its projected 15 percent growth rate for next year.

Southwest’s aggressive policy of fuel hedging — buying fuel in advance at set prices — before oil prices skyrocketed this year has proven to be a good financial risk.

“Southwest is an entity unto its own,” Mr. Neidl said. “It’s got a name, it’s got a product, they’ve got lots of places to expand. They just can’t get [new] aircraft fast enough.”

Southwest Chief Executive Gary Kelly understands the challenges facing his airline and isn’t shy about making changes, Mr. Boyd said.

“We’ve been telling other carriers that they better watch out for Southwest, because the Southwest you know today will not be the Southwest you know tomorrow,” Mr. Boyd said. “They’re going to be the nastiest competitor in town in five years because they’re going to fix their problems.”

Southwest already has tinkered with one of its sacred traditions in the summer when it experimented with assigning seats on a few flights.

“If they’re going to expand to places where they’re not known, they’re going to have to [assign seats]. And they know that,” Mr. Boyd said. “When you’re competing with [low cost airlines] that have seat assignments, as well as wider seats and free TVs, that looks a whole lot better than the ‘fall of Saigon’ boarding method where you’re just shoving yourself onboard.”

Mr. Kelly said passenger reservations are strong for the fourth quarter.

“Although [our] revenue momentum has slowed, demand for low fares has continued and, overall, our revenue growth [potential] is healthy,” Mr. Kelly said.

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