Southwest Charts a New Flight Plan

Throughout its history, Southwest Airlines (LUV) prospered from organic growth, betting that its competitive labor costs, low fares, and unique corporate culture comprised the best arsenal against rivals. Yet with the U.S. air travel market stagnant and larger airlines consolidating into more dominant competitors, Southwest has been forced to rethink its traditional business model in recent years. The latest change came on Sept. 27, when the Dallas-based airline agreed to pay $1.4 billion to buy AirTran Airways, a unit of AirTran Holdings (AAI). The acquisition, only the third in Southwest's history, would give the discounter its first service in Atlanta, a Delta Air Lines (DAL) fortress for decades, and more flights from New York and Washington, D.C. "Southwest is saying it is no longer the airline of Ma and Pa—we are going to become the airline of the business person," says Alan Bender, a professor at Embry-Riddle Aeronautical University.

The deal will make Southwest a truly national discount airline and remove it further from its beginnings flying three planes between three Texas cities. With service to new secondary markets such as Wichita, Bloomington, Ill., and Huntsville, Ala.—plus additional cross-country options—Southwest will be better poised to capture more higher-paying business passengers. "The [network] holes are now officially plugged, and it is truly impressive what they've built here," says William S. Swelbar, a researcher at MIT's International Center for Air Transportation.

Analysts say Southwest had little choice but to pursue new business by buying a rival. Having already expanded its route map to 69 airports in 35 states, internal growth in a down economy was no longer an option. Southwest had no way to expand at a key business airport like New York LaGuardia or to break into Washington-Reagan and Atlanta because of facility constraints. Worse, domestic air travel—Southwest's sole source of business—has contracted in recent years amid America's lingering economic weakness. One result: The carrier posted a $120 million loss in the third quarter of 2008 (its first in 17 years) and has lost money in four of the past eight quarters. "We are not willing to make a bet on the economy or operating costs coming down," Chief Executive Officer Gary C. Kelly says. "And that naturally leads us to having a more energetic focus on 'Well, then how do we grow?' Fortunately for us we found a situation that lets us do that."

Consolidation Movement

The Southwest-AirTran deal was announced less than a week before Continental Airlines (CAL) and United Airlines (UAUA) were expected to close their merger, creating the world's biggest carrier. As part of the concessions needed to gain regulatory approval for that tieup, Continental ceded landing slots to Southwest at Newark, giving Southwest its first flights at the capacity-constrained New Jersey airport. The Continental-United combination will push that airline ahead of Delta, which claimed the title of biggest only two years ago by acquiring Northwest. Kelly denies that the consolidation movement played much of a role in his decision to call AirTran Chairman and CEO Robert L. Fornaro last spring to broach the topic of a deal. He does allow that "two of our legacy competitors have become stronger recently, and we'll need to reflect on that." However, Kelly adds, "to say that because four airlines have become two is the reason we are doing this deal would be grossly inaccurate. But I will admit the acquisition will make us more competitive."

It will also put the company even more squarely in the sights of Delta, which turned Atlanta into the world's busiest airport with the "hub-and-spoke" system of funneling passengers to their destinations. In July, Delta and its regional affiliates controlled 76 percent of passenger traffic at Hartsfield-Jackson Atlanta, according to figures from the airport. AirTran's market share was 17 percent the same month. To Kelly, that signifies a high-fare environment ripe for Southwest service. "We need more flights on a combined basis [in Atlanta] than AirTran has today," he says. "And I do mean significantly more flights—more than a couple." Such a move could spark a fierce response from Delta, akin to a "defend the fortress hub strategy," as Hudson Securities analyst Daniel McKenzie wrote Sept. 28 in a note to clients.

Southwest has already made a few decisions on integrating the two airlines: It will scrap AirTran's $20 checked-bag fee, assigned seating, and two-class cabins, while keeping that airline's 86 Boeing 717s. Adding the smaller jet will require new crew scheduling and maintenance protocols, adding complexity to its time-honed operations. The airline will also acquire its first international flights through AirTran's existing service to Aruba, Cancun, the Dominican Republic, and Jamaica. "We want to have greater appeal to more customers nationwide," Kelly says. "We are at the point where we can think that way after 40 years."

The bottom line: In a bid to continue growing and lure more lucrative corporate travelers, Southwest Airlines is paying $1.4 billion for AirTran.

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