The Not-So Southwest Effect

Southwest Airlines (NYSE: LUV) posted a first quarter net profit of $93 million. It also warned of expiring fuel-hedge advantages and weakening passenger traffic that will negatively affect second quarter results. While fuel-hedging has a couple more years to go before expiring, lackluster traffic growth—partly the result of Southwest’s overambitious expansion and not just a sign of a slowing economy—looms as Southwest’s more pressing problem.

Of late, Southwest’s expansions into new cities have not created the “Southwest Effect” that for decades had been its formula for success. Back in 1993, Southwest, still a regional airline at the time, successfully used the Southwest Effect to sweep into Baltimore-Washington International Airport (BWI), its first Northeast destination and a hub of then-called USAir. Within one year of service, Southwest had carried more passengers than USAir on every route it served, and eventually caused USAir to dismantle the hub.

Now, at Philadelphia International Airport (PHL), Southwest grew from the original 16 daily flights and 6 destinations in May 2004 to today’s 47 flights and 18 destinations. However, passenger enplanements trail US Airways on every route, and the planes are flying emptier. Service to Hartford, which was discontinued in March, had an average load factor in the low 30s. Five other routes have load factors below 60 percent. Columbus, O., may be the next to get the axe.

The latest foray into Washington-Dulles Airport (IAD) began last fall with flights to Las Vegas, Orlando, Chicago/Midway (MDW), and Tampa. Early numbers show some mixed success in capturing traffic from low cost competitors AirTran (NYSE: AAI) and US Airways/America West (NYSE: LCC), and there is also little evidence that the flights are cannibalizing Southwest’s own traffic out of BWI. On the other hand, Southwest is flying a lot of empty seats on the seven daily flights to MDW, which have an average load factor of 43%. The flights may also be cannibalizing Southwest’s BWI-MDW service. Meanwhile United, the largest carrier at IAD, has added capacity and filled proportionally more seats than Southwest—and therefore increased its market share.

Southwest’s expansion into Denver International Airport (DEN) is seeing similar disappointments, as it continues to trail the airport's two hub carriers–Frontier (Nasdaq: FRNT) and United (Nasdaq: UAUA) on most routes it competes, even though it offers nearly the same number of seats as Frontier.

Southwest has traditionally operated with lower load factors than competitors because of its focus on saturating markets with frequent flights. However, there is reason to be concerned about the inability to fill more seats lately. As many of the competitors have successfully restructured in bankruptcy, Southwest no longer enjoys the kinds of cost advantages it once enjoyed. Had there not been fuel hedging, it’s not exactly clear how profitable Southwest would actually be.

At issue is the airline’s current pace of growth. This year the airline plans to add more than 30 aircraft and expand capacity by 8 percent. Where are the new planes going to go? Recent expansions into congested hubs are a symptom of the problem of too many seats. Southwest is running out of new markets, so it is banking on a wing and a prayer that it could drive out one of those carriers at one of those hubs.

It won’t be as easy this time as it was at BWI. Competitors are financially stronger for a prolonged fight, and at hubs Southwest faces huge disadvantages against dominant carriers that offer more flights and have huge frequent flyer bases. In failing to create the Southwest Effect lately, Southwest faces the difficult challenge of keeping revenues in pace with rising costs, without raising fares that Southwest has repeatedly stated it won’t do.