South for Southwest

It used to be that Southwest Airlines was a one-of-a-kind investment. In an industry more prone to bankruptcies than profits, Southwest was both an amazing stock and an even better operator.

Investors who bought in at the dawn of deregulation were up 20,230% as of year-end 2015. Up 3,990% from 1990 to 2015. Or 10x the S&P 500.

For an airline stock.

Herb Kelleher became a legend off the back of that performance. And the praise was justified.

Which is why it is so strange to fast forward to today. Southwest is in the dumps, badly trailing the other major airlines. And activist Elliott Management is coming for blood, building a substantial stake and calling for the company to overhaul the board, fire management, and get rid of a lot of the things like free bags and no segregated cabins that made Southwest famous.

Consumers are going to hate to hear this, but Elliott is right about almost everything. My only quibble is Elliott’s belief that the stock can jump almost 80% within a year if fixes are made. While the fixes are needed, I don’t think the payoff will be quick or is guaranteed to happen. Southwest is caught in a tight spot and while there are obvious moves, there are no easy solutions.

A few thoughts:

1.) This has not happened overnight

A lot of the narrative around Southwest from outsiders involves “wow, when did that happen?” Truth is it has been brewing for nearly 15 years. Southwest made its money in part by being the only smart person in the room for decades. The legacy airlines lived in a pre-deregulation, limited competition world where share was everything and for years chased marketshare blindly and with no regard for profitability. And surprise, surprise, that didn’t work.

To understand the U.S. aviation market, it is helpful to think about the world before and after September 15, 2005. That’s the date Delta filed for bankruptcy. and the beginning of the evolution of the industry. The filing, and the other filings that followed, sparked a round of consolidation (Delta/Northwest, United/Continental, American/US Airways, Southwest/AirTran) that reshaped the industry and left four airlines in control of more than 80% of the domestic market.

It also was the beginning of Delta’s rethink of how to do business, with a focus on profitability over marketshare. It is a model that has been successfully copied by others in the years since. This was the beginning of all of those fees you find so annoying but which are so damn impactful, and the beginning of using technology to better price the product based on demand. The technology also allowed the airlines to carve economy seating into subsections based on specific customer demands, extracting extra revenue from those who wanted extra legroom or priority boarding but also allowing for profitable price matching against discounters for those who didn’t.

In short, the competition caught up and Southwest stayed put. Absent the low-cost and pricing power advantages it once had, Southwest instead focused on differentiation. That meant not tacking on the fees for bags and early boarding. Consumers did appreciate it but were not willing to pay extra for it.

That might have worked if Southwest still had a real cost advantage. But time and size had caught up with it. Labor groups (understandably) felt that given Southwest was the largest U.S. airline in terms of marketshare, they should be paid accordingly. Southwest for a while succeeded on winning loyalty, but it didn’t translate into strong margins.

2.) This is not Boeing’s fault

Southwest is famously an all Boeing 737 operator, so it has been hit harder than most by Boeing’s issues with the plane. Southwest had to rejigger growth plans because deliveries have slowed. That hasn’t helped, but as said in point #1 there is a lot more going on here.

Yes, Southwest has underperformed this year. But shares of Southwest have underperformed Delta significantly over the past five- and ten-year periods. That’s even if you include dividends. This patient was sick long before Boeing started sneezing.

3.) The cure is going to hurt as much as the illness

So, what is Southwest to do? Elliott would like to see a board and management overhaul (makes sense), they want to see technology modernized (an absolute must. The current tech is prone to failure and does not allow for the nimble pricing others enjoy). And they would like Southwest to take a hard look at the fees that it has so far refused to embrace.

It all makes sense on paper. Most of it are things management should consider with or without Elliott. But as noted before, Southwest no longer enjoys the structural cost advantage it once did. At best it is largely on par with the likes of Delta or United, and airlines like Frontier and Spirit can easily undercut them. Its point-to-point route network is ideal for quick hops but it means more connections for those traveling cross country, putting it at a competitive disadvantage when prices are equal.

Southwest’s strongest asset is its brand loyalty. But if a big part of the turnaround means going back on all of the (sometimes bombastic, always adamant) promises made in advertisements about bags flying free and Southwest being the alternative to airlines who nickel and dime them, how strong will that brand loyalty be a year from now?

The current plan is not working for Southwest. Change is needed. But part of that change (the tech upgrade) requires more spending. The revenue part of it risks alienating its most loyal customers, or at least commoditizing the product. It represents the final crumbling of the “Southwest is different” narrative and will likely make this just another airline. There isn’t really a strong, compelling reason to invest in just another airline.

There is nothing wrong with what Elliott is suggesting. But the activist’s involvement doesn’t make me want to buy Southwest shares.

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