In this Business Breakdown, Jenny Rae Le Roux (MC CEO) and Namaan Mian (MC COO) dissect the Southwest Airlines Business Model - and how to fix it. They'll share:
- The Southwest Airlines business model (fixed cost or variable cost?)
- Key metrics for Southwest to pay attention to
- Hot takes on what's next for Southwest
Do you have a hot take we missed? We'd love to hear it - reach out today.
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Transcription: Southwest Airlines Business Model
We think about Southwest probably more than the average person would, because after all, we're in the consulting industry. And when it comes to flying, there are just a couple of options inside the US and Southwest. If it's a direct flight, and if it's going at the right time, and if it's the right price, we will get on a Southwest flight, just the same as we would any of the other majors in the US.
But Southwest also has specifically made the news recently, and we thought this would be a really great target for a business breakdown, because airlines in general, but Southwest specifically, I think is often misunderstood. When you think about how to optimize it, this is a business challenge that even the smartest people in the airline industry haven't really been able to crack. Airlines are notoriously tough, according to famed investors like Warren Buffett.
So we're really excited today to go through what is for us, a very quick and dirty look at Southwest, not at all the deepest expertise. We are not deep investors in Southwest. We have not been studying it for ages.
Key Metrics
This is what we would expect you to do at the beginning of a case interview or pre-day one, the first day of an engagement to just get quick and dirty, really smart on an industry like Southwest. So I'm going to just kick off by sharing a few of the key metrics about the company and why we thought this would be interesting today, and then I'll pass it over to Namaan. First of all, we've got annual revenue in 2023 of $26.1 billion.
These are big revenue organizations. However, on that, annual operating income was $224 million. So comparatively, we have a super, super tiny percentage of that revenue that's turning into profit for the organization.
There are 4,000 approximately flights per day on Southwest. The average passenger load per flight, the revenue passengers carried is about $137 million in total over the course of the year, and the number of planes that Southwest has in the fleet is 817. So with all of that, you would kind of expect, okay, Southwest has been around for a while, but there is some activist interest in Southwest now, at the time that we're filming this on October 9th, 2024, because in Q2, 2024, they had a 46% drop in year over year profits, the Q2 of 2023, despite revenue growth.
So even though they're growing their revenue, you're seeing that they're actually really falling down on the profitability of the business. So I'm going to pass it over to Namaan to break down for us how you would think about this business at large. What's the business model?
Metrics SW Is Looking At
How should Southwest be thinking about itself? Where might they be going wrong? And what should they be thinking about to fix it?
Absolutely.
Thanks so much, Jenny Rae. First, let's just break down the business model really, really quickly. Southwest Airlines is primarily a fixed cost business, meaning that it costs you roughly the same to fly a half empty plane than it does a full one.
And so when Southwest thinks about its profitability, when it thinks about the metrics it should be managing to, it really should be thinking about how it can fill planes with paying customers more than how it can extract every single last cent of revenue out of each customer that it's serving. Like this is a volume play for Southwest and for every other airline, and those are the metrics they should be managing to more often. And so the three metrics that I think about managing to and looking at when I think about Southwest Airlines are as follows.
First, I think about passenger load factor. Second, I think about revenue per available seat mile. And then third, I think about revenue diversification.
Passenger Load Factor
So let's start with number one. Passenger load factor is really butts in seats. How full are the planes that you're flying?
And so for the quarter ending June 30th, 2024, that's the Q2 January that you mentioned, where performance was dismal, Southwest passenger load was only 82.6%. That was almost a one percentage point drop from the Q2 2023. And so in a fixed cost business, again, where it costs you roughly the same to fly an empty plane as it does a full plane, load factor is the first metric I'd be looking at to try and reverse that decline in profitability.
And so the way that I think about this to get a little bit more tactical is, does Southwest need to adjust its route network to increase its load factor? Flying different routes at different times on different days, will that help me increase my capacity? So perhaps do I fly less on off-peak days?
Do I fly less on Tuesdays and Wednesdays? Do I add red eyes to my network? Do I increase capacity where there's demand and cut demand from airports or cut capacity from airports where there's less demand?
These are some of the tactical decisions that Southwest is looking at. These are some of the tactical decisions that the activist investor is forcing Southwest to look at as they look to improve their load factor because that is a primary driver, not just of revenue, but of profitability as well.
Revenue Per Available Seat Mile
The second metric that I would be looking at is revenue per available seat mile. And this is kind of industry parlance, but rarely the way to think about this is that this is total operating revenue per seat. And more specifically, it's operating revenue per seat that's flown one mile.
So it's your unit revenue measurement, and this helps you compare efficiency between Southwest and other airlines. And so in Q2 2024, Southwest Airlines' revenue per available seat mile decreased almost 4% year over year. Now the company had projected a decrease in this metric by only 1.5% to 3.5%.
So even though the number of passengers that Southwest Airlines served increased, their revenue per available seat mile decreased. What does this mean? It means that Southwest is operating more flights but they're less full.
And so again, this goes back to your load factor. When your load factor decreases, your revenue per available seat mile also decreases. And so this is part of the reason why the airline is starting to pay attention to the next metric that I highlighted, which is revenue diversification.
Revenue Diversification
So when you think about competitors like Delta, 56% of the total revenue at Delta is made up of premium, loyalty, and other diversified revenue streams, not necessarily ticket prices. So this is why you see this activist investor pushing Southwest to move into assigned seating, premium cabins, international alliances, right? Southwest has a capacity issue.
It only flies Boeing 737s. And because Boeing has production issues, it means that the airline cannot expand capacity to turn the dial on revenue and profitability. So if you can't expand capacity, what's another way that you can do this?
You can diversify your revenue streams, and you can diversify your revenue streams into higher margin products and services. So Jenny Rae, those are the three things that I'd be looking at and thinking about if I was on the board of Southwest. How about you?
Well, I think that it's good that we didn't compare notes ahead of time because mine are similar. And this will be one way that I really will know that we didn't compare notes because if we tried a little harder, we might have come up with complimentary ones. But I was puzzled by this issue.
Revenue Growth But Decline In Profitability
I think one of the first things that really caught me is that they have this revenue growth but the decline in profitability. So I have to have this assumption that they're pushing revenue in areas that are the most expensive for them to operate. So I just want to note that at the beginning because out of everything that you said, it was really revenue focused, that's how you would think about a capacity constrained business just like this one.
It's not on a per margin, per customer basis. It's really like how across the network do you drive maximum revenue. But I do feel like there's a piece of the story here that we may not get to.
But that being said, my three were number one, the average percentage of seats empty. So I was flipping the number that you were thinking of, but I was trying to figure out, hey, you know, how do we get that, how do we get those seats sold? And do we do it, you know, the way that Southwest normally does it is through very high price capture in the last week.
But maybe there needs to be a less time oriented and a more capacity oriented pricing model at Southwest. So I've noticed that if I'm booking, and I book, you know, eight, ten, twelve weeks in advance, I can get really inexpensive fares on Southwest. If I book the week of, doesn't matter.
I can book, I can look at eight flights in a day. And I can make an assumption that some of the times, those flights are different capacities of fullness. But all eight flights will be exactly the same price.
That doesn't make a ton of sense to me. There are probably some that I should be optimizing price higher for, and others that I should be optimizing price lower for. That rolls into my second one.
Revenue Per Flight
The second one is revenue per flight. If I were building a chart of thinking about the beginning of a case interview, this would be one of my core metrics that I would think about. Because the unit of sale here is a seat to a customer.
But actually, the unit of operating revenue is the unit of a flight. And when I think about the variable cost that do go in, and then the allocated fixed cost, how much of my plane do I have to allocate to the specific flight on top of the direct cost, the jet fuel, the staffing, et cetera? When I think about that, I'm kind of like, oh, you know, I really feel like there's some other opportunity here.
I didn't look at any comparable airlines, but I would be super interested to see how well other airlines do at selling food. For example, like on a Southwest flight, you can get really hungry on a three or four hour flight. They don't have anything.
I mean, it's just a bag of snacks. And I've had to like run off of planes with my kids on a Southwest layover to go get food because we know we can't buy on the flight. We're a captive audience.
They could have sold us $20 hamburgers on that flight. Maybe it's really logistically not sensible. Maybe that's not enough of a line item.
But thinking about that revenue per flight, you don't just have to think about your seat sales. You can think about other capture on the plane as well. The third one that I thought of, kind of along with your revenue diversification, but I just doubled down specifically on one number.
Other Factors
And one of my clarifying questions if I were doing this in a case would be, am I factoring in airline operating revenue only, or am I factoring in other types of revenue? And I would really have appreciated if somebody asked that question of me, if I were the interviewer, because I happen to know just from a little bit of understanding that airlines are credit card companies wrapped as airline operating businesses. And my dad used to work for a retail store, kind of like a Sears or a JCPenney, and really functionally their store became a credit card company wrapped in a retail store, right?
And it's such a profitable operating model. So I did do a little bit of digging, and I actually couldn't find specific Southwest disclosed numbers. They do have a partnership with Chase the same way that United does.
The Delta American Express partnership is the gold standard of the industry. Delta makes over $6 billion a year in revenue, which is literally just like that revenue that falls directly to the bottom line. They don't have to manage a lot of that.
There's a small group internally that has to do that. So I, if I were at Southwest, would think about other ways that we could drive revenue off of the brand and the user base that weren't directly related to airline operations. Namaan, back to you to wrap us up.
Future Of Southwest
So Jenny Rae, I've got two hot takes around the future of Southwest Airlines. One that's a little bit warmer than the other. So I'll start with the warm one and I'll get to the hot one.
First is actually really related to where you just ended, which is that I think that the credit card revenue that Southwest is able to generate on an annual basis really grows exponentially as you can start to associate more tangible perks with having a Southwest credit card. Like if I have a Southwest credit card, does that entitle me to a certain number of seat upgrades a year? Does that entitle me to a seat in a premium cabin?
Now that they're rolling out these diversification, now that they're rolling out these revenue diversification options, you can tie some of those perks to the credit cards. So I think you're going to see an explosion in that revenue that does fall directly to the bottom line. I think longer term, what you're going to see is that Southwest is eventually going to move away from point to point flying.
Like they're going to move away from the Austin to Albuquerque flight and more towards a hub and spoke model. And this would be a wholesale change to the business model. But the changes that Southwest is already making are bringing it more in line with the market.
And I think the last big domino to fall is like an actual change to its core operating model. And I think if they're looking to optimize profitability for the long term, which this investor pressure will bring about, then moving to a hub and spoke model is I think eventually where Southwest is going to end up.
I love it. My number one hot take is that Southwest is going to invest in a premium experience. I think that we'll see Southwest lounges, for example.
Southwest lounges are very inexpensive in general to operate, very, very high margin. They also kind of create that through point of the customer experience. So I think you're going to see this, you know, the credit card be used for that.
No More Free Bags?
My hot take, which is super spicy, is that I don't think Southwest is going to do this on their own, but I think with activist pressure, I think you're going to see the two free bags go away. Looking at the baggage revenue for the other airlines and what a driver it is for credit card subscriptions that when you have a credit card, you get to fly for free. I see them removing some of the perks that have traditionally been Southwest Holy Grail perks and moving those into their credit card or their premium models the same way that other airlines have.
So it's still available to everyone should they choose to partner with Southwest in this other way, but it will become more of a luxury of the experience as opposed to table stakes. So it'll be fun to see what happens with Southwest going forward.