For most of its history, Southwest Airlines (NYSE: LUV ) has been an aggressive growth company. It terrorized legacy carriers like Delta Air Lines (NYSE: DAL ) and United Continental (NYSE: UAL ) by constantly pushing further into their turf.
With lower costs and friendly service, Southwest had a lot going for it. However, today Southwest faces tougher competition. As a result, it's looking to retrench to boost its earnings. Southwest's management has stated on multiple occasions that it will hold capacity roughly flat in 2014 in order to focus on completing the integration of its AirTran subsidiary.
As part of that plan, the company recently announced that it will pull out of three smaller markets: Jackson, Miss., Branson Mo., and Key West, Fla. This will free up capacity for more promising markets with plenty of passenger traffic, like New York.
The changing economics of air travel
In recent years, Southwest Airlines has expanded its route network significantly. Some of this growth has come organically through its entry into major markets like New York, Boston, Denver, and Minneapolis-St. Paul, which Southwest had historically avoided. More recently, Southwest bulked up through its acquisition of AirTran Airways, which gave it access to a variety of new cities.
However, the economics of flying to smaller cities has changed in recent years. With higher fuel prices, it's important to keep airplanes full (without discounting tickets too much). As recently as 2007, Southwest's full-year load factor -- the percentage of seats sold -- was just 72.6%; for the past two years its load factor has risen to over 80%.
In order to match capacity to demand, legacy carriers such as United and Delta hire regional airlines to fly small planes between smaller airports and their hubs. By contrast, Southwest only flies mainline aircraft: in fact, it's in the midst of phasing out all of its aircraft with fewer than 143 seats. Southwest's low-cost operating model is therefore hard to implement in small markets.
Focus on efficiency
The three cities Southwest is leaving are some of the smallest in its network. In Branson, it offers just three daily departures; in Jackson, it has four daily departures; and it operates three daily departures in Key West.
It's not very efficient for airlines to operate in cities where they have very few flights. At any airport where it operates, Southwest needs ticket agents, baggage handlers, and gate agents, as well as gate space and check-in counters.
In other words, there's a certain minimum of cost involved in setting up in a new city. For Southwest Airlines, operating three to four daily flights to a particular city means that it's not getting the most it can from its investment. Southwest will benefit by redeploying capacity from these smaller cities to large markets where it can operate more efficiently and thereby mount a stronger challenge to the legacy carriers.
In fact, on the same day that Southwest announced these service cuts, it also announced that it had acquired six new slot pairs from American Airlines at New York's LaGuardia Airport. (These slots were sold as part of American's merger with US Airways.) At LaGuardia, Southwest will now operate 33 daily departures, more than enough to efficiently utilize its fixed costs on the ground.
Foolish bottom line
Just a few years ago, Southwest Airlines was the clear king of the U.S. airline industry. Today, Delta Air Lines has already surpassed it in terms of profitability; American and United are hoping to catch up soon. In order to regain its leadership position, Southwest needs to be even more ruthless about keeping costs down by utilizing assets efficiently.
As a result, Southwest is pulling out of some of its smallest markets in order to double down on larger, more promising opportunities. For travelers headed to or from smaller markets, the loss of service on Southwest could lead to higher ticket prices. However, fliers in the biggest metro areas will be the beneficiaries, as continued growth by Southwest will help offset the impact of consolidation, keeping ticket prices in check.
Three stocks that will let you sleep well
As every savvy investor knows, Warren Buffett didn't make billions by betting on half-baked stocks. He isolated his best few ideas, bet big, and rode them to riches, hardly ever selling. You deserve the same. That's why our CEO, legendary investor Tom Gardner, has permitted us to reveal "The Motley Fool's 3 Stocks to Own Forever." These picks are free today! Just click here now to uncover the three companies we love.