Last week, Southwest Airlines (NYSE:LUV) triumphantly announced that it had reached a tentative agreement with its flight attendants' union for a new contract. The new deal will run through May 2019 if it is ratified by the flight attendants, and will provide pay raises and other work rule improvements.
However, there is a much bigger labor issue hanging over Southwest. Southwest Airlines' pilots are long overdue for a new contract. Tension between the pilots and Southwest's management has risen to the point that SWAPA, the pilot union, convened a "Strike Preparedness Committee" in May. Fortunately, there is still hope for an amicable resolution of this dispute -- without jeopardizing Southwest's profitability.
Pilots have the power
Keeping its pilots satisfied is a much thornier issue for Southwest Airlines than mollifying its flight attendants and other work groups.
Since the pilots have much higher wage rates, big raises could have a much more significant impact on Southwest's finances. Yet Southwest's resurgent profitability and a growing pilot shortage in the U.S. have given the pilots more leverage than ever, encouraging them to dig in.
Furthermore, Delta Air Lines (NYSE:DAL) pilots are in the midst of voting on a deal that would give them big raises. The Delta pilots may receive an immediate 8% raise upon ratifying the contract, followed by a 6% raise next year and 3% raises in 2017 and 2018, Barron's reported.
This is a problem for Southwest, because one of its key tools for maintaining labor peace over the past few decades has been offering industry-leading pay. Yet the pilots reportedly see themselves as underpaid by 20% relative to the Delta Air Lines tentative agreement, and they want to close the gap.
The real issue
According to data from AviationInterviews.com, Southwest Airlines 737 pilots currently make more than Delta Air Lines 737 pilots at the top of both the First Officer and Captain wage scales. This suggests that even after Delta's pilots get their raises, there wouldn't be that big a pay gap.
The problem for Southwest is that the 737 is the only type of plane it flies. By contrast, Delta and all the other legacy carriers also fly a variety of larger planes. Traditionally, pilots for these larger planes -- especially the widebody planes that fly international routes -- receive higher pay.
In other words, Delta Air Lines pilots can look forward to moving up to larger planes later in their careers, where pay rates are already 10%-20% higher than the top of the Southwest scale. That gap will only get bigger, assuming the Delta pilots ratify the new agreement. (That said, Delta pilots are reportedly accepting a lower profit-sharing rate in exchange for higher base pay.)
For this reason, Southwest has to offer industry-leading pay for 737 pilots, in order to make up for the lack of a further advancement opportunity. But it can't do so at the expense of its cost structure, as its advantage over legacy carriers has narrowed considerably since the latter went through bankruptcy during the past decade.
A win-win solution
One of Southwest's key tactics for keeping unit costs down recently has been buying larger, 175-seat 737-800 planes, rather than the 143-seat 737-700 (which is the mainstay of its fleet). Since pilots get paid the same for all variants of the 737 aircraft, using the larger version allows Southwest to spread the same pilot costs over more passengers.
The carrier already has nearly 100 737-800s, and it recently announced that it has converted all of its aircraft orders for 2016 to the 737-800. Even after getting all those planes, the 737-800 will still make up only about 20% of Southwest's fleet. To help offset the costs of pilot pay increases, Southwest is likely to continue building up its 737-800 fleet.
Additionally, it's possible that a new Southwest pilot agreement would contain updated rules permitting the company to add even larger 737-900ER or 737 MAX 9 planes. This is Boeing's largest 737 model, and could seat 190-200 passengers in Southwest's configuration.
Introducing this plane would further boost Southwest's already-impressive pilot productivity. It would also offer other unit cost benefits: most notably, better fuel efficiency.
Keeping up with the Joneses
Southwest pilots are already among the most productive in the industry. However, legacy competitors like Delta Air Lines can better afford high wages for their top pilots, since they operate big widebody jets where pilot costs are spread over many more passengers.
The best way for Southwest to meet its pilots' demands without compromising its profitability would be to further boost pilot productivity by adding the largest 737 variant to its fleet. Otherwise, it risks staying locked in a bitter zero-sum game with its pilots.
Adam Levine-Weinberg owns shares of The Boeing Company and is long January 2017 $40 calls on Delta Air Lines, The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.