Southwest Airlines Co.

1. Southwest Airlines Co. Case Study – 2018 Base Year MGT 509, Fall 2019

2. Team 3

3. Case Study Overview • The Airline Industry: Case Overview • Southwest Airlines: Strategic Objectives • Case Strategy: Key Aspects • Case Financials: Pro-forma • The Airline Industry: Industry Analysis • The Airline Industry: SGM • Southwest Airlines: Company Analysis • References

4. The Airline Industry Case Overview 4

5. Defining the Industry The Airline Industry The airline industry is comprised of companies providing primarily passenger air transportation to at least 10 million domestic travelers annually. Excluded from this definition are airlines with headquarters outside the United States.

6. Defining the Company Southwest Airlines Purpose: Connect People to what’s important in their lives through friendly, reliable, and low-cost air travel. Vision: To become the world’s most loved, most flown, and most profitable airline. Values: Live the Southwest Way Work the Southwest Way Warrior Spirit Safety and Reliability Servant’s Heart Friendly Customer Service Fun-LUVing Attitude Low Costs Mission: The mission of Southwest Airlines is dedication to the highest quality of Customer Service delivered with a sense of warmth, friendliness, individual pride, and Company Spirit.

7. Case Information General Information • Industry Air-traffic Passenger Demand Growth Rate: 1.9% • Industry Revenue Annual Growth Rate: 3.5% • Industry Revenue: $176.4B • Industry revenue will continue to increase at 3.5%.

8. Major Case Assumptions Industry Level Assumptions: • The market share that Southwest acquires will be evenly split across all primary competitors. • Aircraft will continue to be piloted versus un-manned aircraft. • Industry will remain cyclical, follow the general economy, and is susceptible to multiple external factors, described later. • Economy will remain relatively stable over the next 5 years. Company Level Assumptions: • When adding destinations, Southwest will not be building a new airport but adding gates at existing airports. • Customer expectations will increase. • Low employee turnover rates & high employee satisfaction levels will continue.

9. Southwest Airlines Strategic Objectives 9

10. Major Objectives Return on Assets Revenue Growth LUV is projected to grow its Revenue 28.76% over a 5-year period from $21.97B in 2018 to $28.28B in 2023. Return on Sales LUV’s objective is to increase the Return on Sales by 2.25% over the next 5 years from 11.23% in 2018 to 13.5% in 2023. LUV is projected to increase its Return on Assets from 9.4% in 2018 to 12.75% in 2023. Market Share Revenue on Equity LUV plans to increase its Market Share by 1.05% over the next 5 years, increasing from 12.45% in 2018 to 13.5% in 2023. LUV's Objective for Return on Equity is to reduce in 2023 to 13.9% when compared to 2018 level of 25%.

11. Case Strategy Key Aspects 11

12. Type of Strategy To Follow Offensive Against Strong Rivals The airline industry is especially volatile and subject to trends like seasons and fuel prices. Competition levels are high. We will attack our competitor’s weaknesses in the following areas: Domestic routes Passengers carried Customer Service ratings Low-cost/no-fee offerings The offensive strategy of increasing our destinations, adding to our fleet, and maintaining high levels of customer service, all while continuing to offer low-price options to consumers, will ultimately increase our market share. This also supports our distinctive competencies, discussed in greater detail on Slide 53. 12

13. Generic Strategy • Focused Low-cost Based On: • Strong company culture of engaged employees providing an exceptional customer experience. • Standard aircraft across our fleet minimizes employee training, spare parts stocking, and simplified flight planning. • No frills, no additional fees, and no third-party sales approach reduces additional, unnecessary information systems and overhead costs. • Standard aircraft across fleet allowing Southwest to increase passenger capacity through economies of scale with suppliers compared to other airlines in the US. • A unique and compelling brand appeal increases market opportunities and spreads brand awareness.

14. Key Aspects of Strategy Strengthen Network Southwest will utilize profitability and data analytics to add targeted destinations, both domestically and internationally, to their route network. Southwest will also increase the fleet size to maintain quick turnaround times and meet the increased demand associated with new destinations. Marketing Increased marketing efforts will spread awareness for the brand while also gaining customers in new markets. This directly connects to strengthening the network. Special attention will be paid to digital marketing and innovative trends as consumers lean more towards online sales and ticket purchases. Customer Service Southwest was built on exceptional customer service, which will be maintained as the company continues to grow. A substantial focus on employee engagement and satisfaction will ensure the airline is providing the highest quality service to its customers.

15. Case Financials Pro-forma 15

16. Pro-Forma Income Statement (LUV)

17. Pro-forma Expense Detail (LUV)

18. Calculation of New Strategic Assets Per the Formula provided in the Case Guide Actual 2018 Sales: $21.965B Actual 2018 Total Assets: $26.243B Forecast 2023 Sales: $28.282B Calculated 2023 Total Assets: $29.956B 2023 Total Assets – 2018 Total Assets = New Assets Needed Need: $3.713B

19. Strategic Capital & Other Non-Expense Costs (LUV)

20. Sources of Strategic Funds (LUV)

21. Actual & Pro-forma Balance Sheet (LUV)

22. The Airline Industry Industry Characteristics 22

23. Industry Characteristics 1. Type of Industry 2. Market Size Growth 2018: $11.8 billion, this is down from 15.3 billion in 2017 3. Market Size (per Passengers)/Companies in the Industry Alaska Air Group 4% American Airlines 15% Delta Airlines 16% Frontier Airlines 2% Hawaiian Airlines 2% JetBlue Airlines 4% Republic Airlines 2% Sky West 5% Southwest Airlines 20% Spirit Airlines 3% Sun Country 1% United Airlines 11% • Cyclical • Seasonal • Energy and Labor Intensive • Focused on technology and capital • Highly regulated • Heavily taxed • Extremely competitive

24. Industry Characteristics 4. Stage in Industry Life Cycle 5. Ease of Entry Low: “Competition in the airline industry is intense as barriers to entry are low due to liberalization of market access, a result of globalization. According to the IATA (International Air Transport Association), about 1,300 new airlines were established in the last 40 years.” 6. Ease of Exit High: “The airline industry is highly competitive and capital-intensive. Because of its capital-intensive nature, fixed costs and barriers to exit are high.” Mature: “By most accounts, the modern airline industry is quickly approaching market maturity, despite rapid growth in particular locations and sectors. With razor-thin profit margins and the emergence of low-cost carriers (LCCs), airlines have been required to adopt a variety of marketing and cost-cutting strategies to avoid bankruptcy or undesired mergers. Improvements in customer relations and the integration of advanced digital technologies, along with strategic reductions in expenses, offer the potential to keep an airline profitable in a competitive and challenging market.”

25. Industry Characteristics 7. Customers Per the U.S. Department of Transportation’s Bureau of Transportation Statistics: U.S. airlines and foreign airlines serving the United States carried 965.0 million passengers in 2017. The graph on the right breaks this number down by domestic (the industry this presentation is focused on) and international.

26. 5 Major IndustryCharacteristics The Five Most Important! Industry Growth Rate: 3.5% Competitors Pricing and cost structure Technological Advances Customer Service and Reliability 26

27. Industry Characteristics Industry Growth Rate The Industry Growth Rate is 3.5%. There has been substantial growth within the past 20 years. To meet passenger demand, airlines have increased routes and available seats on flights. Airlines are also focusing on technological advances to streamline consumer activities like booking tickets. Competitors There are approximately 10-12 competitors in the industry. From January 2018 through October 2018, Southwest Airlines dominated the domestic market share in terms of passenger count. The airline held 20% of this market share. Pricing and Cost Structure A key component of the airline industry is the rise of the Low-Cost Carrier, which offer a higher efficiency and better fleet utilization – both of which result in lower ticket prices. This has caused major airlines to introduce new fare products, like Basic Economy, to appeal to price-sensitive travelers. Cost is also dependent on fuel prices, which can be extremely volatile. In the United States, cost to airlines due to fuel increased by 7.1%.

28. Industry Characteristics Customer Service and Reliability Airlines are frequently focusing on operational reliability as a method of winning AND retaining customers. The list below identifies major areas of customer service and reliability in the airline industry: Change Fees Baggage Fees and Carry-on Allowances Seat Selection On-Time Performance, Delays, and Cancellations In-flight Amenities Reservation and check-in experience Technological Advances Technological advances are changing the way people connect. Some technological advances may limit the demand for travel, such as video conferencing and the internet. Other technological advances that may effect the airline industry are: • Artificial Intelligence (AI) • Biometrics • Internet of Thing (IoT) Airline companies are dependent on the use of technology and systems to maintain and run operations. Companies must monitor technology and monitor third party vendors to make sure systems and processes are maintained and secure.

29. Southwest’s VIRO Analysis Sustainable Competitive Advantage 29

30. VIRO Analysis Valuable: Yes – Southwest provides a resource that adds value to customers. There is a demand of Southwest’s low-cost options and focus on customer service. Additionally, Southwest was the largest domestic carrier in the U.S. in 2018. Inimitable: Yes – Southwest has a temporary competitive advantage due to the high competition in the airline industry. Rare: Yes – Southwest tied in ranks for Number #1 in overall airline customer service. They are the only airline to offer two checked bags for free and does not charge a fee on its fares for a customer change. Furthermore, the company does not impose additional fees such as seat selection or snacks. Organized: Yes – Southwest, per the 2018 Report, has an executive and governance structure and shows growth in terms of passengers carried and fleet size.

31. Porter’s Five Forces Competitive Force Analysis of The Airline Industry Competitive Rivalry: Very Strong Threat of New Entry: Very Weak Threat of Substitution: Weak Bargaining Power of Buyers: Strong Bargaining Power of Suppliers: Very Strong 31

32. Competitive Force Analysis Competitive Rivalry: Very Strong There is a relatively high number of competitors and there are multiple with equal power and market share. There is no one clear industry leader. The industry is mature, and growth is relatively slow at 3.5%. The major airlines compete heavily for market share. There are many obstacles to exit the Airline Industry once invested. Most impactful are the assets, the aircraft, are extremely expensive and can only be used in this industry. Customers have no switching costs. They can easily choose any airline since most competitors operate from the same locations. There is diversity in the approaches being taken in the industry between Southwest and Delta which makes it difficult for companies to read each others' signals. Most passengers travel for leisure purposes and decision to travel is discretionary. Sales volume is extremely important thing to companies within the Airline Industry.

33. Competitive Force Analysis Threat of New Entry: Very Weak There are a significant amount of barriers to entry. Including high costs, government regulations, and economies of scale. The cost of capital required to purchase airlines is extremely high. Due to the potential risk associated with air travel there are a significant amount of government regulations associated with the industry by the FAA. There are strong economies of scale and both the supply and demand sides. • Existing companies have low overhead and pay lower prices for fuel and on-board amenities that would be difficult to compete with as a new entrant. • There is a high level of trust that comes with known brands when it comes to air travel. Threat of Substitution: Weak There are very few substitutes for using the airline industry within the United States. The possible substitutes would be rail, bus, or private vehicle. Rail travel is currently limited in the United States and would require transferring to another type of transportation between destinations. High speed rail, such as the hyper loop will be a greater threat, however the technology has not been proven nor are there any destination yet. Aside from rail transportation, bus and private transportation would be limited to short distances or take significantly more time than air travel. Private transportation is the main substitute for those looking for a lower cost alternative with time to spare.

34. Competitive Force Analysis Bargaining Power of Suppliers: Strong The airline industry is concentrated into a few major companies, including Delta, American, United, and Southwest having a significant portion of the market share and there is an even smaller number of aircraft suppliers that would not be able to afford losing any one the major companies since the present a major portion of their business. There is a high switching cost for companies to switch suppliers of aircraft due to labor training, maintenance, and parts compatibility. There is currently no alternative to a well-trained staff which are part of a labor union. Bargaining Power of Buyers:Very Strong Buyers have a significant amount of information regarding flights are their fingertips and can compare prices using online search engines. There is no cost to switch between airline carriers unless they are part of a rewards program. The product is essentially the same getting them from point A to B in a timely manner. Buyers are often purchasing for leisure and can wait until flight prices get to a reasonable level to purchase tickets.

35. Industry Driving Forces Driving Force Analysis of The Airline Industry Changing Industry Growth Rate: Favorable Ancillary Revenues: Favorable Declining Regional Carriers: Favorable 35

36. Driving Force Analysis Changing Industry Growth Rate: Favorable A growing United States economy provides the basis for the airline industry to grow long term. Domestic revenue passenger miles are expected to increase by 2.2 percent annually. Average seat miles, a measure of system capacity, is expected to grow with increased demand for domestic travel. The commercial air carrier industry will respond to four trends: (1) capacity expansion; (2) steady growth of seats per aircraft; (3) increasing competitive pressure due to ultra-low-cost carrier expansion; and (4) increasing price discrimination through ancillary revenues and revenue management. In the domestic market, mainline enplanements increased for the eighth consecutive year, up 5.4 percent. Ancillary Revenues: Favorable Airlines create ancillary revenues by selling products and services other than the airplane ticket. Airlines have unbundled services that in the past was included in the price of the ticket such as checked bags, meals, seat selection. Airlines continue to segment passengers into specific cost categories based on comfort amenities such as seat pitch, leg room, access to social media, and power outlets

37. Driving Force Analysis Decline of Regional Carriers: Favorable The regional airline market is shrinking as this segment competes for contracts with the dominant mainline carriers. The regional airlines have less leverage with the mainline carriers. The mainline carriers have negotiated contracts that are favorable to operational and financial bottom lines. Furthermore, regional airlines are experiencing pilot shortages. Labor costs are increasing in order to raise salaries to offset labor shortages. Conversely, mainline carriers have been increasing seats per aircraft flown and this trend is increasing.

38. The Airline Industry Strategy Group Maps 38

39. Dimensions Summary Customer Service Capacity Destinations Fleet Size Sales 39

40. Key Dimensions Destinations Measured as the quantity of airport locations our aircraft arrive or depart from. Fleet Size Measure by the number of in-service aircraft owned and operated by Southwest Airlines Co.

41. Airline Industry SGM (2018) Conclusions • Southwest is in their own segment. • Large fleet with small number of destinations.

42. Airline Industry SGM (2023) Minimum Success Factors • Industry Growth Rate: 3.5% • Industry Revenue: $209.498B • Increase Destinations: +26, From 101 to 127 • Increase in Fleet: +197, From 753 to 950

43. Competitors Primary Competitors Alaska Air Group American Airlines Delta Airlines Frontier Airlines Hawaiian Airlines JetBlue Airlines Republic Airlines Sky West Spirit Airlines Sun Country United Airlines 43

44. Weaknesses • Skymiles (frequent flier program) is not as user friendly as other airlines • Spending increases as the company attempts to reposition themselves as a “premium airline” • Oldest fleet • Highest membership costs for lounges Primary Competitor Analysis Delta Airlines • Strengths • One of the timeliest domestic carriers • Update lounges and airport clubs • MileagePlus • International partners

45. Weaknesses • Partnership with Expedia may end at the end of 2019 – fares will disappear from their sites • Baggage fares • Aging fleet Primary Competitor Analysis United Airlines • Strengths • Business class upgrade (Premium Plus) • Increased employee morale due to negotiations with unions • MileagePlus • International partners

46. Weaknesses • Higher rate of delayed and cancelled rates (more than 6% the national average) • Doesn’t maintain lounges • Increased pricing for luggage Primary Competitor Analysis JetBlue Airlines • Strengths • Relatively low-cost airline • Mint – premium services for business travelers on transcontinental routes (allowed airline to enter high-value demographic) • Growth in Latin America and Europe • Differentiated Product and Culture (legroom, free TV and snacks)

47. Total Revenue

48. Net Profit (After Tax)

49. Southwest Airlines Co. Company Analysis 49

50. Southwest Airline SWOT Analysis