S1E4: Southwest Airlines

Decoded’s Take

• Southwest Airlines was the most consistently profitable US airline and the most profitable prior to COVID despite charging ~3¢ less per mile flown than the three legacy carriers (Delta, United, American).
• Southwest keeps its costs low by only flying one aircraft type (Boeing 737), refusing to use middlemen (OTAs) to sell tickets, and increasing its planes’ utilization with strategies like first-come-first-served seating, point-to-point routing, and flying smaller secondary airports.
• Delta is demonstrating that co-branding credit cards can be far more profitable than flying passengers, and unfortunately, Southwest is at a disadvantage compared to the legacy carriers in this new arena. The future of airline profitability may no longer solely hinge on operational excellence but rather on the size of its customers’ wallets.

The Business

Southwest Airlines is one of the largest airlines in the US and the world. According to the US Bureau of Transportation Statistics, Southwest ranks #3 by paying passenger miles flown and holds 16.9% of US domestic market share. By this measure, Delta is #1 at 17.7%, American at 17.2%, and United at 16.1%. Together, these four airlines make up roughly 70% of the entire US domestic market. The #5 airline, Alaska, is ~1/3 of Southwest’s size, at only 6.4% of US market share.

Though Southwest may be similar in size to the legacy carriers, it does business very differently. Its cost per available seat mile (seats on planes x miles flown) are roughly 10% to 15% lower, which allows them to charge customers significantly less. It achieves this by both reducing direct costs (eg refusing to distribute tickets via OTAs to save transaction fees or flying to secondary airports to reduce airport usage fees) and by increasing its overall asset utilization. The more planes fly, the more revenue they bring in, the lower the average cost.

According to industry data provider OAG, Southwest plans for an average airplane turnaround time — the time that it takes a plane to arrive, deplane, clean, board the next flight, and take off — of 52 minutes (data for Mar 2023) while the other major airlines plan for 64 to 68 minutes. These 15 minutes of savings may seem small, but in the airline business, every second counts.

Let’s take a look at each of these strategies in detail.

Flight Network

Southwest operates a point-to-point flight network while the legacy carriers operate a hub-and-spoke model. On a legacy carrier, if you’re not flying TO or FROM one of the carrier’s “hub” airports, you’ll most likely need to connect through one. If you were flying from Tucson, AZ to Las Vegas, NV, United connects you through Denver, American through Phoenix, and Delta through Los Angeles. For that same Tucson to Las Vegas trip, Southwest flies 3 direct flights a day.

The hub-and-spoke model optimizes for coverage. Flights are scheduled such that passengers can get from just about anywhere to anywhere with at most one connection through a hub. Flights take off and touch down in batches to allow passengers to efficiently sort themselves onto their connecting flight. Concentrating operations around hubs also creates some economies of scale.

The point-to-point model optimizes for cost and convenience. Most of Southwest’s passengers fly direct between high-traffic city pairs, which increases the attractiveness of its flights compared to legacy carriers and decreases direct costs, as that passenger is flying fewer miles and only taking up one seat on one flight. It also makes its flight schedule highly flexible as each flight is independent from another. This avoids the need to schedule in batches, reducing airplanes’ time on the ground, and enables Southwest to schedule flights at less busy times, reducing fees. The drawback is that Southwest can only serve high-traffic city pairs well and forgo some of the economies of scale that hubs provide.

Southwest also flies a lot of small, secondary airports. Because it doesn’t need to optimize for connections, it favors flying into small airports with limited capacity. These airports typically see less congestion, which further decreases airplane turnaround time. They also charge cheaper fees. Sometimes there’s also the added benefit of the secondary airport being closer to downtown than the major airport on the outskirt of town, another positive for consumers.

Fleet

Southwest flies only Boeing 737 planes that seat between 143 to 175 passengers each. The legacy carriers fly a full range of planes from a variety of manufacturers that seat from 50 to 350. This lack of range restricts which city pairs Southwest can effectively service, but doing so significantly reduces overhead cost as all of its maintenance staff, ground crew, and flight crew only need to familiarize themselves with this one family of planes.

Seats

Southwest has no assigned seats. It instead asks passengers line up by seating order and grab seats on a first-come-first-served basis. This speeds up boarding as passengers generally won’t hold up the line looking for their specific seat and reduces passengers shuffling around. The airline credits this boarding strategy as one of the reasons it’s able to turn planes around 20% faster than the competition.

Distribution

Southwest distributes tickets for leisure travelers exclusively via its own websites and apps. If you were to search for flights on any OTA or aggregator, you won’t see Southwest tickets. It does distribute tickets targeted towards business travelers via GDS systems, as many business travelers need to book via specific corporate portals. Direct bookings generated 83% of its revenue in 2022.

The Numbers

Southwest Airlines is one of the most consistently profitable airlines in the world. It reported 47 years of consistent profitability from 1973 to 2019, only briefly dipping into negative territory in 2020 and 2021 due to the COVID pandemic and quickly recovering back to profitability in 2022 and 2023. This track record is unheard of in the industry. By comparison, United filed for Chapter 11 bankruptcy in 2002, Delta in 2005, and American in 2011.

Southwest has achieved this record despite selling cheaper tickets to customers than its competitors. In 2023, Southwest charged paying customers 17.46¢ per mile flown compared to Delta’s 21.06¢, American’s 20.92¢, and United’s 20.07¢. Flying a mile on Southwest is 17% cheaper than on Delta, which translates into a ~$100 saving on a $500 trip.

While its consistent profitability is no doubt in large part due to the operational strategies discussed previously, it has yet another secret weapon. Southwest has always avoided taking on significant debt to fund airplane purchases, opting for balance sheet health over debt-fueled growth. In 2019, Southwest held only $1.8B of debt against $17B in property and equipment (P&E), implying a loan-to-value (LTV) ratio of ~10%. In comparison, Delta held $8.9B of debt against $31.3B of property and equipment (28%), United held $13.3B of debt against $30.2B of property and equipment (44%), and American held $21.5B of debt against $35B of property and equipment (61%).

By the end of 2023, however, its debt had ballooned to $8B. On first glance, it might look like they have begun throwing caution to the wind, but in reality all they’re doing is hoarding cash — $11.5B worth. It could easily pay back most of its debt — as a comparison, Delta only holds $4B cash — but because most of that debt was financed at an extremely low interest rate, it makes more sense to keep it. Indeed, in 2023, Southwest paid $259M in interest but generated $583M in interest income, the only airline to generate *income* from net interest.

Why does this matter? Well, in bad years, debt interest servicing can quickly turn profits into losses, especially for airlines heavily loaded on debt, like American Airlines. In 2023, American generated $52B in revenues and $3B in operating income but paid $1.6B in net interest expense. If American’s operating costs had been just 3% higher, it would have generated losses instead of profits for the year. In the airline business, every cent counts.

Another key indicator for airlines is asset utilization. As we discussed before, Southwest tries to keep its planes flying as much as possible, minimizing time wasted on the ground. That is reflected directly in how many miles its planes fly. At the end of 2023, Southwest had total property and equipment assets worth $20.6B (including leased assets), the majority of that value concentrated in its 817 planes. It flew a total 170B available seat miles, or roughly 8.3 seat miles per dollar of property and equipment, compared with American’s 7.2, United’s 6.7, and Delta’s 6.4.

	Available Seat Miles (ASM)	Property and Equipment (PE)	ASM per $ PE
Southwest	170B	$20.6B	8.3
Delta*	272B	$42.4B	6.4
United	291B	$43.7B	6.7
American	278B	$38.7B	7.2

Prior to 2020, this impressive asset efficiency translated into superior profitability vs the competition. Unfortunately, Southwest dramatically expanded its capacity over the last three years. Even though it’s flying more seats, not enough customers are filling them, leading to lower revenue numbers than would have been expected. Further, it is also dealing with inflated costs due to newly negotiated contracts with staff. In 2019, Southwest flew 157B available seat miles and generated $2.3B in net profit. In 2023, it flew 170B available seat miles but only generated $498M in net profit.

Investors don’t seem too fazed about the rocky recovery though as they are still valuing Southwest at 2x book value (book value = assets – liabilities) and a P/E ratio of 46.7, arguably the highest premium on a mature airline stock. Delta has a higher price to book ratio (2.4) but its price is strongly supported by its profits (P/E ratio of 5.9). Frontier and Hawaiian are trading at even higher price to book ratios but both are (yet) unprofitable growth stocks. So far, Wall Street seems to be buying the company’s promise to reclaim its crown as (one of) the most profitable airlines in the world. After all, in 2019, it saw an impressive 17.8% return on invested capital (invested capital = how much money is tied up in the operating business in order to generate its revenues and profits), beating top performers like Delta (16.2%) and United (14.6%).

Finally, even though Southwest did eke out a profit in 2023, it wasn’t from hurtling passengers through the sky at 500mph. Its PRASM (passenger revenue per available seat mile) was 13.88¢, while its CASM (cost per available seat mile) was 15.16¢. That’s right! It lost 1.28¢ on every single seat mile flown, only to make up the difference through Cargo and Other operating revenues to generate a pre-tax operating income of $267M. The majority of these extra revenues are comprised of fees Southwest received from Chase to brand and operate the Chase Southwest credit cards.

To round out the math to arrive at the $498M net profit figure, Southwest generated an additional $409M in non-operational income, the majority of which came from paying less money in debt interest than it generated via its cash to arrive at a pre-tax profit of $676M. After paying income taxes, this comes out to $498M.

By the way, this phenomenon wasn’t unique to Southwest. Delta lost 1.33¢ per available seat mile, United 0.15¢, and American 0.45¢. Every single one of these airlines made up the difference via Cargo and “Other” revenue (which again, is majority credit card fees) and ended up in the black. Prior to the pandemic, airlines did make a slight profit on flying passengers directly but the industry just hasn’t recovered to that level just yet.

Analysis

I debated whether to do a Decoded episode on Southwest — or any airline, for that matter. It’s a tough business. There’s very little opportunity to build true differentiation. Operating margins are razor thin — and many times negative. It’s extremely capital intensive and sensitive to macroeconomic factors. And it’s easier to lose traveler confidence than to win them.

However, despite the challenges of operating an airline, Southwest has managed to chart its own course. On the financial side, it held on to its commitment to fiscal discipline, shunning debt-fueled growth even though it can increase returns in good times. On the operating side, it held on to its belief in offering customers true value for money, refusing to sell premium seats and bags, and refusing to charge change fees. It isn’t afraid to be the only airline to ask customers to line up for first-come-first-serve seats to save a few valuable minutes during the boarding process, and to ask customers to book directly with Southwest instead of portals and OTAs to save a couple of bucks per ticket. Somehow, these quirky strategies combined together allowed them to become the most consistently profitable US airline by a wide margin, and prior to the pandemic, the most profitable US airline period.

Alas, past performance does not necessarily predict future success. Southwest has struggled in the post-pandemic world, expanding capacity too quickly and lowering overall returns. It may also be facing a future where competition with other airlines no longer hinges exclusively on operational excellence, but on the spending power of its loyal customer base. Unfortunately for Southwest, that fight is one that Delta is looking increasingly likely to win.

Delta was the top performer among US airlines in 2023, achieving a net profit of $4.6B and return on invested capital of around ~10%. It also had the largest loss per available seat mile, at 1.33¢. The amazing thing to note here is that it could afford to lose all that money because it made so much money from cargo and other revenues: $9.1B, or 3.36¢ per available seat mile (ASM), more than double that of United, which earned the second most in cargo and other revenues per ASM. Out of the top 4 airlines, Southwest came in last at 1.44¢ earned in Cargo and Other Revenues per ASM.

2023	PRASM – CASM	Cargo + Other Revenues per ASM	Operating profit per ASM
Southwest	-1.28¢	1.44¢	0.16¢
Delta	-1.33¢	3.36¢	2.03¢
United	-0.15¢	1.60¢	1.45¢
American	-0.45¢	1.54¢	1.09¢

Because Delta makes so much money via these other revenues, it can afford to lose money on its passengers. In fact, it could afford to lose twice as much and still be profitable. What makes Delta’s “other” business so good? Its loyal customers spend A LOT of money its co-branded American Express credit cards. In fact, Delta’s CEO announced last year that 1% of US GDP is transacted through Delta credit cards, amounting to 10% of all American Express transaction volume!

Today, Delta is looking less and less like an airline that happens to make ancillary revenue from credit cards, but more like a credit card issuer that operates an airline to attract and retain customers. It’s also perfectly positioned to win this game, as it is the most expensive airline that attracts the most premium clientele with the most spending power AND it’s partnered with the credit card company known to target affluent consumers.

United and American already generate more of these revenues per ASM than Southwest and are likely better positioned to increase these over time, being full-service carriers with domestic First Class service and lots of international service coverage through owned operations and partnerships with international airlines. They attract more wealthy customers and stand to generate more credit card and ancillary revenues than Southwest and other discount carriers.

That said, Southwest is still the second most valuable US airline today, trading at $20B to Delta’s $27B, United’s $15B, and American’s $10B. Once Southwest balances its supply and demand, its planes should fill up and its profits should recover too. Its extremely strong balance sheet allows it to weather economic headwinds better than any other US airline. And who knows? Maybe it’ll figure out a way to change up the ancillary revenue game to its advantage, charting its own course for future profits just as it’s done with its other operational decisions, reclaiming the crown as the most profitable US airline.

Buckle up ladies and gentlemen, there’s sure to be some turbulence along the way.

Until next time!