Southwest Airlines Has Been Badly Broken (NYSE:LUV)

Southwest Airlines (NYSE:LUV) has grown in its 51 years of service from a scrappy Texas intrastate airline that has repeatedly defied airline industry convention to now becoming one of the world’s largest, most consistently profitable, and most valuable airlines in the world as measured by market cap. However, the events of the past two weeks have deeply scarred Southwest. While it’s hard to assess the cost and impact of an event while it is still in process and neither Southwest or any market analysts have provided any guidance on the implications of the massive cancellation events which have engulfed Southwest, the toll is bound to be much, much higher than the airline industry has ever seen and will also lead to transformational change not just for Southwest but also for the airline industry. I wrote just months ago that Southwest would trail its legacy carrier peers in profit growth post-pandemic and this latest event is certain to confirm that trend.

What exactly happened at Southwest?

In order to begin to assess the impact of the mass cancellation event on Southwest’s finances and its future as well as of the airline industry, it’s necessary to first understand what happened and why. It’s no surprise to many Americans that a massively disruptive series of winter storms began moving across North America in the week leading up to Christmas. Starting in the Pacific Northwest, the storm forced the rare closure of Seattle’s airport as ice made it impossible for ground crews to clear runways since airports cannot use the same methods for ice removal as used on roads due to their corrosive effects on aircraft. As the storm moved across the United States, bone-chilling cold air followed in many parts of the U.S., sending temps well below zero degrees Fahrenheit in the northern tier of states with even parts of Florida freezing. Rapid changes in air masses led to fog in some locations while parts of the northern U.S. were buried under high snow totals, particularly this early in the winter.

Airline operations have long been subjected to severe summer and winter storms but a combination of the size and scope of the winter weather and its timing right as the Christmas travel season began spelled doom for airline passengers. Denver has become Southwest’s largest operating base due to strong economic growth in the mountain states and a large airport that can accommodate considerably more air traffic than it handled pre-COVID. Denver has long been a major hub for United Airlines so a stark contrast in how the storm was handled by each airline was set up in that city. Southwest’s route system was built around operating point to point routes, eschewing the hub and spoke networks of the legacy carriers such as Alaska (ALK), American (AAL), Delta (DAL), and United (UAL). In recent years, Southwest has evolved more and more into a hub operator as a result of using larger aircraft and being able to serve more of the U.S., something the hub and spoke system does very efficiently. But hub operations are extremely vulnerable to localized operational disruptions which, if not contained, can lead to massive disruptions to airline networks.

Because it concentrates most of its operations at its hub at Seattle, Alaska Airlines posted high cancellation and delay rates as the storm pummeled the Pacific Northwest. The big three legacy carriers fared better since the storm moved slowly enough across the U.S. that they were able to isolate the weather impacts to specific hubs and reset their operations fairly quickly as the weather system moved away from the largest airport hubs. While ALK and the big three legacy carriers were able to reset their operations shortly after Christmas even though several of those airlines posted cancellation rates in excess of 20% on several days, it became increasingly clear after Christmas that the airline operational disaster of Christmas 2022 was becoming Southwest’s crisis alone.

Since the cancellation event is still ongoing, it’s impossible to begin to fully tally the damage to Southwest’s finances, but there’s no hyperbole in saying that Southwest’s operational disaster that will bring 2022 to a close will be the largest and most costly operational meltdown that any single U.S. airline has ever experienced. LUV has already cancelled more than 25,000 flights including more than half of its entire network for multiple days at a time, a level of disruption that is unprecedented, especially noteworthy since Southwest is the largest single airline operator in the U.S. While the legacy carriers use regional airlines to supplement their service on mainline (large jet) flights and those regional carriers have their own operating systems, every Southwest flight is operated by Southwest itself.

Because Southwest has increasingly becoming a hub and spoke carrier, including in heavily impacted cities like Denver, the ripple effect across LUV’s network was immediate. Southwest still operates much of its network on a linear fashion so that a plane might leave the U.S. east coast in the morning, traverse one or more major Southwest bases such as Baltimore, Chicago/Midway, Nashville or Dallas, making stops in smaller cities such as Cincinnati, Kansas City or Tulsa as it makes its way across the U.S. Other planes start in the western or southern states but follow a similar process of bouncing between major bases and smaller cities.

While United was able to weatherize its ground equipment and was able to restart its operations in hard-hit and bitterly cold Denver, Southwest was paralyzed. Hours went by with no Southwest flights operating while competitors were able to turn their flights even with delays. While Southwest has repeatedly said it was fully staffed, there are abundant reports that Southwest did not have enough ground staff in many cities including Denver, compounding the inability to restart the operation as the storm worked its way across the continent.

Southwest’s labor groups quickly pounced on the carrier citing a lack of infrastructure, especially of IT systems that are essential to matching up available pilot and flight attendant crews – which may work separately or together depending on the flight segment – as well as the specific aircraft that operates each flight. The legacy carriers themselves have all suffered their own operational meltdowns but have invested in systems and processes to complete the process of resetting the operation each night, something Southwest was unable to do. Because many airline crew members commute by air from distant cities, the process of matching up available crew members with flights that need them can be extraordinarily complex. Southwest’s sole use of the Boeing 737 should have made the process of assigning specific aircraft to a flight should have been much easier than for legacy carriers which use multiple fleet types, but LUV’s fleet simplicity was of no help.

The financial impact will be breathtaking

It has not been uncommon for historic U.S. airline operational disasters to cost upwards of $100 million but not only will this one far surpass any other event but Southwest will almost singularly be negatively impacted by this event, even though Southwest is hoping it can resume normal operations this weekend. A simple look at LUV’s financial statements from the second quarter of 2022 shows that Southwest generates approximately $70 million worth of revenue per day or more than $2 billion per month. An event such as this that has affected as much as half of the month could impact more than $1 billion in revenue. Due to the high rates of cancellation and the inability for passengers to find alternate flights, as much as one-third of that revenue could have been permanently lost. Some passengers cancelled their reservations and will use their flight credits on future Southwest flights but many passengers were enroute and had no choice but to find alternate ways to their destination so bought tickets on other airlines – often at premium rates – or rented cars or took public ground transportation such as buses or trains where that was available.

Southwest stated in its commitment to the U.S. DOT that it would provide passenger amenities to customers in the event of operational disruptions but, like many airlines, waives that requirement if the cause of the delay is due to weather as was the case initially. After the U.S. Secretary of Transportation tweeted after Christmas that the DOT was concerned about the operational disruptions at Southwest and LUV’s lack of compliance with its customer service commitments, LUV stated that it would reimburse passengers for en-route expenses such as food and hotels as well as for transportation via other means. In addition, there are undoubtedly hundreds of thousands if not millions of bags that are displaced from their owners, resulting in many passengers having to buy new clothes and personal necessities. The toll for all of that compensation could amount to hundreds of millions of dollars.

As the disaster unfolded, Southwest offered its employees as much as triple pay in order to come to work, take extra assignments and help extricate the airline from the disaster. Depending on when LUV is able to stabilize its operations, they could shell out another $100 million plus in extra employee pay.

All of the cash costs that will be incurred in 2022 could easily exceed a half billion dollars, wiping out any possibility of a profit in the fourth quarter and erasing much of their accumulated profit from earlier in the year.

The final impacts to Southwest’s finances will come in 2023 as millions of customers use travel credits which Southwest typically offers as an apology for travel disruptions, on top of the refunds that many passengers will take. As those travel credits are used, Southwest’s revenue in 2023 could be reduced by hundreds of millions of dollars more.

And the final impact to Southwest is the loss of market value of LUV stock which has already been reduced by more than $1.5 billion as of the time of writing even with a rebound on Thursday. As other airlines report strong earnings, which they’re certain to do, and potentially also report stronger than expected guidance as their bookings for the first quarter of 2023 have likely accelerated as air customers book away from Southwest, the contrast between LUV and other airline finances will be acute. Given that winter travel rebounds beginning in mid-February, Southwest is likely to lose out on many bookings and that trend could continue until the summer.

Government intervention and industry change are certain

Southwest Airlines has long prided itself as being a customer-friendly, government pleasing airline that has been able to “get by” with more than other airlines because of its perception of offering low fares and not piece-mealing the travel experience with many of the add-on charges that are typical of many other airline fares. As cities around the country and the federal government itself receive feedback about the enormous disruption that their constituents have faced, Southwest’s reputation has been badly damaged and will take years to restore. The U.S. DOT provided strong warnings to airlines to clean up their customer service habits after operational disruptions swept across the industry in the spring and early summer of 2022. Most airlines operated quite reliably during the second half of the summer and maintained that into the fall apart from significant weather events. LUV’s unique loss of operational control and its inability to restore its operations to acceptable levels for such a long period of time is certain to result in a deeply intrusive review of Southwest’s operations by the feds and the likelihood that even further customer protections will be enacted for the industry as some legislators have been seeking.

One of the key procedures that federal regulators are likely to review is the process – or lack thereof – of carriers exchanging tickets between each other. The legacy airline industry was built on the concept of the interchangeability of airline tickets between airlines, initially via paper and later electronically. While legacy airlines usually restrict discounted fares for use on their own airline, they technically have the capability to transfer tickets to each other, esp. under irregular operations. Southwest, by design, and along with other low cost airlines, has not distributed its tickets via many industry channels and also does not participate in the reciprocal ticket agreements in the airline industry that would have allowed customers to take their Southwest tickets to other airlines if they could find space. Overwhelmed by the scale of the operational disaster, Southwest agents could not even directly buy tickets from other airlines which Southwest has been known to do in extraordinarily circumstances. Spirit, which itself suffered a massive operational meltdown during the pandemic, was able to get enough agents to help write tickets on other airlines to allow stranded passengers to get home, if those passengers had not already purchased tickets on other airlines. The chances are high that the concentration of the airline industry in the hands of so few players will lead to greater requirements for airlines to be able to honor each other’s tickets in certain circumstances.

Southwest faces yet another level of federal scrutiny as it sorts through the aftermath of the Christmas meltdown. The Wall Street Journal exclusively reported on Dec. 24that a retiring FAA inspector sent the results of a survey of FAA inspectors in a scathing email to a high-ranking FAA administrator as well as widely throughout the FAA workforce. The DOT Inspector General determined several years ago that FAA inspectors were not following the same diligence in policing Southwest’s operations, which are governed by the FAA’s Dallas office, as is the case for other airlines. The WSJ article notes that a recent survey of FAA inspectors shows that a majority believe nothing has changed and that senior FAA leadership still protects Southwest from enforcement of regulations with which other airlines have been required to comply. Because the FAA is focused on safety and operational processes that are related to safety, the potential scope of government oversight of LUV will be magnified many times above the consumer protection component that will make up much of the DOT’s intervention.

Yet another dimension of Southwest’s operations that must be overhauled is its employee relations. Many of LUV’s employees have experience at other airlines and have been sounding the alarm for years about the lack of IT infrastructure and the necessary tools to support the employees. Southwest tainted its employee relations with letters to employees, first in Denver, essentially doubting that those who called in sick may not have been genuinely so and requiring that they provide a doctor’s note or face disciplinary action even as the operation began to fall apart and more hands were needed. While Southwest has denied it has a staffing problem, many employees have posted anonymously on social media that Southwest has had a staffing problem at Denver airport for some time and a number of ramp employees left the company rather than work through the brutal winter weather. The Southwest pilots union has published a scathing letter faulting the company for a lack of support in infrastructure and for making employee jobs much harder while operating with minimal operational margin – which proved insufficient during this past month. Southwest historically bred incredible loyalty among its passengers and employees and both groups are grieving the loss of the Southwest Airlines that they once loved and to which they dedicated enormous amounts of their lives. Rebuilding Southwest will require the airline to rebuild the tattered relationship with its employee groups and make fundamental changes in the way it operates, even as LUV faces the renegotiation of multiple union contracts with expectations set high based on agreements that have been reached with employees of other airlines.

The Rebuilding Process Began Yesterday

Southwest’s Christmas 2022 operational meltdown is one of those existential events that will permanently alter an organization. As someone who has watched the airline industry and studied organizational dynamics for more than four decades, I can’t accept the notion from some that LUV will quickly bounce back from this event. Their lack of investment in technology will not be solved by just spending money, even if they do that with a vengeance. This event exposed significant flaws in LUV’s relationships with its employees, its customer processes, and will require that it reprioritize how they deliver their service. While I do not believe that Southwest management appreciated how significant the event was that has just played out, I believe they now understand fully what is at stake. As they rework their strategic plans and incorporate changes necessary to ensure they operate reliably in the future, I believe Southwest will adapt just as they have on many other occasions.

However, LUV is a publicly-traded stock and the financial impact to the company both in the current quarter and into 2023 is not yet understood by investors and has not been addressed by the company. I don’t think it’s hyperbole to say that the financial impact to Southwest will far exceed what most have even begun to estimate and, more significantly, other airlines will actually be moving even more in a positive direction, in part at LUV’s expense. Therefore, as hard as it is for me to do, I have to remove any recommendation to buy or hold LUV stock until the company fully details the costs of the disaster and the recovery plan from it. While I believe Southwest will recover, this event will set them back competitively for years as other airlines build upon their post-pandemic plans which, in many ways were more radical during the COVID era and which better position them to improve their margins and stock values.