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ANALYSIS: Wright Amendment Expiration Highlights Battle Between American and Southwest – Part 2

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ANALYSIS: Wright Amendment Expiration Highlights Battle Between American and Southwest – Part 2

ANALYSIS: Wright Amendment Expiration Highlights Battle Between American and Southwest – Part 2
October 17
08:20 2014

 


Editor’s note:

In part 1 of our analysis, we offered a history of the Wright Amendment, and took a look at Southwest Airlines’ prospects now that it has been lifted at Dallas Love Field after 43 long years of fighting.  Today we look at competitor American Airlines’ competitive response at Dallas-Fort Worth International Airport.


 

Competitive Impact on American Will Be Mixed


There is no question that the end of the Wright Amendment will have an adverse impact on American’s O&D market and revenue share in the markets affected. O&D passengers are more profitable than connecting ones, and insofar as American’s absolute O&D figures on these routes is set to decline, this will generate a hit on the profitability of American’s largest hub at DFW.

Southwest Airlines is the leader or even with American in terms of O&D market share in the 16 markets it currently serves, and while American generates a fare premium in those markets, for the 14 city pairs where Southwest is adding service, American currently generates 60% O&D market share and 70% O&D revenue share. From here on out, it will trade those figures for something like 45% and 60%.

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American’s stranglehold on business travel in the region should continues, as it will offer superior frequency in every single market save Oakland, which it does not compete directly in (while offering a combined 16 daily flights to San Francisco and San Jose in the Bay Area). Business customers have a well established preference for higher frequency, and when combined with the massive global reach of American’s DFW hub including rapidly growing links to Asia, corporate contracts centered on the region will continue to (heavily) favor American.

This is not to say that Southwest will not be able to capture a substantial share of business traffic. It already does so in existing markets from Dallas Love Field, but that market share (driven disproportionately by Austin, Houston, New Orleans, and San Antonio) is generated in part because Southwest is at parity with American in terms of frequency on those routes.

In the near term, the impact of Southwest’s entry will likely be O&D revenue and share declines, and likely a modest hit on margins. However, in the long run, American has a couple of factors weighing in its favor.

Banking on Connectivity


American is counting on its re-banking initiative to boost connectivity at DFW, with a commensurate jump in revenue. The plan is driven by the experience of pre-merger US Airways, who rode banked hubs at Philadelphia and especially Charlotte to high profitability despite limited O&D markets.

Relative to the rolling hub structure that American currently uses at DFW with flights spaced (relatively) evenly throughout the day, the new banked hub will feature far more volatility. In a banked hub structure (the most common type around the world), flights depart and arrive in alternating waves, and at a hub of DFW’s size, these waves might number 50 or 60 cities at a time.

Banked hubs offer more connectivity than rolling ones, which raises revenue potential, but they also cause challenges in terms of asset utilization and cascading delays at certain airports. However, American is rolling out banking projects at DFW, Chicago O’Hare, and Miami, seeking to boost revenue as the merger changes traffic flows.

Specifically with regards to the Wright Amendment, American will lose some traffic that migrates to Southwest’s new services. Love Field is extremely convenient for Dallas based leisure travelers (though DFW is quite convenient in its own right), and overall, the airline will win passengers away. But American will be able to offset that traffic decline by filling its planes with connections. And thanks to the ever-increasing pricing power of U.S. airlines, American should be able to maintain margins and absolute profitability in the market with high-fare connecting passengers.

Economics and Demographics Favor American


The Dallas-Fort Worth metropolitan area is one of the fastest growing in the United States. Cheap housing and a booming economy are drawing residents to the region, while businesses lured by Texas’ business-friendly tax policies and regulatory environment have generated well-paying jobs. These demographic and economic trends have boosted air travel demand, both leisure and business, substantially over the past 25 years and are expected to do so for at least another 15.

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Clearly this is beneficial for both carriers, which will see fuller planes and rising demand. But American is better positioned than Southwest to take advantage of the growth of the region, and the reason has to do with the compromise allowing Southwest to begin nationwide service in the first place. Thanks to the 20-gate cap, of which Southwest is unlikely to control more than the 16 it does today, Southwest is effectively stuck at 153 or 155 flights per day as the natural limit for daily utilization of its gates. Now there are ways for it to grow its operation at Love Field as we will outline below, but those methods have drawbacks and once again have a natural limiting factor.

Meanwhile American basically has no restrictions at DFW. It has plenty of terminal space to expand into today, and the airport has ample room for additional terminals as necessary. As O&D demand rises in the Metroplex, American will be able to soak up a larger share of the growth than Southwest (because of both frequency and network – it will always serve more destinations), and it would not be surprising to see American holding 50- to 70-percent O&D splits even in markets where it competes head-to-head with Southwest a decade from now.

Southwest Is Not As Much of A Threat as it Used To Be


Fifteen years ago, the prospect of a Southwest freed from the shackles of the Wright Amendment would have rightly terrified American, who would have been undercut at every turn by a nimble, low-cost carrier and see fares plummet. Today? Southwest isn’t really a low-cost carrier and it needs similar fares to those required by American for profitability. The cost gap between the two airlines has narrowed substantially, and while Southwest remains a formidable competitor, it is a different kind of competitor.

Moreover, American also has an advantage in its new management team, composed primarily of pre-merger US Airways executives. No legacy airline did a better job of fighting off Southwest than US Airways (who had no choice given its revenue shortfalls). While Las Vegas was sacrificed to Southwest and Allegiant, US Airways more than held its own in Phoenix and most notably, drove Southwest out of Philadelphia with its tail between its legs after Southwest attempted to build a secondary Northeast connecting complex with close to 75 daily departures. If you could pick one management team to face off with Southwest in a post-Wright Amendment world, it would be Doug Parker, Scott Kirby, and company.

Southwest’s Growth Opportunities are Limited


Circling back to Southwest for a moment, its growth prospects at Love Field are not great. The natural cap for its daily departures is around 155 unless it can get its hand on more gates. That being said, in terms of pure capacity, Southwest does have some room for growth on the basis of aircraft mix. For the January day in question, Southwest will split its 153 daily departures across all four aircraft types in its fleet, including 24 daily 737-300s, 30 daily 737-500s, 87 daily 737-700s, and 12 daily 737-800s.

That works out to 21,633 outbound seats, a substantial increase over pre-repeal capacity. But just 12 of the 153 flights use the 737-800, which seats 175 passengers versus 143 for the 737-300 and 737-700 and 122 for the 737-500. Replacing smaller 737s with the 737-800, of which Southwest has an additional 43 on order, or (later) the 737 MAX 8 or 737 MAX 9, could be its best strategy for capacity.

If Southwest were to convert all of its daily flights (up to 155) to the 737-800 or eventually the 737 MAX 8, it could offer 27,125 daily outbound seats. If it upgauged even further to the 737 MAX 9 as has been heavily rumored, and assuming a 200-seat MAX 9, it could offer up to 31,000 daily outbound seats. Using annualized comparisons (which are imperfect given that this analysis uses peak-day departures), that’s the equivalent of adding more than 4 million or 6.5 million annual seats (bi-directional) respectively.

Compositionally, Southwest does not have a ton of room to grow with additional destinations. That being said, in a scenario where it up-gauges to the 737-800, it could conceivably free up frequencies for new destinations. Consolidating the Houston Hobby service to an hourly shuttle would free up six daily flights, while consolidating Austin and San Antonio to eight daily flights apiece would add four to the tally. Albuquerque, Lubbock, and Midland could be brought down to three daily departures apiece, as could Amarillo and El Paso, adding eight additional frequencies. Finally, Kansas City, New Orleans and St. Louis could each drop down to six daily flights, giving Southwest a total of 22 additional frequencies to work with.

There’s also the chance that Southwest entirely eliminates Wichita and Birmingham from the network – two relatively recent additions with small O&D markets for another five daily flights. And if it has enough profitable opportunities, Southwest could eliminate Amarillo, Lubbock, and Midland entirely, giving it a grand total of roughly 36 additional frequencies to work with. In Southwest’s hands, that could generate anywhere from six to 18 new destinations (likely somewhere in the middle).

Of course paring frequency in existing markets will reduce Southwest’s O&D market and revenue shares in those markets, some of which could conceivably bounce back to American. Yet another reason why the competitive dynamics in the market are hardly dire for American.

Hardly #NonstopLove


With its heady marketing taglines and a well-timed sale launched just a day after the expiration, Southwest has certainly scored points and set the expectation that it will drive down fares. But Dallas consumers should not expect a sudden decline in ticket prices thanks to Southwest’s entry. In fact for many, ticket prices will actually increase. 

As we mentioned before, Southwest Airlines is no longer a purely low-lost carrier, but rather a hybrid network carrier with a complex business model and variegated product offering. The Southwest Effect above and beyond standard new entrant impact is dead, and the days of Southwest offering genuinely cheap fares is gone. In the Metroplex, that role will continue to fall to ultra-low cost carrier Spirit Airlines.

Southwest needs fares at roughly the same level as American to generate profits, and accordingly the pricing in most markets shouldn’t decline more than 5-7%. Moreover, there are many customers, who had previously traveled outside the perimeter from Love Field, for whom fares are actually going to increase.  After 2006, Southwest began selling “through” tickets at Love Field – direct, one-stop flights to beyond perimeter cities via an allowed airport. These one-stop flights helped Southwest fill its planes as traditional demand patterns tailed off, but they also were extremely low yielding.

In many of the markets where it is adding nonstop service, Southwest was the lowest fare carrier in Q3 of 2013. Southwest is going to want to charge a premium for new non-stop service and accordingly passengers will have far fewer dirt-cheap one-stop flights from Love Field. Anyone expecting fares in the Metrpolex to drop sharply as a result of repealment is in for a disappointing surprise.

Partying Like its 1996


Southwest’s festive celebration of the passing of the Wright Amendment gave the impression that the market had changed in a monumental manner, but realistically, the Metroplex has simply returned to its status quo for much of the post-deregulation era. For years, American was the dominant player at DFW, but it was held in check by Delta Air Lines, who had a large hub in its own right at DFW (though American still led the market).

Southwest Airlines was the cheap, no-frills carrier who offered limited service to myriad destinations. Today? American is a dominant player at DFW though it is held in check by Southwest, who has a large operation in its own right at Love Field (and bears close resemblance to legacy carriers today).

Spirit Airlines is the cheap, no-frills carrier that offers limited service to myriad destinations. Southwest Airlines may be overjoyed at the elimination of the Wright Amendment. But for many customers in the Dallas – Fort Worth metro area, their emotions today might be more aptly described as a muted sense of deja vu.

 

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