SOUTHWEST AIRLINES

Southwest Airlines



Southwest Airlines

Background 

Southwest Airlines is a lowcost carrier (“LCC”) airline with domestic point-to-point service (as compared to the hub-and-spoke system utilized by legacy carriers). The company employs a lowcost model that has become the envy of the U.S. airline industry. 

Southwest began operations in 1971 as a local carrier? based out of Love Field in Dallas? with routes only in Texas. During the 1980s? Southwest expanded its presence throughout the southwestern and central United States? including service to Los Angeles? Phoenix? St. Louis? and Chicago. During the 1990s? the airline continued to expand its routes? including in its coverage service to New England? the Pacific Northwest? the Atlantic Coast? and the Southeast.

Each time Southwest decided to enter a new market? it did so with an opportunistic strategy that would later become the model for other LCCs. The company would identify those markets that were either underserved (often due to retrenchments by other airlines) or that had high prices due to a lack of competition. Southwest would then enter that market? offering lower fares in order to rapidly build market share. They would then slowly raise prices to make the route as profitable as possible while still undercutting competing airlines. The keys to Southwest's successful expansion policy were both its intelligent identification of attractive new markets and itsability to consistently keep its costs below those of its competitors. The metric of cost competitiveness in the airline industry is CASM (“Cost per Available Seat Mile”).

CASM is derived by dividing total operating costs by ASMs (the available number of seats for passengers multiplied by the number of scheduled miles flown). Within the highly-competitive airline industry? the highest and the lowest-cost carriers in any given year may be separated by as little as $0.02 per ASM. Southwest's lower labor costs and greater operating efficiency have allowed it to achieve lower CASM levels than its peers? including both legacy carriers and LCCs. This CASM advantage has increased in recent years due to South-west's industry-leading hedging program.

Southwest's Hedging Program 

Hedging refers to a contract or set of contracts that a company enters into in order to limit its exposure to a business risk that could negatively impact the results of its operations. A cereal maker might hedge against a rise in corn prices caused by drought; a hotel might hedge against a drop in visitors caused by bad weather. So? for example? a cereal maker might hedge against a rise in corn prices by buying a three year call option that gives it the right (but not the obligation) to buy a given amount of corn three years from now at today's price. If corn prices rise? then the cereal maker will exercise the option and buy the corn at today's price. If corn prices decline? the cereal maker will allow the option to lapse and buy the corn at the then cheaper market price.

For several years Southwest Airlines has hedged its fuel needs to protect itself from fluctuations in jet fuel prices—one of the largest ...