Defining challenges for airlines and stock buybacks

The next few weeks or likely months will be rough for airlines. Major airlines in the US have announced major cuts to their flights, domestically and internationally.

Major airlines in the US already asked for assistance and bailouts from the government. When you are in a bind and employ thousands of folks, it’s understandable to request for help for the greater good, right? Or is it?

Bloomberg reported that in the last decade, biggest US airlines spend almost 90% of its free cash flow on stocks repurchases. In other words, instead of saving cash for a rainy day like what we are going through now or investing in back to the business more than what they already had or paying employees more, airlines repurchased their stocks to please shareholders and increase stock prices (likely).

Source: Bloomberg

Am I opposed completely stock buybacks? Absolutely not! Stock buybacks is definitely a legitimate use case of free cash flow at the disposal of executive teams whose fiduciary duty is to shareholders. If the folks who monitor the business on a daily basis decide that stock repurchase is the best course of action, who are we to argue?

However, the current pandemic and the criss that is engulfing airlines put things in perspective. The public has all the right in the world to question why airlines deserve a bailout after years of spending a boatload of money on stock repurchases. On an individual level, we are all advised to save up money for emergencies. Why should airlines receive a bailout? Especially when a recession was always a likely scenario after a decade of bull market.

Airlines have a lot to answer for after this crisis blows over. There should be some measures put in place to prevent this phenomenon from happening again. Nonetheless, I, by no means, advocate for a complete ban of stock buybacks. Truth be told, it’s a fairly complicated matter. But it’s how the government officials earn their paychecks. Mark Cuban already offers some sound advice

Baggage fees by airlines for domestic flights in the US

I came across this piece of news from Skift

JetBlue Airways is raising fees for checking bags again by $5 — to $35 for the first one and $40 for the second — on flights within the United States.

Baggage fees in the US have become a significant source of revenue for airlines in the US. In 2018, baggage fees brought more than $4.5 billion in revenue for major airlines in the US, compared to $1.1 billion in 2008. Throughout the first three quarters of 2019, the figures are well on their way to surpass the 2018 ones. Though I understand the monetary perspective through which many look at this issue, I find it annoying that airlines seemingly take advantage of customers this way. We often travel with luggage and for some certain routes, there are very few options as only one or two carriers operate on the routes. Customers have little freedom to choose.

I compiled the baggage policy of major US airlines below, as well as some information on their baggage revenue and how much of the total revenue it makes up.

Source: Bureau of Transportation and official airlines’ websites

“Low price” airlines such as Frontier and Spirit have a significant portion of their revenue from baggage fees. The low prices are often misleading as we rarely travel without a carry on. Only an addition of carry-on fees will reveal the whole cost of a flight ticket with the low price airlines. Among the bigger carriers, as far as I know, only United Airlines (not shocked at all) charges customers for carry-on in certain cases.

The stark difference in how airlines display their purchase policies

During a purchase process of a flight ticket, interested buyers like you and myself care a lot about the policies such as those on baggage, change, rewards redemption, cancellation or refund. The longer and more expensive a flight is, the more we want to know about the policies of such a flight. Let’s look at how some of the popular airlines display their policies

Cathay Pacific – Great

It’s easy to see the important policies on Cathay’s flights.

Emirates – Great

You can see the difference in policies across tiers. It gives the audience a chance to compare the options and select what works best for them.

Eva Airways – Good

Eva Airways opts for a text-based presentation of policies instead of bullet points and icons like Emirates and Cathay. Even though the information can be read easily enough, there is room for improvement

Delta – Acceptable

Delta spells out whether a flight can be changed or refunded, but the UI is not as user-friendly as other airlines that we have seen above

Singapore Airlines – Great

Similar to Emirates or Cathay, Singapore Airlines makes it easy for travellers to see what they are paying for

Korean Air – Good

Even though the comparison is easy to spot, the information leaves something to be desired.

American Airlines – Below average

The airline displays some basic information, but you’ll have to click on the baggage and optional fees on the bottom left corner to have more details. Even then, it’s not really easy to digest their complex policies

United Airlines – The absolute worst

Look at these chunks of text. The airline doesn’t seem to want their customers to know what they are paying for. The use of text instead of visuals is bad enough. They manage to make it worse by using capitalized fonts which are not user-friendly AT ALL.

Customers do buy services or products deemed good value for their money. Subtly and implicitly scamming customers doesn’t generate much trust or goodwill. In a cut-throat industry, trust and goodwill can be the difference between prosperity and struggles.

Delta Airlines’ efforts to deliver a great customer experience

As I am fascinated by successful turnaround stories in business, below is my research on how Delta delivered a great flying experience to customers as part of their effort to turn the company around.

Tim Mapes, the current Chief Marketing and Communications of Delta, said the following in 2017: “[The Northwest merger] was our opportunity to emerge from the pack of U.S. airlines, the legacy carriers, and differentiate Delta, not as a commodity, where a seat is a seat, but as a different experience, with levels of service that are different from our competitors,” 

Since emerging from its bankruptcy, Delta has been relentlessly focused on delivering superior customer experience, willing to sacrifice short-term profits in exchange for better customer experience.

In 2018, Delta announced renovation for its 777 fleet, reducing the number of abreast seats from the industry standard of 10 to 9 in order to give its customer seat more room. For premium section, the carrier added “sliding-door accesses to a private cove filled with entertainment options, a personal table, and a 24-inch-wide reclining seat”. The reduction of seats meant a short term drop in revenue. The investment in premium section came with an increase in expenses. It showed how far Delta was willing to go to deliver a great customer experience.

In terms of in-flight entertainment, in 2016, Delta became the first US airline to offer all in-flight entertainment for free. Since then, it has added wireless back-seat screens and free messaging in flight for passengers, the latter of which allowed passengers to stay connected with others on the ground.

Additionally, Delta looked for other ways to make the whole flying experience from start to finish as pleasant as possible. In 2016, Delta spend $50 million in a technology called Radio Frequency Identification (RFID) for baggage tracking. RFID not only allows accurate handling to be more efficient, but also lets passengers know where their luggage is at any time via Delta mobile application. In 2018, the carrier started to let fliers file a baggage claim via its mobile application at the final destination instead of having to physically visit a Delta office. Confident in its ability to handle baggage, Delta is now committed to a 20-minute policy for luggage on domestic flights. Under the policy, if luggage doesn’t arrive on a carousel within 20 minutes of arrival of a domestic flight, passengers will be entitled to 2,500 bonus miles.

Late 2018, Delta rolled out the first biometric terminal for direct international flights from Terminal F at its Atlanta hub. The new technology allows passengers to check in without presenting papers. If you are annoyed by having to take out electronic devices for carry-on and personal items, you won’t have to with the new technology from Delta, making the boarding experience smoother and more pleasant. 

Clear and effective communication is key to customer satisfaction. Delta was the first US airline that offered customer support on Twitter. Since then, the airline has used social media extensively to offer customer support to passengers. In 2019, when a flight was delayed due to uncontrollable weather, Delta sent personalized emails to explain the situation and apologize to customers, along with 10,000 bonus points in their account. 

All the investments in and focus on improving customer satisfaction seem to pay off majorly for Delta. In 2019, it won the TripAdvisor Travelers’ Choice Awards for the Major Airline in North America category. Revenue from Premium products made up 31% of Delta’s total revenue in 2018, up from 18% in 2011. According to Delta;s CEO, passengers purchased 65-70% of premium seats on international and domestic routes, compared to only 13% of domestic premium seats sold in 2011. Loyalty Program’s revenue share rose to 9% of the carrier’s total revenue, up from 5% in 2011. Customer loyalty is also shown through the use of Delta branded credit card. In 2018, the carrier received $3.4 billion in revenue from American Express for the purchase of miles and merchant credit card fees. The margin from American Express payment was estimated to be higher than that of Delta’s core operations and grow at an 11% annual clip.

Disclosure: I own Delta stocks in my personal portfolio

Southwest & Airtran Merger

In this piece, I’ll talk about the merger of Southwest and Airtran. The merger took place 8 years ago. The reasons are two-fold. One is that I learned about the operating models of airlines in general while the other is that this merger is an example of how cultural and operational factors play an important role that could break deals.

Critical Facts

To remain competitive in a cut-throat industry, airlines in the US have had to turn to consolidation or merge and acquisitions (M&A) in recent years (Wharton, 2010). In 2010, Southwest bought Airtran for $1.4 billion (Esterl, 2010), to create a $3 billion airline that would be the 4thlargest carrier in the US. The acquisition of Airtran was, at the time, only the 3rdin Southwest history. It paid $134 million for Morris Air in 1993 and $60.5 million for Muse Air in 1985 (Esterl, 2010). Despite the takeover, not all Airtran’s operation was integrated into Southwest’s immediately. McCartney (2013) reported that only 28% of Airtran’s destinations were moved under Southwest’s operation and that the two continued to function separately until the end of 2014.

Southwest commenced services in 1971 and as of December 31, 2010, the airline operated solely Boeing 737 aircrafts in a point-to-point model to only domestic destinations in the US (Southwest, 2011). The company’s mission statement is “dedication to the highest quality of Customer Service delivered with a sense of warmth, friendliness, individual pride, and Company Spirit” (Southwest). On the other hand, Airtran was, at the time of the acquisition, one of the largest low-cost carriers (LCC) in the country with significant presence at some of the most popular airports in the country such as New York’s LaGuardia Airport and Boston’s Logan International Airport. The airline operated Boeing B717 and B737 to domestic destinations and a few international ones such as San Juan, Puerto Rico; Cancun, Mexico; Montego Bay, Jamaica; Nassau, The Bahamas; and Orangestad, Aruba (Southwest, 2011).

There are two main types of airlines in the US: the point-to-point and hub-and-spoke (Moss, 2010). In the hub-and-spoke system, an airline concentrates its operations at a few first-rate airport locations. The point is to route traffic to ultimate destinations from these key hubs. The system is typically favored by legacy carriers, but comes at the expense of delays due to traffic congestion and other tasks such as baggage handling, gate and slot management.

On the other hand, the point-to-point system refers to the direct traffic from one point to another. It is usually deployed by LCCs for short-haul flights, but tends to be used more for longer flights. The point-to-point system typically involves secondary airports and smaller cities in order to help LCCs avoid head-to-head confrontation with bigger legacy carriers.

Southwest relies on a simple pricing strategy with only one tier and no charges on date changes or bags whereas Airtran offered multiple pricing tiers and additional fees on changes, cancellations and baggage (Wharton, 2010).

Three years after the merger was announced, the pilot issue was resolved (Yamanouchi, 2012) and the majority of Airtran employees accepted jobs at Southwest (Maxon, 2014). In 2014, the last Airtran route was integrated into Southwest’s system and Airtran operated its last flight. Furthermore, Southwest standardized the system for both domestic and international flights, using Amadeus as the technology vendor (Maxon, 2014).

Customer_satisfaction_Southwest

Customer satisfaction, as measured by consumer com- plaints per 100,000 enplanements (Gabreski, 2013)

Southwest prefers to operate only Boeing 737s to keep the operations simple and cost down while Airtran had a fleet of Boeing 717s in addition to 737s. The two airlines adopted two different approaches when it came to distribution. Airtran sold tickets through global distribution networks such as Expedia (Esterl, 2010) while Southwest did it all internally, cutting out the middle man. Wharton (2010) reported that the most contentious issue of the whole merger was the personnel issue. Taking in so many new employees from Airtran might put Southwest at risk of not managing them well enough. Plus, pay and seniority among pilots posed another serious challenge. If the two companies merge, where in the hierarchy would each company’s crews rank?

At the time of the merger, Southwest recorded $12.1 billion in revenue and $460 million in profit (Southwest, 2010), equivalent to 4% of the top line. On the other hand, the figures by Airtran were $2.6 billion and $38.5 million respectively, equivalent to 1.5% of the turnover (Airtran, 2011). Employee-wise, Southwest had almost 35,000 staff on the books (Southwest, 2010) whereas Airtran employed 8,500 people (Airtran, 2011).

The Dallas-based company estimated that the merger would bring in $400 million a year in operating synergies by 2013, yet would cost in the beginning at least $300 in one-time integration costs. MacLennan (2015) reported that Southwest’s shares went up by 230% since the merger’s announcement, compared to a 51% gain for the S&P 500 in the same period. Southwest also noted in the 2013 annual report that the international expansion met the 15% ROIC goal.

Analysis

First of all, the merger was in line with the mission statement of Southwest. It aims to deliver the highest quality of customer service to customers and obviously new routes brought over from Airtran supported that.

Porter Five Forces

Porter’s Five Forces (Porter, 1979)

If we look at Porter’s strategy framework, the merger made sense. Southwest grew by flying from point to point and using secondary airports. At some point, the strategy would hit a limit and Southwest would have to do something drastic to fuel growth. The purchase of Airtran lessened the competition by eliminating a proven LCC. Regarding the threat of entry barriers, the merger gave Southwest an added fleet of great aircrafts and valuable access to hugely important airport hubs: Atlanta and Ronald Reegan in Washington DC. The former made it more difficult for any new challenger to match the size of Southwest’s fleet while the latter prevented anybody wishing to dominate those two airport hubs. Additionally, growing in size increased the bargain power Southwest has over suppliers, especially fuel suppliers. The increased power could play a significant role in keeping the cost low.

Though the move made sense strategically, it came with a host of risks in terms of operating philosophies, cultures and operations. Southwest had been a quirky airline before the merger. The organization had been very cautious when it came to expansion by acquisitions, a fact proven by its only two M&A moves before Airtran in its history. Southwest didn’t want to risk its closely monitored and managed culture and organization. Merging with a significant airline such as Airtran would be almost guaranteed to disrupt such a closed environment.

Southwest had been a point-to-point carrier for domestic flights with emphasis on customer satisfaction and employees’ well-beings. On the other hand, Airtran believed in the low-cost proposition and adopted the hybrid system for both domestic and international flights.

Differences in Airline Models

The merger pushed Southwest to an uncharted territory. They didn’t have experience operating international flights or the hub-and-spoke model. They didn’t have a complex pricing system or much focus on low-costs. Essentially, the table above showed a set of stark differences inherently between Southwest and Airtran. The management of the acquirer had a decision at hand: whether it should continue to operate two separate models or to take risks and choose to stick with one model?

Let’s look at this from another perspective.

Porter Generic Competitive Advantage

Porter’s Generic Competitive Strategies (Porter, 1990)

Following the diagram above, Airtran competed by being a cost leader while Southwest pursued the differentiation path. A full integration meant that Southwest had to choose one final strategy. It didn’t make sense that Southwest acquired Airtran just to eliminate a competitor. The company had had only two deals before Airtran and in the industry that requires quite a high operating capital, spending more than $1.3 billion just to remove some competition without any synergies would be too much an investment, no matter how big Southwest was at the time. Without synergies, the merger wouldn’t have helped either company strategically.

If a full integration was the right direction, the question that remains is: which direction would Southwest choose? Given that Southwest had, at the time, more than 5 times as many employees as Airtran, integrating Airtran into Southwest would be an easier task than the other way around. Plus, Southwest’s operating philosophy was more robust and sustainable than Airtran’s.

VRIO Framework

VRIO Framework to analyze the sustainability of competitive advantage (Judgev & Thomas, 2002).

Southwest created its own sustained competitive advantage through dedication to employees’ welfare and excellent customer service. It led the industry in customer satisfaction and was profitable for 38 years in a row at the time (Southwest, 2010). It had the brand name as well. The competitive advantage that Southwest built was, in my opinion, very difficult to replicate in such a fierce industry. On the other hand, Airtran’s competitive advantage in my opinion was not as sustained. It could be argued to be a temporary competitive advantage. If other LCCs or legacy airlines had engaged in a price war, I doubt that Airtran would have survived for long. Plus, the constantly rising fuel cost was one of the main drivers of consolidation in this industry in the first place. It made Airtran’s competitive advantage less sustainable.

As a result, it made sense for Southwest to keep its original philosophy and integrate Airtran in its system.

To make the integration work, Southwest had to iron out a few wrinkles as follows:

  • The fleet of Boeing 717s
  • Difference in distribution system
  • Difference in focus on employees and dedication to customer satisfaction
  • Difference in reservation systems, especially for international flights
  • Difference in pricing models and fees
  • Inexperience in handling activities at major airports
  • Pay and seniority of Airtran’s pilots and employees

The risks above were the reason why critics and doubters had lukewarm reaction to the merger. They were indeed difficult challenges. Unless handled smoothly, they could impact negatively both the integration and what Southwest originally had. However, the benefits were significant. In Airtran, Southwest found a solution to its quest for growth. It could add more resources and competencies, particularly international flights. In my opinion, the benefits at least justified the risks.

Conclusion

Culturally and operationally speaking, the merger posed an immense risk to Southwest. The two companies were very different and without a well-planned and smoothly-executed integration, it would negatively affect what they already had going on at the time. However, the risk was rightly justified by the potential gains economically and strategically.

In the end, it was wise for Southwest to integrate Airtran into its system due to the reasons articulated above. Years after the merger, the financial performance shown in the “Critical Facts” section was proof of how well Southwest pulled off the integration.

This case taught me the two models in airlines industry and how they differ from each other in terms of operations and culture. Indeed, such a difference highlights an important aspect that management has to consider before any merger.

References

Airtran. (2011). AirTran Holdings, Inc. Reports Net Income of $38.5 Million for 2010. Prnewswire. https://www.prnewswire.com/news-releases/airtran-holdings-inc-reports-net-income-of-385-million-for-2010-114799669.html

By Acquiring AirTran, Will Southwest Continue to Spread the LUV?.  Knowledge@Wharton (2010, October 13). Retrieved from http://knowledge.wharton.upenn.edu/article/by-acquiring-airtran-will-southwest-continue-to-spread-the-luv/

Esterl, M. (2010). Discount Carriers Southwest, AirTran Tie Knot. Wall Street Journal. Retrieved from https://www.wsj.com/articles/SB10001424052748704654004575517510208350940

Esterl, M. (2010). Southwest Alters Plan; AirTran Deal Injects Risk, Opens Way to Big, New Markets. Wall Street Journal. Retrieved from: https://www.wsj.com/articles/SB10001424052748703882404575520292075270202

Judgev, K. & Thomas, J. (2002). Project Management Maturity Models: The Silver Bullets of Competitive Advantage? Project Management Journal.

Gabreski, T. (2013). Values, company culture and strategy: CSR reporting at Southwest Airlines. Journal of
European Management & Public Affairs Studies

Holloway, S. (2008). Straight and level: Practical Airline Economics, 3rd edition, Ashgate publishing limited.

MacLennan, A. (2015). Goodbye AirTran, Time for Southwest Airlines to Fly. The Motley Fool. Retrieved from: https://www.fool.com/investing/general/2015/01/27/goodbye-airtran-time-for-southwest-airlines-to-fly.aspx

Maxon, t. (2014). Now departing: AirTran Airways flies off into the sunset after Southwest merger. Dallas News. Retrieved from: https://www.dallasnews.com/business/airlines/2014/12/27/now-departing-airtran-airways-flies-off-into-the-sunset-after-southwest-merger

McCartney, S. (2013). Southwest and AirTran Airlines: Mergers and Aggravations; Frustrated Frequent Fliers Wait as Kinks Get Ironed Out. Wall Street Journal. Retrieved from: https://www.wsj.com/articles/SB10001424127887324448104578611980670019710

Moss, L. D. (2010). Airline Mergers at a Crossroads: Southwest Airlines and AirTran Airways. The American Antitrust Institute. Retrieved from:https://www.antitrustinstitute.org/sites/default/files/SouthwestAirTran%20White%20Paper.pdf

O’Connell, J.F., & Williams, G. (2005). Passengers’ perceptions of low cost airlines and full service carriers: A case study involving Ryanair, Aer Lingus, Air Asia and Malaysia Airlines, Journal of Air Transport Management, 11(4), 259- 272

Porter, M. (1979). How competitive forces shape strategy. Harvard Business Review. Retrieved from: http://faculty.bcitbusiness.ca/KevinW/4800/porter79.pdf

Porter, M. (1990). The Competitive Advantage of Nations. Harvard Business Review. https://hbr.org/1990/03/the-competitive-advantage-of-nations

Southwest. Mission Statement. https://www.southwest.com/html/about-southwest/index.html

Southwest. (2010). SEC Filing 10Q. http://investors.southwest.com/~/media/Files/S/Southwest-IR/documents/company-reports-ar/ar-2010.pdf

Southwest. (2011). 424B3 Prospectus filed pursuant to Rule 424(b)(3). Retrieved from: http://www.southwestairlinesinvestorrelations.com/~/media/Files/S/Southwest-IR/air-tran-acquisition/airtran-proxy-statement-and-prospectus.pdf

Yamanouchi, K. (2012). AirTran, Southwest pilots approve seniority deal. The Atlanta Journal-Constitution. Retrieved from: https://www.ajc.com/business/airtran-southwest-pilots-approve-seniority-deal/yyTnyonwhHRLf0BY8rDcPJ/