This is a brilliant case study of how even the greatest of companies can be taken apart in the stock market in the space of a four years. Almost all of us have grown up being fed the Southwest Airlines case study as one of disruptive innovation. Lisa Maclellan’s reprises the familiar story succinctly in her thoroughly insightful article for Fortune: “Herbert Kelleher cofounded Southwest more than 50 years ago as a local, low-cost airline serving Texan cities. As the airline grew, it took a radically different approach to air travel than its competitors. In addition to creating a no-frills, few-fees experience, Southwest adopted a point-to-point routing system, allowing passengers to fly between cities without transferring, rather than the hub-and-spoke model, which requires fliers to stop over in another city. Southwest also used only one type of plane, a Boeing 737, to standardize operations. And most famously, the startup embraced an open seating plan and, until 2007, a first-come, first serve policy.”
However, post-the pandemic, the original Southwest strategy started backfiring. Ms Maclellan writes: “Since the pandemic, Southwest has lagged competitors in financial performance, and its share price is down 50% compared to 2021.”
So what happened? Why did a strategy that worked for 50 years start backfiring? The proximate cause is easy enough to identify: “In late December of 2022, an “extratropical cyclone” brought all manner of menacing winter conditions to two-thirds of the U.S., including the entire Eastern Seaboard and parts of Canada. Wind-chill warnings, whiteouts, and extraordinary snowfall complicated travel for millions.
Flight cancellations from what was unofficially dubbed Winter Storm Elliott were inevitable, creating chaos at most airlines for a day. But for Southwest Airlines and its outdated crew-scheduling software, the madness dragged on for over 72 hours as the carrier canceled more than 16,000 flights. An undisclosed number of people were forced to sleep in airports or improvise road trips with strangers to salvage their holidays. The meltdown was so bad that Southwest was pilloried by Saturday Night Live.”
However, the author says that Southwest’s woes ran deeper than cyclone of Dec ’02 and this is where Southwest becomes a very instructive case study for long term investors such as us: “…the same unique traits that made Southwest soar—its egalitarian seating and anti-fee stance—have paradoxically weighed it down, says Donald Sull, an MIT Sloan School of Management professor of business practice and author of Revival of the Fittest: Why Good Companies Go Bad and How Great Managers Can Remake Them.
Sull, who has followed Southwest’s story for years, tells Fortune that the airline’s current crisis is reminiscent of companies like Blockbuster and Compaq. In short, Southwest has been responding to changes in the business landscape by doubling down on its existing strategy.
“Business history is littered with the corpses of companies that have fallen prey to active inertia,” he adds…”
Ms Maclellan explains that beneath the bawdy, irreverent persona that Herb Kelleher had built for himself, he was a brilliant strategist. “After Kelleher died in 2019, management guru Roger Martin paid tribute to the founder, writing that he was one of a few who understood that “the only path to distinctive results is with distinctive choices.””
Unfortunately for Southwest, Mr Kelleher’s successors were not in his league. When the world changed, they did not. Instead the carried on doing the same things that Southwest had done for decades and that left Southwest exposed. “2015 to 2019 was a particularly heady time for the U.S. airline industry in general, characterized by strong demand and profitability, Nicolas Owens, airline analyst at research firm Morningstar, tells Fortune. Low oil prices were the key tailwinds at the time, Owens argues, since airlines tend to pass on fuel costs to passengers when oil is expensive, and chop ticket prices when fuel costs drop….
The pandemic briefly sent airline valuations into a free fall. But another change came as the pandemic eased and airlines began ramping up again. Customer preferences shifted, and more Americans chose to fly internationally or revenge-spend on premium services, while taking fewer same-day business trips between U.S. cities.
The airlines weren’t ready for the surge in demand, Owens explains. Just finding pilots was challenging; many of those who hadn’t been furloughed had retired. However, other than Southwest, the large U.S. airlines were prepared to meet the flying public’s new inclinations, having the right travel networks and products in place to take advantage of pent-up demand for Paris getaways or adventures in Tokyo. Before the pandemic, they had built up their capacity through mergers, and given themselves many levers to pull to respond to the marketplace. For example, they had three or more levels of passenger service to sell, along with airport lounge access. They could charge passengers for extra leg room or faster boarding privileges. With their international routes or airline partnerships, they were prepared to serve globe-trotters, vacationers, short-haul business travelers, and anyone else….
Southwest’s competitors have also been introducing basic economy seats, cutting into its no-frills strategy and “flooding the price-conscious-traveler space with additional seats within their existing networks,” says David Vernon, an analyst with Sanford C. Bernstein. In short, major airlines have been innovative with their fare-segmentation strategies in a way that Southwest has not.…
As a result of the shift in consumer tastes and increased competition for budget travelers, not to mention higher labor and fuel costs, Southwest has been struggling in the post-pandemic environment….
Winter Storm Elliott was also a blow, and one that could have been avoided had the company prioritized an update of its crew-scheduling system. The software had no way of automatically reassigning crews to planes following cancellations, and instead required staffers to manually find and schedule crew members. That was a manageable issue when relatively few flights were canceled, but a logistical nightmare when it came to thousands.”
In India a company can continue underperforming in the manner Southwest had done with no consequences for its management team. In the cutthroat world of American capitalism such management teams stand to get axed. And that’s exactly what activist investor Elliott Management has done to half of Southwest’s board. Hopefully, one day in the not too distant future, SEBI will change the takeover rules to allow this brand of cutthroat capitalism to come to India as well.
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