Southwest CEO Risks Keep-it-Simple Strategy to Reignite Growth
By Mary Schlangenstein and John Hughes - Sep 28, 2010 5:48 AM MT

Southwest Airlines Co. Chief Executive Officer Gary Kelly, taking on his biggest acquisition ever, is dismantling the carrier’s keep-it-simple strategy in a bid to reignite growth.

The largest U.S. low-fare carrier’s decision to buy AirTran Holdings Inc. for $1.4 billion will mark its first foray into a second jet type and its first boost in seating capacity since the end of 2008.

Southwest will also face off with bigger Delta Air Lines Inc. at its primary hub of Atlanta, the world’s busiest airport and the only major U.S. city Southwest doesn’t serve. The Dallas-based carrier will start flying at Washington’s Reagan National, add its first international flights and mesh 8,000 employees into its workforce.

“They ran out of places where they could keep it simple,” David Swierenga, president of consultant AeroEcon in Round Rock, Texas. “They’ve become such a widespread, far-flung airline and served just about every city that met that simple requirement. They figured it was time to go beyond that.”

With the cash-and-stock purchase, Kelly gives up some of the last vestiges of Southwest’s historic low-cost strategy, including flying just one fleet type, Boeing Co. 737s, to hold down maintenance and training costs, making short hops between cities at high frequencies and owning most of its jets.

More Seats

The deal will add 138 planes, ending Southwest’s self- imposed capacity ceiling that began at the end of 2008 and became the longest dormant period in 20 years. The combined company is to have 685 aircraft, including 86 Boeing 717s from AirTran. Southwest’s 737s can carry at least 122 passengers, while AirTran’s 717s have 117 seats.

“Growth is in Southwest’s DNA, and the growth pause of the last several years has not been a naturally comfortable place for the company,” said Douglas Runte, managing director at Piper Jaffray & Co. in New York. “The addition of AirTran will allow them to satisfy their briefly dormant, but always present, inclination for growth.”

AirTran flies to Cancun, Mexico, and the Caribbean, giving Southwest the “perfect opportunity” to add flights outside the U.S. for the first time, Kelly said yesterday at a news conference at Southwest’s headquarters.

Southwest’s offer values Orlando, Florida-based AirTran at $7.69 a share, including its convertible notes. That’s 69 percent more than the carrier’s closing price on Sept. 24.

Southwest rose $1.07, or 8.7 percent, to $13.35 in New York Stock Exchange composite trading yesterday, while AirTran jumped $2.79, or 61 percent, to $7.34.

Merger Terms

Under the merger agreement, each of AirTran’s common shares will be exchanged for $3.75 in cash and 0.321 share of Southwest common stock. Including AirTran debt and capitalized aircraft operating leases, the transaction has a value of about $3.4 billion, the airlines said.

AirTran’s debt as of June 30 included about $280 million in convertible notes, according to a July regulatory filing. Southwest will take on about $2 billion of AirTran’s aircraft operating leases, according to the Standard & Poor’s ratings company.

Southwest will partially fund the purchase with $670 million from cash on hand. The carrier currently has $3.3 billion in cash and short-term investments, and an available $600 million revolving credit line, it said yesterday.

The acquisition will add $2 billion a year in revenue and $400 million in cost and revenue synergies, the companies said.

‘Growth Opportunity’

“We have evolved our company to be able to take on a growth opportunity like this,” Kelly said. “Our own growth prospects near-term are quite modest.”

The merger must be approved by AirTran shareholders and the Justice Department. The U.S. clearance is “not a slam dunk,” said Vaughn Cordle, managing partner of AirlineForecasts LLC in Clifton, Virginia.

The two carriers overlap on 32 markets, more than twice as many as in the pending merger between UAL Corp.’s United Airlines and Continental Airlines Inc., Cordle said in an interview.

The Justice Department will analyze direct service on a route-by-route basis to determine whether the merger leaves too few competitors in any individual market, said Steve Martin, a senior vice president at InterVistas Consulting in Washington. Buffalo, New York-Orlando; Baltimore-Orlando and Baltimore-Las Vegas are among routes that will come under scrutiny, he said.

Acquisition History

Southwest, which started flying in 1971, has made two previous acquisitions: Morris Air in 1993 for $134 million in stock and Muse Air in 1985 for $60.5 million in stock and cash. AirTran, founded in 1993, formerly was called ValuJet.

Southwest failed in a 2009 bid to acquire Frontier Airlines out of bankruptcy. Frontier, based in Denver, was then acquired by Republic Airways Holdings Inc.

While Southwest hasn’t suffered annual losses that ravaged competitors such as American Airlines parent AMR Corp. and UAL, it posted net losses in four of the past eight quarters. The carrier’s third-quarter loss in 2008 was its first in 17 years.

In the 12 months ended Sept. 24, the shares jumped 29 percent, the sixth-best performance among the 12 carriers in the Bloomberg U.S. Airlines Index. UAL more than doubled in the period, and US Airways Group Inc. and Alaska Air Group Inc. each surged 83 percent.

Pilots, Attendants

Southwest told employees yesterday it would add as many as 200 pilots and 300 flight attendants next year, in addition to AirTran employees. Combined, the companies would have about 42,700 employees, based on second-quarter data.

Southwest’s unions will negotiate with AirTran’s unions on how to mesh their seniority lists. There will have to be representation elections and contract negotiations with the carrier because the airlines’ major work groups belong to different unions.

Based on miles flown by paying passengers, Southwest now ranks as the fifth-largest U.S. carrier, while AirTran is eighth. The merged carrier will be No. 4 after United and Continental combine.

Southwest plans to use AirTran’s base in Atlanta and its flight slots at Reagan National to build on its strategy of attracting more business travelers. A blended Southwest and AirTran will account for 69 percent of flights at Baltimore- Washington International.

LaGuardia, Newark

The airline also will gain additional flight slots at New York’s LaGuardia Airport with AirTran. Southwest agreed last month to lease flight space from Continental and United Airlines, which plan to complete their merger this week, at Newark’s Liberty International airport.

“Southwest has, until recently, avoided serving congested Northeast airports,” said Alan Bender, professor of aeronautics at Embry-Riddle Aeronautical University in Daytona Beach, Florida. “This is a major entry into those markets. Southwest is saying it is no longer the airline of ma and pa -- we are going to become the airline of the business person.”

While Southwest flies into several airports that serve as hubs for rival airlines’ connecting flights, it hasn’t yet come up against the dominant position that Delta holds in Atlanta with 75 percent of passengers.

In Los Angeles, American Airlines has 16 percent of passengers, compared with 12 percent for Southwest. In Denver, United has 32 percent of passengers, compared with 15 percent for Southwest, and in San Francisco, United has 34 percent, while Southwest has 8 percent, according to the U.S. Bureau of Transportation Statistics.

‘Greater Appeal’

“We want to have greater appeal to more customers nationwide,” Kelly said. “The gaping hole in our route system right now is Atlanta. There is no easy way for us to get into Atlanta. We can start day one profitably and go from there.”

Southwest plans to extend its policy of not charging for the first two checked bags to AirTran, as well as its offer of a single class of service on aircraft. The combined carrier, which will remain based in Dallas, won’t assign seats.

The deal allows Southwest to eliminate AirTran, the second- biggest discounter, as a competitor and increase pressure on rivals JetBlue Airways Corp., Frontier and Virgin America Inc.

“It’s certainly going to change the competitive dynamics of the low-cost sector,” said Paul Mifsud, a Washington consultant and former airline executive. “They are going to become an extremely big competitive force in the domestic industry.”

To contact the reporter on this story: Mary Schlangenstein in Dallas at maryc.s@bloomberg.net; John Hughes in Washington jhughes5@bloomberg.net

To contact the editor responsible for this story: Ed Dufner at edufner@bloomberg.net.
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