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Will This Airline's Change in Strategy Spell Glory or Doom?

Ted is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Southwest Airlines (NYSE: LUV) made headlines in 2011 when it completed the purchase of AirTran for $1.4 billion in cash and stock. The acquisition was hailed by analysts as a terrific move to spur growth. Many observers noted that there would be no cannibalization because there is so little overlap between the two companies. However, the lack of overlap is precisely why the acquisition will turn out to be the worst move in Southwest's decades-long history.

Ingredients for Success

Few companies prosper after abandoning a tried-and-true method of success. Southwest has earned an operating profit in 39 consecutive years by flying short-haul direct flights with a fleet of only one aircraft type.

Southwest is famous for its domestic direct flights that often arrive in mid-tier airports where the landing fees are lower. This strategy minimizes delays by avoiding congested airports and holds down food costs because the flights are usually not more than a few hours.

The company is also famous for using one aircraft model for its entire fleet. This simplifies maintenance scheduling and training. At the end of 2011, Southwest's fleet consisted of 610 Boeing 737s.

Southwest's short-haul direct flights and single-model fleet has given it one of the industry's lowest cost structures. The company regularly earns higher margins than legacy carriers like United Continental (NYSE: UAL) and US Airways (NYSE: LCC). United and US Airways have gone through multiple bankruptcies and have proven unable to compete in a structurally-challenged industry with their legacy carrier model. However, budget airline Jet Blue (NASDAQ: JBLU) earns margins closer to that of Southwest by using a similar model.

<img src="/media/images/user_13490/airline-pretax-margin_large.png" />

Abandoning a Winning Strategy

Since Southwest and Jet Blue's success are proof that the business model works, it is anyone's guess why Southwest would want to abandon the strategy for something closer to the legacy carrier model. The AirTrain acquisition was lauded by analysts because it gives Southwest access to 37 new markets that have little overlap with Southwest's markets, which provides enormous growth potential and reduces cannibalization.

However, analysts fail to notice that Southwest is moving away from the short-haul direct flights and single-aircraft model that has enabled it to become one of the most profitable airlines in the industry. By acquiring AirTran, Southwest also acquired 88 Boeing 717s, which essentially nullifies the company's single-aircraft advantage. In addition, AirTran has a presence in much larger airports like La Guardia in New York and Logan Airport in Boston, which eliminates Southwest's short-haul direct flights to mid-tier airports model and shifts it to the more traditional hub-and-spoke model that legacy carriers like United use.

Investment Prospects

It's puzzling why Southwest would want to move away from the strategy that has served it well for four decades. At 11x historical pre-tax earnings, the stock does not look especially cheap. However, a company's operating history has no predictive power for a company that will operate much differently in the future. There are really only two possible outcomes: Southwest does better in the future than it has in the past, or it does worse in the future than it did in the past. If I had to guess, I'd guess that, in five or ten years, Southwest's financials will look more like United's than Jet Blue's. But it's anyone's guess how a major corporate transformation will turn out.


titans8904 has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Southwest Airlines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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