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Time for Southwest to Raise Fares & Ancillary Fees

Airlines have yet to fully understand what higher bag [and other ancillary] fees will do to demand once fully developed. One has to assume that extra fees will eventually cut into the fare revenue stream.

Increasing the fees too quickly or by a large amount will result in less traffic and earnings as passengers flock to lower priced competitors. It is appropriate to de-bundle the services provided by airlines, but high cost airlines will be competitively disadvantaged if the value proposition is less than that of the competition.

We are making the valuation case that Southwest will have no choice but to follow the herd with increased fees, especially as it relates to charging a fee for the 1st and 2nd bags. In my estimation, the company needs to raise fares by 5 to 8% AND start charging for bags if it is to prop up an over-priced stock. The downside is that Southwest will have to pull down significantly more than the 6% capacity reduction planned for this year. Of course, it could pay out a special dividend or initiate another stock repurchase plan. By our estimation the company has approximately $1.6 billion in excess equity on the balance sheet.

Absent an acquisition, management has limited options for both growth and strategies to increase shareholder value, and this must be a primary focus of management. The inability to produce opportunity cost shareholder returns gets to the heart of Southwest's primary problem.

We calculated earnings from increased baggage fees to be in the $165 - $280 million range, but don't expect the company to change things this year, based on what CEO Kelly is saying. The EarlyBird Check-In for $10 is a smart way to raise revenue and help the consumer.

Kelly is rightfully worried about Southwest's brand and what higher bag and ancillary fees will do to that brand. However, the value of the brand component that is related to not charging typically bag and ancillary fees must be measured against the value created by charging higher fees. I would argue that the [market] value created with higher fees exceeds the brand [market] value component that is lost.

Using the mid-point of our conservative estimate results in an increase in share price of ~ $3.6, all else held constant. In other words, the share price increases 50% if Southwest simply matches other airlines. FYI, we took into account the [price elasticity of demand] fall off in traffic and revenue if additional fees are charged and adjusted for employee profit sharing and taxes. So, the question is how much "brand" value is Kelly protecting given the opportunity cost of not raising fees? Is that value worth $2.7 billion ($3.6X 741m)? Not likely.

I don't mean to beat up on a management team that can't control most of the forces and factors that buffet airlines and earnings. However, investor frustration is building because the company has not been able to earn its average cost of capital since 2001, let alone get the stock price moving up.

Southwest's war of attrition strategy has been a wealth-destroying proposition for the last 9 years, and has trashed the pricing power of the industry, generally speaking. Perhaps it is time for a new direction - one that involves raising fares to a level that covers capital costs. We believe that investor pressure will continue to build and eventually force management to change course in regards to increasing bag and ancillary fees. Moreover, without the higher revenue from increasing fees and/or fares; it's just a matter of time before the market concludes that Southwest no longer deserves a valuation premium. In other words, the currently over-priced stock will fall.

None of this provides comfort to the passengers who must endure the hassle of being nickel and dimed. The alternative is for airlines to charge a fare level that results in a viable business that is worthy of investment.

When the former Wall Street darling, Southwest - the so-called "low-cost and low-fare" airline - loses money, it's time for management to develop a new strategy. If the current management team is incapable of improving returns, it risks being replaced by a fresh team with a new strategy, especially as it relates to properly pricing its product.

Disclosure: No position in Southwest