Frontier Acquisition: Southwest Comes Out Swinging

Includes: LUV, UAUA
by: Loren Steffy

The bankruptcy court auction for Frontier Airlines began this week, and Southwest (NYSE:LUV) already upped the ante, raising its bid to $170 million on Monday. As I pointed out in Sunday's column, winning will put Southwest in an unusual position when it seeks anti-trust approval from the Justice Department.

The carrier that helped redefine airline competition in the post-regulation world will have to argue that having one less carrier in Denver will increase competition.

That issue struck a nerve with the Dallas-based airline, and Ron Ricks, the executive vice president for corporate services, called me Monday afternoon to explain the carrier's position.

"We didn't do all this just so we could walk up to the DOJ and get stuffed,'" he said. "We have a plan to win."

That includes demonstrating that Southwest's plans for Denver will be pro-competitive. Southwest contends that Frontier isn't actually a low-fare carrier, that its fare are low only in markets where it competes with other low-fare airlines. In markets where it competes solely against, say, United (UAUA), its fares are much higher.

When Southwest entered the Denver market in 2006, it had the same effect that it's had in other markets - fares declined, Ricks said. Based on government data, fares from Houston to Denver, for example, fell and average of 21 percent. Frontier itself lowered fares by 20 percent to compete. At the same time, passenger traffic increased by 27 percent, he said.

That isn't really the issue, though. The issue is what happens after it buys Frontier.

As it stands now, United controls about half of the Denver market, and even if it combines with Frontier, Southwest will hold less than a third, Ricks said.

"We're buying Frontier in order to become an immediate force in the marketplace," he said.

In other words, Southwest will argue that it can compete more efficiently against United if it has more market power. But that ignores the fact that the merger would also create a near duopoly in Denver. In way, Southwest is asking the DOJ to trust it to keep fares low. If any airline could pull that argument off, Southwest could, given its track record.

But as I noted in my column, Southwest has been losing big bucks in the Denver market, probably since it entered. A big chunk of those losses can be blamed on Frontier, not United.

Ricks, though, rejects my assertion that buying Frontier is a defensive strategy. Even with the increased price of the bid, it's getting a billion-dollar airline with international routes and gates in new markets such as Atlanta for the price of about five 737s.

"It allows us to do virtually overnight what might take a decade to do and cost a lot more money," Ricks said.

That's the same case Southwest has been making to its employees.

"We had some major issues here with our own workforce," he said. "We are in a no-growth mode right now because of the economy, and Southwest Airlines has never been in a no-growth mode. Some of our unions are very unhappy about that."

So, Ricks argues, the whole strategy is straight out of the classic Southwest playbook. It's about growth and busting United's chops, not removing a competitive threat from Frontier.

"The real story here isn't Frontier," he said. "The real story is the competitive war that's about to break out between an invigorated, a more powerful, a bigger Southwest combined with Frontier against United."

There's no question that buying Frontier offers a lot of benefits for Southwest, both in terms of growth and in bulking up against United. But given its losses in the market, and given United's own shaky financial condition, I still say its going to be a tough sell before the DOJ.

With Frontier gone, Southwest could - indeed probably should - raise fares enough to at least make Denver profitable. So it's essentially arguing that higher fares and fewer market participants improves competition.

That, as I said in my Sunday column, is an argument only a legacy airline could love.

Disclosure: no positions