Southwest Airlines Share-Earnings Curve

by: Victor Cook

Natural market share and relative earnings are theoretical ideals. Management can realize these ideals only when the inputs necessary for the operation of their business are in balance.

Balance means that the inputs cost exactly what they earn - at the margin. That's the point where total earnings are greatest. This balance cannot be observed. But it can be calculated using a theoretical equation derived from my 1985 Journal of Marketing paper on "The Net Present Value of Market Share."

The following graph is a snap-shot of the share~earnings curve for Southwest Airlines in its competition with the eight major carriers in U.S. Before digging into the theory, consider two of the important conclusions that can be drawn from its application.

First, in a peer group with eight other carriers Southwest's actual share of 2009 U.S. revenues was 16.13%. Its natural share was 15.79%. These two points bracket the unobservable "sweet- spot" at the top of the share~earnings curve. The difference is -0.34 share points.

Second, Southwest's natural earnings were $878.5 million compared with actual earnings of $878.0 million (excluding $616 million in accounting depreciation and amortization). The difference was LUV's relative earnings: -0.1%. No other airline came close.

Southwest Airlines had eight major domestic competitors in 2009. These were Alaska (NYSE:ALK), American (NASDAQ:AMR), Continental (NYSE:CAL), Delta (NYSE:DAL), Frontier (FRNT), JetBlue, United (UAUA) and U.S. Airways. Since Southwest operates only in the U.S., it's important to carve-out the domestic revenues of carriers that also serve international markets.

The information needed to carve-out U.S. revenues is buried in the notes to company financial statements. Fortunately, Edgar Online's I*Metrix Professional software makes it possible to dig selectively into the electronic financial statements of international carriers without downloading the annual SEC reports on each one.

The second column in the following table reports U.S. revenues as a percent of total annual revenues in 2009 for each carrier. The data are divided into three categories. The three [red] carriers had U.S. revenues equal to less than half their total revenues. The three [white] carriers had U.S. revenues greater than half their totals. The three remaining [blue] carriers had no foreign revenues in 2009.

Bottom line: the U.S. revenues for all nine carriers were $64.2 billion. This amounted to 60.7% of their $105.7 billion total revenues.

There are two components to airline expenses in the analysis of natural share and earnings: flight operations ("cost of goods sold") and enterprise marketing expenses. Pinning down these two components usually requires rearranging some line items in each airline's reported income statement.

Flight operations are the costs of aircraft rentals, landing fees, maintenance and fuel. Enterprise marketing is selling, general and administrative plus labor and related expenses. For a rundown on rearranging these expenses see Appendix 5-A, page 130 in my 2006 book Competing for Customers and Capital. Surprisingly, Yahoo Finance already has rearranged its report on LUV's 2009 costs and earnings in this format.

It makes sense to assume the cost of flight operations is highly correlated with revenues. The greater a carrier's revenues the more fuel it burns, the more landing fees it pays, and so on. But it turns out enterprise marketing expenses also are highly correlated with sales revenues. In passenger airlines that correlation runs 0.97. Because of this high correlation we can apply the "U.S. to total revenue percentage" in the table above to carve-out both enterprise marketing expenses and the cost of flight operations of international carriers.

Enterprise marketing and flight operations costs appear in the following table. These costs are divided into the same three groups.

Bottom line: for this group of nine air carriers, domestic enterprise marketing expenses were 51.6% of revenues. The domestic cost of flight operations was 42.5% of revenues.


The theoretical equation for natural share is simple. First, express earnings after the cost of goods sold and enterprise marketing expenses as a function of market share. Second, take the first derivative of this function, set it equal to zero and solve. The result is the following theoretical equation for natural share. For a proof see the Appendix, page 250 in Competing for Customers and Capital.

The four factors that drive natural share appear under the radical in this equation:

1. Peer U.S. enterprise marketing expenses [f];
2. LUV's U.S. enterprise marketing efficiency [x];
3. LUV's U.S. gross margin percentage [g];
4. Total U.S. airline market revenues [R].

Only two of these factors (x and g in green) are under management's control: enterprise marketing efficiency and gross margin. The other two (f and R in yellow) are under the market's control. The four factors in this model apply to any industry.

One of the advantages of the four factors model is one can verify the results with a hand-held calculator or a smart phone. In a pinch, one can run the numbers on the back of an envelope.

LUV's peers spent $28.328 billion on enterprise marketing. Southwest's extraordinary marketing efficiency allowed management to buy their optimal inputs for 88¢ on the dollar. This efficiency more than made up for a lower than average gross margin. Of course, all competitors faced the same level of market demand: $64.167 billion in total U.S. revenues. How did LUV management do this?

First, LUV flies only one type of aircraft. So "the planes spend around twelve hours a day in the air, as opposed to an average of seven hours a day for other leading airlines. This operational streamlining helps the company recover the cost of a Boeing 737-about $35 million-more quickly than its competitors."

Second, since all flights are point-to-point there's no hub-and-spoke to complicate scheduling. Here's what Gary Kelly said about the company's common fleet strategy at that UT Austin speaker series in 2003:

Don't make it complex. Any pilot can fly any plane. Any flight attendant can work on any flight. We don't spend a lot of time and money figuring out who can do what.

Third, LUV picks only underserved and overpriced markets. In a recent interview with Jeff Bounds at the Dallas Business Journal Kelly said:

At Southwest, arguably, we're not even halfway done. We don't even serve all the cities in the United States that we could. There are new and exciting things that we can continue to explore for Southwest in the future. Our competitors are retrenching and going backward.

Fourth, LUV is growing its passenger base even in the continuing recession. In the Q&A session of their Q4 2009 earnings call Gary Kelly said:

… you will continue to see record load factors at Southwest Airlines. … we reduced capacity in the fourth quarter 8% and at the same time we grew our passengers. … it all sort of points to roughly 1% share shift in the domestic US which is huge. I hope they charge $100 per bag. That would be terrific. We will have 100% load factors.

Finally, in that Dallas Business Journal interview Mr. Kelly concluded:

I always wish I had that little bit of extra information or knowledge to do my job.

I hope this article gives you (and Mr. Kelly) that little bit of extra information or knowledge needed to do your job.

Thank you for viewing. As usual, your comments are welcome.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.