Southwest Airlines Turnaround Comes With Baggage

Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks. Historically, Southwest, when they would go into a downturn, given their balance sheet, would use the downturn as an opportunity to take advantage of the market. They normally were going on the offense when everyone else was receding into hubs or going into bankruptcy. This downturn was different.

Hello and welcome to the Barron's Streetwise Podcast. I'm Jack Howe, and the voice you just heard is Connor Cunningham from Melius Research. He's an airline analyst who recently upgraded Southwest from sell all the way to, well, to hold. That's progress. The stock has been outperforming over the past 2 months. Call it a turnaround amid an identity crisis that now might be running up against an industry downturn. We'll talk about it. Listening in is our audio producer Alexis Moore. Hi, Alexis.

Hi, Jack.

What did you mean when you told me that you come from an airline family?

I mean that I basically grew up in an airplane. My mom worked for an airline, two of my uncles did. So we just stayed in the sky.

It sounds like free flights, right?

Free flights.

Yeah.

Standby.

Did your mother work on a plane or did she work in an office?

She worked in an office.

Oh, so I was gonna ask you what's the craziest thing she ever saw happen on a plane? Flight attendants have great stories about that sort of thing. It's like the first thing I always like to ask a flight attendant. But I guess you don't have those stories, right?

No stories about that.

No stories.

And does she still work for the airline? Do you still get free flights?

I don't, but she and my dad do for the rest of their lives.

Oh.

I know.

Now, are you sure they're not just telling the kids that? Where they're saying, "Oh, no, we've got to go by ourselves. Sorry. The free flights are only for the parents." And you know what?

They did go to Greece last year. So it's adding up. It's adding up.

It's starting to look suspicious.

Okay, so Jack, I got a question for you.

Hit me.

Is it true that you've never flown on a Southwest flight?

I never have. Southwest for many years had these devoted fans, but the thing is it's Southwest. So they're in—

What do you mean?

Well, I'm in the Northeast decidedly. I'm in New York.

Actual geography, got it.

Yeah, I'm in New York and they started in Texas. Now, Southwest expanded to New York in, I think, 2009. So you can get Southwest flights out of New York now, but it's just not one of the big carriers here. It's not one of the, you know, unless you're really looking for Southwest, maybe you're not flying them so much out of New York. I think that might be part of the issue with them is, um, you know, they expanded a little bit into markets where they don't totally fill their planes, but we'll get into that. I want to just first say a couple of words acknowledging that the stock market went a little bananas this week. Sometimes we do an episode where we focus on a micro thing in a week that then becomes a macro week when everybody's wondering about the market and not so much about particular companies. I think that's what has happened with this week. The stock market took a big dive when President Trump announced some of the details on his tariff rates. China, 67%. That's tariffs charged to the USA, including currency manipulation and trade barriers. So we're going to be charging a discounted reciprocal tariff of 34%. I think, in other words, they charge us, we charge them, we charge them less. So how can anybody be upset? Some of the rates are raising eyebrows. These are supposed to be reciprocal tariffs, and I guess the idea is that the US would impose tariffs equal to half what other countries are charging us. And it's easy to figure out what they're charging us in tariffs, but these rates also lump in factors like currency manipulation, which is a hard thing to calculate. It's hard to say, is there currency manipulation? And if so, how much? And, uh, you know, what's the actual percentage we should put in that? But we do now have concrete rates. What we don't have is an exact estimate of what this might do to the US economy or to company profits. Let me give you an example. Bank of America's top stock strategist, Savita Subramanian, she's been on the podcast before. She put out a report titled There Is No Tariff Playbook. She writes that investors who are looking for historical parallels are faced with scant observations from incomparable eras. One example is the Smoot-Hawley tariffs in the 1930s. Those ended badly. Import and export exposure by company, that's difficult to estimate. It's not regularly disclosed. Savita writes that secondary impacts were even hazier. Prolonged negotiations could stall activity, spiraling into a recession. So her math, which she concedes is oversimplified, suggests that S&P 500 earnings per share could take a hit of 5% to 35% based on these tariffs. Think of that range, 5% to 35%. That's a range of, don't worry, we'll get through this, to Lord Almighty, what happened to my 401(k)? Just thinking about it in common sense terms, you can kind of see why that's the case. You have to figure out how much these tariffs will raise prices for customers, and then how those customers will respond in their purchasing patterns. Then you have to figure out how much other countries will retaliate and what that will mean for employment and what that will mean for demand back here at home, and so on. There are a lot of moving parts. And by the way, are these numbers going to stick for a while, or are they just a starting point for negotiations? Investors don't like unknowns, and even though these tariffs have specific percentages now, there's still a lot to be figured out. We'll say more about this and how investors should respond or not respond in future episodes. It's early for a break, but Alexis, what do you say we take one now so we can play my conversation with Connor uninterrupted, as they like to say on— I don't know where they say that, but beautiful.

Let's do it.

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Welcome back. Okay, let's move on to airlines. Alexis, you have described yourself as a, up until recently, a Southwest loyalist.

Yes.

And you're wondering whether you should abandon ship, whether you should make a change. What's got you concerned about Southwest?

I think, well, there's a couple things. One, baggage fees.

Baggage fees. You used to get 2 free checked bags, which was unheard of. And just last month, the company said it will be introducing baggage fees. Spirit Airlines was the first airline to bring baggage fees to the US. That was back in 2007.

Really?

Yeah. They copied this from an Irish carrier called Ryanair. The idea that you would charge people to bring luggage with them, it was unheard of before then in the US. Spirit started it. Then all the legacy carriers followed, but Southwest was a holdout for this long and now they're bringing baggage fees. So that's got you steamed. What else?

I mean, there's just so many changes, which I know you get into with Connor. I think like it had such a sheen when I was growing up, right? Like it was the fun airline. You can wear shorts to work. My mom was like, I can't wait to go work for them one day. And now it's, it's, you know, it's just like everybody else.

I didn't know about the shorts, but, but, but, uh, you know, for a Texas-based company, I mean, that's, that's shorts country, isn't it?

Yeah. It's par for the course.

Shorts for sure.

It's a health hazard to not wear shorts to work.

So Southwest pioneered this low-cost business model and they were early adopters of technology. They kept things simple. No assigned seats, right? Just pick any seat.

Exactly. Not for long, but that was their thing.

Not for long. The, the free bags are going away May 28th. There was an announcement back in September that the company will transition to assigned seating with premium tiers. So we'll have to see how and when that happens and what the different tiers look like. You're not loving it.

Yeah, I might not see it.

Yeah.

We'll see.

I think a lot of people are in the same boat and a lot of people are saying, what's going on here? Is this Wall Street greed? Is that why Southwest is doing it to us? And maybe, but let me tell you what I think they're responding to. First of all, the stock has stunk over the past 3 years. And when we get into my conversation with Connor, you'll hear him explain why Southwest might have expanded too much in markets where it doesn't fill the planes. Second, it has a record of using its strong balance sheet in the past to invest and expand and take market share during industry downturns. We had the mother of all airline industry downturns during COVID Southwest turned a loss for the first time in 48 years. But more than that, it was not able to use its balance sheet to go out there and take market share because the downturn was so severe that the US government bailed out airlines. It paid tens of billions of dollars to help cover payroll and other costs. So the industry stayed fiercely competitive. This is a specific thing, but Southwest also had a software-driven meltdown in 2022 that left a couple of million passengers stranded around Christmas time. That wasn't good for business. This past February, Southwest announced the first major layoffs in its history. I think that's an acknowledgement that the company had expanded in ways that hurt its profit margins, but it's also under pressure. Last summer, a company called Elliott Investment Management announced a sizable stake in Southwest and it began publicly agitating for change. It basically said, look, you used to be a great company, but now the stock has stunk for a long time and the margins stink too. We think that you've just become entrenched in these ideas that are outdated. You don't charge for bags like everyone else. You have— you don't have assigned seating like everyone else. You don't have premium tiers like everyone else. You're leaving money on the table. We want board changes and we want a management change. And the company since then has announced 6 new board members and it's made or announced many of the changes that Elliott is demanding. And the stock is responding. I recently looked at it versus some other airline carriers. Since the end of January, Southwest was up 4%. Okay, no big whoop, but the S&P 500 during that same stretch was down 5% and Delta, United, and American Airlines had all plummeted more than 30%. So that's a big relative outperformance for Southwest. Anyhow, that's enough for me on the subject. I wanted to ask Connor about where are we in this turnaround? What are the prospects of it succeeding? If Southwest is going down this road, if it's supposed to be the low-cost carrier, but now it's adding fees for bags and a lot of other upcharges, does it now have to out-Spirit Spirit Airlines? Hmm. Have you ever flown Spirit? Alexis? Yeah.

Yeah.

I was thirsty the whole flight.

How much they charge you for water?

Too much.

I'm sorry. I shouldn't laugh at your thirst. I actually recently considered, I've never flown Spirit. I considered a Spirit flight because I'm trapped in a cult called youth travel basketball. And that's where like sensible parents fly kids cross country in hopes of them making it to the trophy game for the Cash Grab Classic Teal Division Regional Qualifier. And then when they get there, they inevitably face a team from back home. It's a whole thing. And the cost of it, if you add in another cult called private trainers, the cost of it is about— it's a little more than college is the cost of travel sports these days. I can't prove that Spirit Airlines is behind this. But it does push itself on oversported families with its impossibly low fares. And one of them caught my eye recently, a New York City to Houston flight. The price was $70, $70 per person round trip. Now you have to— round trip. You have to add to that $80 for the airport fees and taxes. Okay.

Okay.

But still, and then of course you have to pay for a bag, right? That's like $55 each way or thereabouts.. But even after you did that, the fare on the flight came out to about half what some of the other team families were paying for Southwest. So it's tempting. I asked around whether, you know, people thought I should do it. Some people said yes and some people said no. They said the seats are uncomfortable and that's a long flight.

Yeah.

And you're a tall person.

I'm a tall person. I, I did a lot of backpacking in my twenties, so part of me feels like I can tough it out, but now I'm, in my 50s, and maybe I can't. So anyhow, you can see how that would be a very competitive environment for Southwest if they're going to go the Spirit route. I asked Connor about that. He says they don't quite have to do that. So let's get into that conversation now. Here's Melius Research analyst Connor Cunningham. I want to learn about Southwest. I saw that you recently turned— not bullish, but you, you left your bearish view behind. You're ready to turn neutral on Southwest, and I want to ask you about about that. But first, maybe you can just give me a little bit of background on the company. First of all, when I look at the stock this year so far, it looks like, you know, it's down single-digit percent last I saw, but the other big U.S. airlines are down 30 to 40%. So why is Southwest doing so much better? Is that because they say they're going to start charging baggage fees like everyone else and Wall Street's excited about the cash, or what's going on?

So there's obviously a lot going on at the company. So historically Southwest, when they would go into a downturn, given their balance sheet, would use the downturn as an opportunity to take advantage of the market. They normally were going on the offense when everyone else was receding into hubs or going into bankruptcy or whatever was going on around the operating environment from their perspective. So this downturn was different in the sense that everyone got bailed out.. So the balance sheet didn't matter as much. And so the historical precedent where you had where other airlines would give up share or not, uh, the competitive environment was just a lot different this iteration than it was historically. At the same time, you had a lot of pilots retire, you had a lot of TSA agents, and you saw a lot of, uh, air traffic controllers go away. So it was just a much more difficult environment that worked against historically a very productive company, at least relative to the competition. So the post-COVID era, Southwest just couldn't win and their network got really out of whack. They also at the same time hired a lot of people. You know, they had a big order book and they knew that they were going to grow in the future and there were all these hopes that Boeing was going to deliver and they never did. And so they were stuck with a lot of folks.

Let me just dig into that point a little bit because I was going to come to this. Southwest, they had these, uh, you know, very passenger-friendly policies, and passengers loved it. And it seemed for a long time like Wall Street loved it. It must have been good for business. What exactly stopped that from being such a productive path for the company? Why did that no longer work?

So the preferences amongst travelers change. And yes, Southwest historically had bags fly free, and that was a very public advertisement that they had for a lot of So they gave you a lot. Were they getting compensated fully for that? You could argue that Southwest left money on the table given the product was, you know, better than most. Like if you're thinking about them competing against a Spirit, Spirit's nickel and diming you left and right. Southwest is giving you all this free stuff. The problem is, is that the world has changed. You know, I don't know about you, I don't check a lot of bags, but there are people that obviously do check bags and want to have that, that, that free service. But these things cost money to fly. Incremental baggage weight alone costs a lot of money. You also have this credit card and loyalty programs being incredibly important. So you could say that Southwest was underperforming on the credit card side because if you sign up for a credit card at United or wherever, you get the free bags and all that stuff. And so if you incentivize people to get into your loyalty program, into your credit card program, there's another stream of revenue that theoretically is maybe more profitable than that incremental passenger that you didn't necessarily need. So again, back to these guys coming out of the pandemic, these guys were just slow to act in how they were going to change the operation. Now they're making that change. And so Elliott sparked a lot of this.

This is an activist investor that took a stake and began arguing for some change.

Yeah. So I don't necessarily want to say that the analysis was perfect. I think that if you were to take a step back and compare Southwest to some of the other US domestic pure plays out there, You know, JetBlue, Spirit, Frontier. I think Southwest actually held up okay. But if you compare them to Delta and United who had opportunities on the international side, big loyalty programs, corporate travel, so on and so forth, they looked like they underperformed. But the point is, is that I think you can blend those two worlds on some level. You can offer premium services. You could have a more important loyalty program. You can go after corporate share, but also still cater to some of the leisure side of the equation. One of the big things here too is that, you know, United is now run by Scott Kirby. He is, uh, has a lot of big ideas. One of the big ideas was to eliminate change fees, and that was again, one of the big benefits that Southwest customers would have. United then copied that in the midst of the pandemic. So the products started to get very similar from that perspective. Also, at the same time, you could argue that the product in the US domestic market is arguably the best it's ever been.

It's a bold claim you just made. All I I'm thinking about it. All I ever hear from people is complaints about airlines.

It's easy to complain.

You do a 30— I hear 30-minute stand-up comedy routines just about airline issues. But, um, you know, they've gotten better, I guess, is what you're saying, right?

I mean, do airlines have their issues?

Absolutely.

But I think, again, it's, it's easy to go after them because everyone has an opinion.

Talk to me about premium class. All I hear about is airlines focused on how quickly can we add more premium services, premium class. All the money is being made in, you know, first class. And Delta, I hear, is doing great there. They're, they're, you know, raking it in and others want to follow. What's happened? Do the airlines just break even on, on coach and all the money is made in the premium classes or what's happening there?

So there's been a big change in preference, right? I think that the pandemic, when there wasn't a lot of people on the planes, you had to try different products. And once you go up, it's really hard to go back. Delta always brings up this analogy. You know, if your first car Maybe it's a Honda Civic or whatever, and then you move up to a BMW or a Mercedes. It's really hard to go back to the Honda Civic. So there is that mentality that's within it. Also, you get on a plane, the first thing you walk by, um, are these lie-flat seats, beautiful service, all this stuff, and then you go into row 35.

And then my kids, because the one time I flew them first class way back when, now when we pass by, they, they, when they were small, that they, they would yell out, how come we can't sit in the front again like, like last time? Well, you know, we can't always do that.

Yeah. So you spoil them. And so now they want the good life. Well, what's really happened is that, well, configurations of aircraft layouts have changed, right? So they're adding a lot of different options within it. And the reason why they're doing it is that there's this opportunity of attracting you with a somewhat cheap base fare. Right. And then being like, hey, yeah, this costs $100, but you want a little bit more extra legroom. We can offer you that. And what is different from now versus history is that the paid load factor, or the actual paid butt-in-seat, has, has improved significantly. And so they're actually selling the products. They're not giving it away to their highest loyalty people anymore.

It's gotten harder to score like free seats through loopholes and, and programs and things like that.

Yeah. But now the actual price difference between row 35 and an economy plus is not that much. It's like $70. It's reasonable. The point is, is that like the, the, the differential in spread is not what it used to be.

You're no longer going from $300 straight to $5,000. They got things in between you can do that you can do to make life a little more comfortable.

Absolutely. And then but really at the end of the day, if you— Delta has a great chart on this. They show the layout of their aircraft and where it was in 2010 to where it is today. The main cabin portion has not grown at all. Like it's flat. All of their growth is through the premium seats. And so not only are they doing a better job of selling you those seats, but it's at sometimes the only seats available to you.

So how can you adapt to this world if you're Southwest? I haven't actually flown Southwest, but I gather that, you know, they had a thing where people would just go in and grab their seats and then the seats were kind of all similar. So what do you do? You have to remake your planes.

Yeah. So Southwest has, they've gotten rid of the, the open boarding seating policy. So now there's an opportunity for them to individually price seats, right? So that's one revenue lever, good or bad for the consumer. We'll find out if they push back on it. And then they're also introducing their version of premium. Again, it's not going to be the first class offering that Delta has. You got to remember what Southwest bread and butter is here.

You're not going to be lying flat at Southwest unless we're talking about the bench in the airport, maybe there. Yeah.

Well, hopefully that's not the case, but yes, they're not going to compete on the highest of high levels. They are very aware who their customer is, but they realize that there is an opportunity to price up a little bit better and have more structure to the fare structure in general. So like they're introducing basic economy. So yeah, they got rid of the bag fees, but you can buy up into another thing where you get the bags. The question is, is like, does Southwest need to change its route network to accompany a lot of these changes that they're doing on the product itself? You know, like in highly competitive markets like Denver where they're going against Frontier and United? Do they need to pull back on a market like that and lean more into a market like Nashville, for example, where they think that they can dominate? Because at the end of the day, if you look at any airline and any of the most profitable hubs that are out there, Atlanta is like the most profitable hub in the globe. And that's because 75% of the capacity is controlled by Delta. You got to own the market and you got to be relevant to your customers. So do they need to adjust to that reality that they're going to cede some share in these really competitive markets and need to go back into their core hubs.

They may. Okay. So for investors out there on the stock, what turned you bearish at first on the company and then what has recently brought you to neutral on the stock? What progress have you seen?

Yeah, I mean, when we were really negative on it, there was a lot of hope and prayer, I think, associated with a lot of these initiatives that they had rolled out a couple years ago. Again, I think that the biggest problem at the end of is that they overhired and the capacity that they were putting in the market did not reflect any of the incremental headcount. So they were basically just way overstaffed and weren't producing the amount of supply that they should have. And when they were trying to push supply, it was all coming at fares that were dilutive to the overall margin structure. So they put them in this really, this catch-22 situation where you needed to make a lot of adjustments on the cost side, to regain your low-cost structure and make a lot of hard choices on the network. I think that their network got really out of whack. They chased leisure demand on them coming out of COVID and then leisure demand dried up as people started to go to Europe. And that's not something that Southwest was offering. And so everything was working against them and they didn't have a plan to execute going forward. There's a plan now. Initially, when they rolled out a lot of the premium stuff, it wasn't new to me. We were all kind of expecting it. The upside to estimates wasn't anything crazy, but now they've layered in multiple other billions of dollars of initiatives. So even if they had half of them or a quarter of them, numbers needed to go up in a pretty material way. And the biggest pushback that I had and investors have had is that the valuation made no sense, at least relative to Delta and United. And so if you thought there was even a small chance of them getting to this mythical a $4 to $5 EPS number in the future, you know, it wasn't maybe so egregiously valued. At the same time, like they've made a lot of changes on the headcount. You know, it's been obviously written about a lot. They eliminated almost 2,000 jobs in the corporate headquarters. Do I still think the stock is expensive, at least relative to some of the others? Absolutely. They are supporting it with a pretty aggressive share buyback program, and I think they're trying to do about $2.2 billion over the first 7 months of the year.

Are they in a position where where now they have the bag fees, do they have to now outspirit Spirit? Because nobody outspirits Spirit. I mean, Spirit is so cheap. I saw a flight the other day where the cost of a flight, it was like New York to Texas, and the cost of the flight was lower than the airport fees and taxes that they put on the flight. I don't even know how they do that. And they just emerged from bankruptcy proceedings at Spirit. Or, or does Southwest continue to have something higher value to offer people?

I mean, that is a great question and a debate that we're all going to have, I think, over the next year and a half. I would argue that Spirit needs to change, that Frontier needs to change. Their costs have ballooned just as much as the industry's, if not more. So historically, if you think about what the ultra-low-cost airlines used to do, they basically used to grow 20%, outrun their costs, and then try to stimulate demand with really low fares, really just focusing on spill traffic in big markets.

I'm sorry, what's spill traffic?

So it's like if you're in Atlanta, for example, and you got priced out of the market because you can't fly Delta anymore and it got too expensive, they used to just go into these markets and offer, you know, somewhat infrequent service and they wouldn't necessarily be huge in markets, if that made sense. But they were there. That came to your point about the airport. Fees. It's proven now that that doesn't work. You got to know your customer, where they want to fly. Going into markets and offering things at $39 fares just isn't rational anymore. So the point is, is that Spirit needs to change its model, and they are. They're, they're also going up this premium ladder, so on and so forth. But is the, is the benefit still skewing more towards Southwest? Southwest offers a much more robust network. Spirit's more, you know, it's not as immense of a network as what Southwest is. Again, they're the largest domestic airline out there.

Last question for you, and you've been generous with your time, and thank you. If you are neutral on Southwest, and it doesn't sound like you're a big bull on Spirit, are there airlines out there right now that you're bullish on? And give me some commentary about the industry in general, supply versus demand right now, what it looks like going forward. It seems like it must be kind of tough times this year. What do you think about that, and are there any airlines where you're bullish right now?

We turned pretty bullish mid-last year on the theory that the industry needed to structurally fix itself. Southwest went up on stage, said they're not going to grow capacity at a meaningful clip until return on invested capital and earnings improve and so on. And historically, that's been a bull signal for the industry, which I think is why you saw United go up 150% last year and Delta had a great year as well. Actually, the industry across the board did quite well. I mean, this year was supposed to be a year about we would get positive earnings revisions on the back of really tight supply and still quality demand out there. What's changed now is that there's a ton of uncertainty within the market. Things quickly changed from the first quarter. I think that January was a really good month. February was a bad month for the U.S. airline industry. You had a lot of aviation incidents. The tariff debate started to really pop up. Consumer confidence tanked. And then March was a continuation of that trend. It was not very good in general. We've been bouncing along the bottom as we try to figure out the macro backdrop. So it's been a, been a trying, you know, couple months to start the year. You know, I think that we're at the point where the market knows that earnings revisions to the downside are coming. So the question then becomes like, is this the floor in terms of the overall cuts for the space? That's going to be the million-dollar question at this point. If they get to a point where they don't necessarily are assuming a huge macro inflection in the second half of 2025, then the positive earning revisions could potentially come again if the market breaks in any way. From my perspective, I think Delta and United remain best in breed. If you think about Delta, even on a pretty meaningful earnings reduction, their free cash flow production is still very, very high. Uh, should be relatively supportive and talk to the durability of their overall earnings stream. Um, United kind of holds all the cards, uh, in terms of industry supply. They've been growing very quick. Do they pull back? Do they not? That's the real question for them. If they were to modestly tweak capacity down, I think that's bullish for the industry in general. I think it's bullish for them, gives confidence that we're willing to make adjustments when the market changes on us from a demand perspective.

Thank you, Connor, and thank all of you for listening. If you have a question that you'd like played and answered on the podcast, send it in and you could hear it on a future episode. You just use the voice memo app on on your phone, send it to jack.hough@barons.com. Alexis Moore is our producer. Alexis, I think the only thing that remains to be seen is how Southwest loyalists are gonna feel about some of these changes and extra fees, whether it's gonna hurt business or whether they're gonna take it in stride. I wanna run a focus group of one to learn the answer to that question. After hearing all of this about what Southwest is facing and what it's doing, Where do you come down? Are you still going to give them a try or are you, are you done? And who are you leaving them for?

I might be done.

Yeah.

I'm leaving them for American.

Ooh. American's loving it right now. They just, they just sat up in their seats. Southwest is like, what are we going to do to win her back?

Me and the group chat of Southwest loyalists.

You better get to work, Southwest. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen. If you listen on Apple, write us a review. See you next week.

Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.