Southwest Announces a Merger With AirTran

Southwest Airlines announced earlier this week that it would acquire AirTran, America's third-largest discount carrier. The deal surprises many industry watchers, including yours truly, because it represents one of the most drastic changes from Southwest's tried-and-true business model which have worked so well for the company for nearly 40 years. Southwest will take on a new aircraft type with this acquisition--the Boeing 717, as well as enter new international routes in the Caribbean. It will add stations with low frequencies, and, it will finally gain access to Atlanta--a crucial hub and business travel market that Southwest has studiously avoided for years.

The deal is a big coup for Southwest, which has extended its dominance in the domestic industry and created a low-fare behemoth that will be hard for any other discounter (JetBlue, Republic, Spirit, or Virgin America) to match. It will also give the company increased pricing power in some markets which, due in part to ferocious low-fare competition between Southwest and AirTran, have very low yields, including Baltimore/Washington, Orlando, and Fort Lauderdale. While passengers are likely to see fare increases from any industry consolidation, these markets are most likely to see fare increases as the consolidated discounter cuts capacity in those oversaturated cities.

The conventional wisdom is that this deal will put enormous pressure on JetBlue, the last remaining sizable discounter, to find a merger partner quickly to achieve the cost synergies of its combined competitors. But as is often the case, I don't think this advice pans out. JetBlue has successfully leveraged its position as the largest carrier at New York's Kennedy Airport to forge codeshare relationships with a large number of international carriers, including Lufthansa, Aer Lingus, El Al, and South African Airways. JetBlue has also started a codeshare relationship with American Airlines, allowing JetBlue customers to access connecting destinations through Kennedy on American that JetBlue does not yet serve. These relationships do very little in terms of costs, in fact, they tend to increase the complexity of JetBlue's operations and likely raise costs. But the revenue benefits far outweigh any cost increases, and that will be the key going forward. JetBlue gains customers who would most likely otherwise fly on a different airline for their domestic segments, helping to fill aircraft in a very competitive market. As JetBlue's CEO has noted, JetBlue is most like Alaska Airlines, in that it has a very strong brand in its core markets (NYC, Boston, and Florida) with loyal customers who swear by the company. Similarly, Alaska has a plethora of codeshare agreements with other carriers which help feed traffic to the company's regional and Alaska routes while maintaining a loyal following in the Pacific Northwest. JetBlue does have relatively high costs, and while the company can make some adjustments to reduce these, it also operates in relatively expensive markets where it receives a price premium for its services, and the company has achieved a scale where further consolidation will have declining marginal returns to the bottom line.

This is not to suggest that JetBlue has no reason to worry. Southwest and AirTran will be an imposing force in the three big East Coast markets that JetBlue intends on growing in--Boston, NYC, and DC. These markets, popular with business travelers, demand high frequencies and service to a wide variety of destinations, which a bigger airline is more able to provide. The growth of Southwest in these markets will make it harder for JetBlue to carve out a niche with business travelers, and may subject the airline to continual price wars on key East Coast routes. But on the whole, JetBlue is an apt competitor and has built a strong following in its core markets. While the merger is not necessarily good for JetBlue, there should be no cause for alarm at JetBlue headquarters.

There are losers in this deal, and the biggest is likely Republic, the owner of the former Frontier and Midwest Airlines. The expanded Southwest will be a very imposing presence in this carrier's two biggest markets, Denver and Milwaukee. Southwest has publicly stated its intention to expand its operations in both markets, and the company has had enormous success in Denver, though mostly at the expense of United and not Frontier. I imagine, however, that as Southwest continues to grow in these markets that it will have a detrimental impact on the viability of Republic's mainline operations. The new Frontier lacks the same codeshare feed that JetBlue has, and although both Frontier and Midwest had a loyal customer base, it will be increasingly difficult to remain loyal to Frontier as it reduces the size of aircraft used on many routes (many of which lack the personal TVs and other amenities passengers are used to) while charging fees for many of the same services (such as checked luggage) that Southwest provides for free. Republic's smaller aircraft also have higher operating costs and are competing with larger, more fuel-efficient planes on many routes. And Frontier is not that well known outside of Denver (and now Milwaukee), and there may be relatively few opportunities for expansion, which would give the company further economies of scale that would enable it to more effectively compete with a combined Southwest/AirTran.

This is not to say that Frontier is doomed, but in that company's case, I think that further consolidation will be necessary to its survival. Possible candidates include JetBlue (which operates both A320 and E190 aircraft that Frontier does, and has LiveTV onboard), or Virgin America (which operates A319s and A320s like Frontier does). The third possibility, though unlikely, is US Airways, also an Airbus and Embraer narrowbody operator. While US Airways has had difficulty with mergers in the not-too-distant past, and is still sorting out some issues related to its deal with America West back in 2005, a merger with Frontier could be a very positive development for US Airways, if it could get the labor situation sorted out. The company would have a stronger presence in the Western U.S., and also potentially enhance its relationship with United, by providing feed to United's international flights from Denver. This is a longshot, admittedly, but it would make US Airways a larger domestic competitor and allow the company to diversify its route structure.

Obviously, the Southwest/AirTran merger is not a done deal yet, but if it goes through, it will clearly have considerable implications for the industry, and in particular the dwindling number of discounters left in the United States.