Southwest Airlines: Business Evaluation

Submitted by: D. Dill March 13, 2006

EXECUTIVE SUMMARY

Purpose, Method and Scope

Southwest Airlines began business over 30 years ago in Dallas, Texas, to provide customer with a low-cost way to fly and has grown to the third largest airline in the nation. To evaluate whether Southwest has good investment potential, there must be an evaluation of the airline industry and Southwest. The industry will be evaluated using Porter's Five Forces Model. Southwest will be evaluated using a strengthsweakness-opportunities-threats (SWOT) analysis. After the assessments are

complete, they will determine if Southwest stock should be purchased as in investment.

Strategic Analysis Findings

First, Porter's Five Forces Model showed the airline industry to be high risk, but not to be discounted if held as part of a diversified portfolio. Second, a comparison between segments determined the U.S. airline market is more stable and faces fewer threats than the European market, so any investment will be made with a U.S. based carrier. Third, Southwest was shown to have outperformed other U.S. carriers.

Fourth, Southwest business level analysis shows its functional strategies offset the threats and weaknesses revealed by the SWOT analysis and Porter's Five Forces

Model; it also shows Southwest is well positioned to take advantage of the strengths and opportunities showcased in the SWOT analysis. Lastly, Southwest has excellent organizational structure, controls and corporate culture to adapt to industry changes in the future.

Solutions and Recommendations

Although the airline industry is unpredictable, some airline carriers are more dependable and have better historical achievements than others. Southwest shows superior performance and implementation of business strategies. recommendation is to invest in Southwest. Therefore, the

INTRODUCTION

Southwest Airlines was established over 30 years ago by Rollin King and Herb Kelleher to provide customers with low fares, to ensure on time flight arrivals and departures, and create a fun experience for passengers. This novel approach to airline service was a critical event in Southwest's founding. King and Kelleher used these ideas to develop and select the business and functional level competencies they pursued to become the fourth largest airline in the U.S. Southwest continues to pursue an aggressive low cost strategy which has helped it gain and maintain market share. However, with costs rising, Southwest has an almost Herculean task of

maintaining low fixed and variable costs to retain its leadership position; it also needs to sustain growth into new service markets amid ever present competition.

To evaluate how well Southwest is pursuing its strategies and to determine whether it has good investment potential, there are multiple factors to review. First, the airline industry as a whole will be evaluated using Porter's Five Forces analysis. Second, how U.S. airlines compare to European carriers will be studied. Third, an

examination of Southwest compared to other U.S. carriers should be completed to determine how well Southwest is positioned in the industry. Finally, a detailed strengths-weaknesses-opportunities-threats (SWOT) analysis will be done, how strategies are enacted, and what controls Southwest uses to determine its current and future potential.

STRATEGIC ANALYSIS

Airline Industry

Overview

The consumer airline industry experienced a severe slump in ticket sales due to the terrorist attacks of September 11, 2001, "a weak economy, the war in Iraq, and the deadly SARS virus; [these events] have conspired to slam demand for airline tickets" ("Airlines," 2003). The airline industry still has not completely recovered to the sales volume it had prior to these events. Global losses since the terrorist attacks have totaled $30 billion US dollars which has had lasting effects on airline financing, manufacturers and lessors. ("Airlines," 2003). Over the past four years, several airlines have been forced into bankruptcy Chapter 11 reorganization in an effort to stay in business, e.g. Delta Airlines, Northwest Airlines, United Airlines, US Airways, and ATA Airlines.

According to Richard Bittenbender, senior credit analyst at Moody's, there would be no recovery in the airline industry until several factors were mitigated consumer fear of flying during wartime, the slow economy, and the cutback in airline capacity due to forced bankruptcy. Mr. Bittenbender forecasts that airline liquidity would not recover until 2004 or 2005; airline industry earnings and cash flow wouldn't recover until 2005 ("Airlines," 2003). Overall, the airline industry has high business and

financial risk, and this risk mixture causes most of the industry's profit unpredictability (Gritta, Chow, and Freed, 2003). While these industry risks are a concern for any investor, if an airline industry stock is purchased as part of a well diversified portfolio, the risks can be softened.

Porter's Five Forces Model

Michael Porter's Five Forces Model is used to describe the forces that shape competition within an industry and to identify any strategic opportunities and threats. The airline industry can be evaluated using this model; it will determine how established companies in the industry will be affected by microenviromental several factors.

First, the threat of potential companies entering the industry will be limited to those companies who can raise enough capital to purchase planes, gates at airport terminals, and a hub to conduct business. Entry will also require getting government approval to start an airline, which may be complicated. These barriers to entering the airline industry are fairly high due to high startup costs, but the high costs alone haven't prevented new airlines from attempting a business venture into the airline industry.

Second, once a company has entered the market, there is limited differentiation between companies and typically low switching costs. This leads to strong rivalry in the airline industry and encourages alliances. This intricate co-operative structure, an attempt to consolidate the industry, still does not prevent companies from lowering prices to gain market share. Overall, this actually tends to lower prices and raise costs which constitute a threat to established airlines (Hill, 2004).

Third, the bargaining power of buyers will impact airlines if the buyer is viewed as a competitive threat. There are a large number of buyers (consumers) in the airline industry with the ability to easily switch between airline companies; it gives them a certain power in the market. This "buyer power" can force prices down or it can force costs up by demanding better services or quality. The airline industry has had price wars, in part because the industry was more consolidated due to the alliances. With the airlines now interdependent, when one company changes its competitive strategy and lowers prices, the other airlines are forced to follow suit in order to keep market share. This has confirmed interdependence can be considered major threat (Hill, 2004).

Fourth, the bargaining power of suppliers will impact airlines if they become a competitive threat by forcing prices up the airline must pay for goods or if the supplier reduces quality (Hill, 2004). Suppliers in the airline industry have some power because they produce goods that don't have a substitute, e.g. airplane parts and aviation fuel. Airlines have a low cost associated with switching between suppliers, but the number of suppliers is limited. In addition, each plane requires specialized labor to fly; the pilot's labor union has very strong "supplier power" because there is no substitute.

Lastly, there is a threat of substitute products to the airline industry. Alternate transportation is available but not always practical for most travelers because of time constraints. This means substitution between taking a plane and resorting to other travel methods isn't very high. However, the airline industry is fairly homogeneous, consolidated, and has low switching costs; this makes substitution between airlines a very real threat. As airline industry competition has increased, it has also increased substitution risk and the need to reduce this risk. In summary, Porter's Five Forces Model illustrates several points. The airline

industry has high barriers to entry and significant rivalry. The power of suppliers is

high, and the power of buyers is moderately high. It also shows substitution between transportation modes is low, but substitution within the airline industry is high.

Domestic vs. European Airline Carriers

Because the airline industry is subject to several influences, there are aspects that make the U.S. market more appealing than international segments. The U.S.

currently provides 39.7% of the global industry's value while Europe accounts for another 33.8% of the industry's global value. Because Europe and the U.S. contribute so much of the global airline market, it provides good information for investors to compare the two market segments. For example, European airlines are besieged by "high oil prices, new safety rules, environmental concerns, tax-for-aid, state aid restrictions, [and] passenger rights - the pressure is piling up with no apparent policy co-ordination" ("As bankruptcy looms," 2006). The European airlines "have had to compete in a far more complex, crowded environment where flag-carriers have pushed for protectionist policies" (Boles, 2004). Table 1. * Region Passenger traffic RPK** million Domestic USA 58,636 2.6% Passenger traffic RPK** change

North Atlantic 10,627 -2.9% Latin America 4,169 3.9% Trans Pacific 6,789 -3.3% All International 21,584 -1.8%

Total Month 80,220 1.4% * provided by Airline Business, December 2003 ** RPK is an abbreviation for "revenue passenger kilometer." It is one benchmark for measuring airline size.

In spite of the intricate milieu, the growth in the European markets has been fantastic. In 1980, there were only five European Commission member airlines operating 16 aircraft. Today, there are 70 airlines operating 1,300 aircraft. Passenger volume has increased from 58,000 passengers per year in 1980 to 83 million per year today. Once the catalyst for growth in the airline industry, the European Commission is now proposing new, costly plans which could seriously harm the industry (Boles, 2004). In addition, because there are more complex competitive forces in Europe, any change in policies requires a check of business and functional strategies. According to Pierre-Henri Gourgeon, president of Air France, "European airlines were not taking off [in recovery] just yet" ("Airlines still struggling," 2004).

The U.S. industry hasn't had as many forces acting upon it as the European segment has had to endure. While there has been "increasing industry consolidation, fortress hub dominance, predatory behavior, and high fare pockets of pain'" since the U.S. industry was deregulated in 1978 (Goetz, 2002), the downturn in the economy during the early twenty-first century has led to another cycle which is weeding out the weaker competition ("Airlines," 2003). A market analysis for the U.S. industry is predicting expansion of 19.7% in value by 2009 as compared to the 2004 value ("Airlines," 2005, p. 8). As shown in Table 1, the U.S. passenger traffic is

significantly above any other major industry segment. Couple this trend with a predicted increase of 19.5% in passenger volume ("Airlines," 2005, p. 16), and there is a positive indication the U.S. market will be strong in the coming years.

This indication, along with reviewing the industry climates of both European and U.S. airline segments, suggests there is stronger long term stability in the U.S. industry segment. If an investment is taken, it should be with a U.S. airline carrier rather than a European carrier.

Comparison of U.S. Airline Carriers

In order to make an informed decision on which U.S. airline to invest in, a comparison of the market leaders should be completed. Tables 2 through 4 will be used to facilitate comparison between Southwest Airlines, American Airlines, Continental Airlines, and US Airways. These airlines represent a good cross-section of the U.S. airline industry because of their market strength and/or business strategy. "American and Continental Airlines, the only big network airlines carriers that have stayed out of Chapter 11 bankruptcy protection, reduced their operating cost by 78% and 83%, respectively" (Bond, 2006) to stay competitive. US Airways did fall into bankruptcy, merged with American West Airlines, and reentered the market as US Airways Group; it "has set a goal of being the nation's largest low-cost carrier" (Belden, 2006).

Even with American, Continental and US Airways changes and cost cutting strategies, Southwest Airlines outshines them in potential. Table 2 shows Southwest is the only airline with a positive Retained Earnings (earnings left in the company from inception) in 2004. As Table 3 shows, Southwest was the only airline of the group that posted a positive net income for 2004, a positive Earning Per Share, and paid a dividend. These two tables show Southwest has been able to lessen industry downturns better than its competition.

Table 4 reveals more vital information. Southwest has higher liquidity ratios which means it has a stronger ability to pay off short-term debt as the debt comes due. Southwest also has higher Receivables Turnover at 34.37 and lower Average Collection per Day at 10 days; both ratios indicate Southwest has efficient billing and collection processes.

Table 4 also shows Southwest also has strong profitability ratios. With Return on Assets at 2.76%, Southwest has earning power and overall profitability. In addition, Southwest has a Return on Equity at 5.67% which shows favorable financial leverage; it has a Return on Investment at 4.33% which measures the profit earned on the capital the company has invested, and shows it is creating value. Collectively, these profit ratios show that Southwest is outperforming its competition.

On Table 4, the leverage and shareholder return ratios give further proof that Southwest is doing better than the other airlines. Southwest has a positive Interest Coverage ratio of 4.56 which shows it is the only airline with enough gross profit to cover its annual interest expense. Southwest has a lower Debt-to-Equity ratio than the other airlines which means it is a lower credit risk, and it also has a lower Debtto-Assets ratio which means it hasn't used as many borrowed funds to finance investments.

After reviewing the financial statements and ratio analysis, Southwest Airlines is the strongest candidate for investing in the U.S. airline industry. A complete analysis is required to value the company by itself upon its strengths and weaknesses, business strategies, and control processes. potential. This examination will determine its investment

Southwest Airlines

History, Development and Growth

Southwest was founded 30 years ago and is now the largest domestic airline in terms of customers boarded. Southwest "is an air carrier that primarily provides short haul, high frequency, point-to-point, low-fare services in 31 US states" ("Southwest," 2006, p. 4). Because of the point-to-point route system used, there are fewer connections

required, and this has minimized total trip times and delays. The point-to-point system also prevented Southwest from incurring the expense of setting up a central hub for its planes. It took advantage of secondary airports which lowered its gates fees and increased its flexibility to service customers. Southwest also made a

decision early on to utilize only 737's for its aircraft type; this has led to decreased maintenance inventory, lowered training hours because only one type of aircraft is used, reduced down time for aircrafts because ready substitution aircraft is available, easier rotation of pilot and crewmember staff, and faster cost analysis per trip because of the "uniform" plane used each time. This standardization of its plane choice and a point-to-point system has led to huge fixed cost savings for the company.

Southwest was also the first company in the 1990's to implement other cost saving measures. Southwest lowered its variable costs by eliminating food service and assigned seats on flights. This change decreased clean-up time between flights, improved turn around time, and lowered employee labor required at the gate. It was also the first company to "offer customers the option of ticket-less traveling" ("Southwest," 2006, p. 5), to use a computer reservation system to automate booking, and to purchase tickets on-line directly from Southwest thus eliminating travel agency fees. These changes streamlined ticket sales and further lowered variable costs.

The next major change came in 2003 when Southwest consolidated its nine reservation centers down to six. This move reflected the reduction in ticket sales over the phone and the effectiveness of its on-line booking service. The next year, Southwest also realigned and flattened the company organizational structure in order to gain the right level of vertical differentiation. In 2004 Southwest bid for various assets of ATA Airlines, an airline in Chapter 11 bankruptcy. This led to a

codesharing agreement with ATA airlines (when it emerged from bankruptcy) in January 2005, and Southwest was able to strategically connect Chicago Midway with

several ATA destinations.

Additionally, in 2005, Southwest launched a movie

downloading service (an agreement with MovieLink) and a "direct link" to customers' PC desktops called "DING!". Moreover, Southwest also announced it would offer eleven new non-stop flights in 2005 to various U.S. locations ("Southwest," 2006, pg. 7).

SWOT Analysis

As Southwest has shown, a successful company will make strategic changes over time. To evaluate where Southwest is today, a strength-weakness-opportunitiesthreats (SWOT) analysis will determine its value added functions, and where it is strong and weak. The macroenvironment the company must confront should be kept in mind during the analysis. Lastly, the findings will be summarized.

Southwest has several strengths and one is in market leadership; Southwest "ranks first in the number of passengers boarded, and in total stock market value" (Reed, 2006). It gained most of this strength from a first mover advantage of a low-cost model, and it has done a good job through marketing to maintain brand loyalty. The second strength is directly related to its low-cost model. Southwest has the "lowest cost on a per mile basis" ("Southwest," 2006, p. 17). The low costs come directly from using only 737 planes, high frequency point-to-point flights, and high labor efficiency. The third strength comes from Southwest's strong financial performance. Strong travel demand for low cost fares and the quick expansion of flight segments offered have helped Southwest "overcome rising costs to record its 58th-consecutive quarterly profit" (Reed, 2006). Southwest has been outperforming its industry peers, and this gives Southwest a competitive edge ("Southwest", 2006, p. 18).

In contrast to these strengths, Southwest has a potential weakness in one financial area. Southwest has a lower current ratio of 0.94 and quick ratio of 0.72 than

industry averages of 1.3 and 0.90, respectively. Because these ratios are lower, it is considered a disadvantage. A second weakness comes from Southwest failing to establish alliances in the industry. Although Southwest now has codesharing with ATA Airlines, that is more an agreement born from Southwest acquiring ATA assets then a true alliance ("Southwest," 2006, p. 18). The third weakness comes from the possibility of declining passenger revenue yields (revenues / passenger miles). To maintain its low-cost image, Southwest has kept ticket prices low; with rising costs, this has contributed to falling passenger revenue yields.

In spite of these constraints, Southwest has opportunities in the industry. Between 2004 and 2005, Southwest increased the new service routes it offered. Currently, it has increased point-to-point segments by 17 routes. By increasing the routes offered, Southwest should be able to increase revenues ("Southwest," 2006, p. 19). Though it is a possible weakness, the "alliance" with ATA Airlines is an opportunity to expand market share for Southwest. Southwest has a third opportunity because there is a positive outlook for the US airline industry. The industry is coming out of its slump, and this will lead to increased investing in the industry as the outlook continues to get positive press.

Although the industry outlook is positive, there are still threats to Southwest. Increasing fuel costs is one threat that can cause Southwest to lose margin. A second threat is the fact that air travel demand has seasonal tendencies. If demand falls too rapidly and suppresses revenues, Southwest could be impacted more than other airlines because of its lower liquidity ratios. Lastly, Southwest must always plan for and be aware of increased competition. Southwest had made a niche for itself as the low-cost carrier, but as other airlines slash costs and lower ticket prices, Southwest is experiencing increased pressure. This competition could cause Southwest to lose market share.

Overall, Southwest is in a strong competitive position and has implemented several tactics to maintain profitability given its position in a mature industry. The next section confirms the choices made by Southwest support its corporate and business level strategies.

Corporate, Business and Functional Level Strategies

As Southwest Airlines participates in only one industry, its corporate and business level strategies are the same. Southwest has positioned itself very well to respond to items pinpointed in its SWOT analysis and to industry issues exposed by Porter's Five Forces Model. The steps it has taken are appropriate for the macroenvironment and industry conditions Southwest finds itself in today.

Southwest has adopted its business level competitive strategy as a low-cost leader in airline travel and carved out a niche for itself; it has pursued several areas to maintain its leadership and brand awareness. Southwest has increased the service routes it

offers which will potentially increase its market share. Also, Southwest has done an outstanding job creating loyal customers to maintain its market share, countering the industry pressure of low switching costs, and decreasing customers seeking substitutions within the airline industry. According to Kathy Petit, director of

customers, Southwest has loyal customers because it puts employees first. Southwest knows "when employees are valued by their company, they value their customers" ("Nuts," n.d.) and provide a high level of customer service. By creating an

appreciative working environment, Southwest has reduced employee turnover, reduced costly training time, and made itself as a great place to work.

Capitalizing on its strength as a market leader and great place to work, Southwest has leveraged that image to implement labor agreements with mechanics and pilots to keep labor costs down and increase efficiency. In effect, Southwest has reduced the

airline industry pressure of "supplier power." In September 2005, Southwest was able to continue its agreement with 1500 mechanics of the AMFA until 2008 ("Southwest,"2006, p. 7). Additionally, in December 2005, Southwest reached an agreement with its pilot's union to fly an additional 1-1/2 more hours each month; this increased pilot labor productivity "would save Southwest about $4 million annually, because [it] won't need to hire as many pilots as it expands its schedule about 10% a year" ("Southwest Pilots," 2005). These agreements are in direct support of

Southwest's business strategy to have a low-cost business model.

Southwest has enacted another tactical strategy directly related to its low-cost business model as well as dealing with some of the threats it faces. The entire airline industry faces the threat of rising fuel costs. Southwest had the foresight to shield itself from fuel price increases with a hedging program (a technique designed to reduce or eliminate financial risk if prices change) designed to run through 2009 (Ferrick-Roman, 2005). This foresight has led to millions in cost savings.

Additionally, to increase its leverage with regard to lower fuel usage and therefore even more savings, Southwest "has equipped its 447 aircraft with life vests for its passengers and crews" which "will save millions of dollars on fuel from being allowed to fly 162 nautical miles out over water" for more direct routes between Florida and the Northeastern U.S. (Jackovics, 2006). In 2005, Southwest also

incurred a one time cost to retrofit all its 737-700 aircraft with "blended winglets" because "the wing enhancements [will] extend the range of the planes, save fuel, lower engine maintenance costs, and reduce takeoff noise" (Corridore, 2005). These one time expenditures to purchase life vests and retrofit airplanes will quickly be offset by the millions saved in fuel costs.

Southwest has a strong financial position because of its attention to cost saving measures like fuel hedges and watching labor costs. Southwest is known for its financial strength, even when the airline industry struggled, as shown in Tables 5

through 8. That strength is only blemished by Southwest's lower than industry average current and quick ratios. While Southwest's low current ratio of 0.94 and quick ratio of 0.72 are lower than typical, Southwest "had $2.5 billion in cash at the end of 2005, plus an unused credit line of $600 million" (Bond, 2006). Furthermore, as shown in Table 7, Southwest had a positive $1.2 billion cash flow which indicates it should be able to fund future investments without having to borrow money. Because of the cash, unused credit line, and positive cash flow, Southwest has offset the threat of lower than average liquidity ratios.

Southwest has also come up with a strategy to offset the threat of uncertainty in demand, and its weakness for declining passenger revenue yields (revenues / passenger miles). In February 2006, Southwest signaled it would increase fares this year by "roughly 10 percent and business fares 4 to 5 percent" (Mohl, 2006). With higher fare revenues, passenger revenue yields will increase. Higher revenues will also help offset any uncertainty in demand. Southwest will have a higher cash inflows to compensate for a drop in passenger tickets sold. This functional strategy does not deviate from the business strategy; Southwest is still the low-cost provider in the industry and is not as susceptible to industry "buyer power" even with the small ticket price increases.

Even as the low-cost leader in the industry, Southwest isn't immune to industry pressures of rivalry. In order to reduce rivalry, alliances are formed. While there is some dispute of how much of an "alliance" was formed between ATA Airlines and Southwest, the fact remains they have entered into a strategic alliance for the benefit of both firms. Southwest was able to gain a hub position in at Chicago Midway, and ATA gained "a seven-year, code-sharing agreement that consists of a plan to sell certain ATA flights through Southwest distribution channels ("Reorganizing ATA," 2005). This will allow both airline carriers to offer expanded services without

investing excessive capital. By entering into this alliance with ATA, Southwest has

taken advantage of opportunities to offer even more routes for to its customers and positioned itself for even more growth.

In keeping with Southwest's goal to maintain growth, it is considering moving its headquarters (HQ) from Dallas, Texas, to Phoenix, Arizona. Southwest's HQ is at Dallas Love Field which has current federal restrictions for long-haul airline travel. Southwest has campaigned since 2004 to have the federal flight restrictions repealed so they can fly without limitations from Dallas Love Field (Torbenson and Levinthal, 2006). While the move would be costly in the short term, if the current HQ location doesn't meet the needs of Southwest's business strategy, then a new location is logical and necessary.

Overall, Southwest has successfully adapted its business and function level strategies to adapt to the changing industry forces and macroenvironmental forces it has to overcome. Each change has allowed Southwest to maintain its competitive edge as a low-cost airline. Southwest has keet to its core business which is a sound decision given its industry.

Structure and Control Systems

Southwest has made other sound decisions when implementing structure and control system so its processes match its business strategy. In August 2004, Southwest went through a realignment of its corporate organizational structure and "flattened" it ("Southwest," 2005, p.7). Southwest needed a more direct structure to prevent

communication delays and misinterpreting messages between management levels as it continues to grow. A flatter organization structure also keeps management costs lower because fewer managers are required. Good communication and a low-cost management structure are aligned with Southwest's business strategy. Moreover,

Southwest utilizes a functional structure which builds a cohesive culture and creates a support structure for effective control (Hill, 2004).

Southwest also has good control systems that support its overall strategy. In order to be a low-cost leader in the competitive airline industry, Southwest must have the support of its employees to make that happen. Southwest CEO Gary Kelly

acknowledges the airline industry "is a customer-service business, and Southwest has excelled at on-time performance, baggage handling and fewest canceled flights" (Warren, 2005). Southwest uses these control measures to determine how well and efficiently it provides services to its customers. When employees earned five

consecutive annual Triple Crown awards (a award given for Best On-time Record, Best Baggage Handling, and Fewest Customer Complaints), Southwest showed its appreciation by dedicating an airplane, Triple Crown One, to its employees. In addition, Southwest "employees are motivated to keep the company profitable because they gain too: 15 percent of Southwest's pretax operating income is invested in profit-sharing, and 25 percent of each employee's account is invested in Southwest stock" ("Nuts," n.d.). By linking part of employee compensation directly in

Southwest stock, employees are motivated to help the company achieve its strategic goals.

Beyond just helping Southwest achieve its goals, employees have adopted costconscious, customer-orientated, family-style business culture. For example, every employee receives a birthday card from Southwest on his or her birthday "as a way to show the employee, the card doesn't just say 'happy birthday,' it says, 'You're important to us'" ("Nuts," n.d.). Southwest believes in finding time for fun is as important as getting the work done. Southwest had developed an adaptive culture which encourages its employees to show initiative to lower costs, raise efficiencies, and promote customer service. Kathy Pettit, Director of Customers, believes

Southwest's organizational culture of managing costs "pays off: every month, 20 or

30 letters arrive from employees with suggestions for ways the company can save a dollar" ("Nuts," n.d.).

Employees are also able to see how valuable Southwest's culture is to top management. In 2006, Fortune Magazine ranked Southwest as the third-most

admired company in the U.S; Southwest responded that "any success or recognition that is bestowed upon Southwest can be traced back to what separates us from so many other companies namely outstanding customer service driven employees" (Torbenson, 2006). This unassuming attitude from management drives home the point that Southwest is all one team, and the team is only as good as how well they all work toward common goals.

In general, Southwest has used an adaptive culture with a flattened managerial structure to implement control process and an organizational culture which has brought them success. Southwest is well positioned to adapt to industry changes because it has employee support for corporate goals, and its employees will be committed to making future changes work. Southwest has been able to find the right combination of structure, control, and culture to match its strategy allowing it to become an industry leader.

SOLUTIONS AND RECOMMENDATIONS

Southwest currently uses correct business and functional level strategies enhanced by a precise organizational structure, good control process and caring corporate culture. At this time, there are no recommendations required to improve Southwest's performance and profitability into the future. Southwest has already implemented strategies that mitigate their weaknesses and the threats it faces; it has also made strategies to take advantage of their strengths and to place themselves in position to take advantage of new opportunities. Given the current airline industry, Southwest

has done an excellent job adapting to the changing business environment and maintaining market leadership.

This industry leadership and sound performance is why Southwest stock is given a Standard & Poor's opinion of buy. Standard & Poor gives a buy recommendation

because it reflects their belief Southwest is the "financially strongest U.S. airline as well as operationally well positioned" and has "expectations of increased investor interest in the sector if industry conditions improve" (Corridore, 2005). Southwest stock has a beta of 1.16 which makes it only slightly more unpredictable than the market.

With that said, the question still remains if Southwest is a good investment. The cons for investing in Southwest are: the airline industry has high business risk, and stock prices fluctuate; Southwest has lower liquidity ratios and may be more effected by industry downturns; higher fuel costs could still cause profitability issues for Southwest; and Southwest must gain more gates at different airports to maintain an effective point-to-point flight system. The pros for investing in Southwest are:

strong financial performance over other airlines in the U.S. industry; the company has an implemented its business and functional level strategies very well and positioned itself for future growth; it has strong customer and employee loyalty; the airline industry is coming out of is slump; and Southwest has a proven track record of success. The pros outweigh the cons, and Southwest can be chosen for investment of the $5 million available.

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APPENDIX A

TABLE 2.

COMPARATIVE BALANCE SHEET

($ MILLIONS)

SW AIRLINES AIRWAYS Dec 2004

AM AIRLINES

CONTL AIR-B

US

Dec 2004

Dec 2004

Dec 2004

ASSETS Cash & Equivalents $ Net Receivables Inventories Prepaid Expenses Other Current Assets Total Current Assets 137 54 685 2,172 1,048 $ 248 450 233 4,886 3,382 $ 821 214 388 2,824 1,669 $ 553 58 142 625 317 109

Gross Plant,Property & Equipment 1,281 Accumulated Depreciation 625 Net Plant,Property & Equipment 657 3,198

11,921

25,817

8,507

9,773

2,193

8,723

16,044

6,314

Investments at Equity Other Investments Intangibles Other Assets 34 408 -

156

1,388 3,144 959 240

18 164

30

TOTAL ASSETS

11,337 $

25,462 $

10,511 $

1,475

LIABILITIES Long Term Debt Due In One Year $ 155 Accounts Payable Taxes Payable Accrued Expenses 420 1,047 945 1,853 766 666 174 33 109 146 $ 579 $ 670 $

Other Current Liabilities 195 Total Current Liabilities 665

529

3,542

1,157

2,142

6,919

3,259

Long Term Debt Less Current Due 640 Deferred Taxes Other Liabilities Total Long Term Liabilities 774 1,610 361 3,671

1,700

9,848

5,167

8,800 18,648

378 1,552 7,097

134

EQUITY Common Stock Capital Surplus Retained Earnings Less: Treasury Stock TOTAL EQUITY 790 299 4,506 71 5,524 3,273 (3,378) (105) 1 1,408 (113) 1,141 155 1 632 (289) 308 36

TOTAL LIABILITIES & EQUITY 1,475 Value Line Financial Report TABLE 3.

11,337 $

25,462 $

10,511 $

COMPARATIVE INCOME STATEMENT

($ MILLIONS, EXCEPT PER SHARE)

SW AIRLINES AIRWAYS Dec 2004

AM AIRLINES

CONTL AIR-B

US

Dec 2004

Dec 2004

Dec 2004

Sales 2,339

6,530

18,608

9,899

Cost of Goods Sold 1,806 Gross Profit 533 $ 2,107

4,423

14,604

9,583

4,004

316

Selling, General, & Administrative Expense 447 1,055 713 1,052 3,291

Operating Income Before Deprec. 316 86

Depreciation, Depletion, & Amortization 140 Operating Profit $ (54) $ 572 $ (411) $ (99) 483 1,124 415

Interest Expense 82 Non-Operating Income/Expense 166 Special Items 9 Pretax Income (89) 489 38

88

652

389

23

106

(18)

136

(127)

(821)

(449)

Total Income Taxes 0

176

(40)

Adjusted Net Income $ $ (89)

313

(821)

(409)

Earnings Per Share Basic (6.19) $ (5.99)

0.40

Earnings Per Share Diluted (6.25) $ (5.99)

0.38

EPS Basic from Operations (4.67) $ (6.38)

0.40

EPS Diluted from Operations $ (4.73) $ (6.38)

0.38

Dividends Per Share -

0.02

- $

Com Shares for Basic EPS 66.10 $ 14.86

783.00

Com Shares for Diluted EPS $ 66.10 $ 14.86

815.00

Value Line Financial Report

TABLE 4.

COMPARATIVE ANNUAL RATIO REPORT

(RATIO, EXCEPT AS NOTED)

SW AIRLINES AIRWAYS Dec 2004 Liquidity Current Ratio 1.01 Quick Ratio 0.73 0.71 0.61

AM AIRLINES

CONTL AIR-B

US

Dec 2004

Dec 2004

Dec 2004

0.87 0.68

0.94 0.64

Activity Inventory Turnover 38.46 31.58 47.32 31.1

Receivables Turnover 34.37 23.54 19.35 25.14 Total Asset Turnover 0.62 0.72 0.94 10 11 27 1.51 15 8 26 19 12 26 14

Average Collection Per (Days) Days to Sell Inventory Operating Cycle (Days) 9 20

Profitability Pretax Profit Margin (%) Net Profit Margin (%) 4.79 7.49 -4.41 -4.54 -3.8

-4.41 -4.13 -3.81

Return on Assets (%) 2.76 Return on Equity (%) 5.67 Return on Investment (%)

-3.22 -3.89 -6.03 781.9 -263.87 4.33 -244.25

-8.43 -7.69 -13.16

Leverage Interest Coverage Before Tax 6.56 Interest Coverage After Tax 4.56 -0.26 -0.15 -0.09 -0.26 -0.05 -0.09

Long-Term Debt/Equity (%) 30.77 -9,379 3,334 1,757 Total Debt/Total Assets (%) 16.28 40.95 55.53 53.88 Total Assets/Common Equity 2.05 -242.5 67.81 40.48

Shareholder Return Price per share $16.43 $10.95 $13.54 n/a

Earnings per share

$0.40 $0.00 ($6.19) ($5.99) -2.19 n/a

Price-Earnings Ratio 41.08 n/a

Book value per share $7.05 n/a Market-to-Book Value 0.43

$2.34 $2.45 n/a 0.17 n/a

Total Shareholder Return (%) 0.65 (assumes investment of $10)

0.09

0.354 n/a

Dividend per share Dividend Yield

$0.02 $0.00 $0.00 $0.00 0.0012 n/a n/a n/a

Value Line Financial Report

TABLE 5.

SOUTHWEST AIRLINES

ANNUAL BALANCE SHEET ($ MILLIONS)

Dec 2005 ASSETS

Dec 2004

Dec 2003

Dec 2002

Dec 2001

Cash & Equivalents $ 2,280 Net Receivables 71 Inventories 71 Other Current Assets 99 Total Current Assets 2,520 150

2,531

1,305

1,865

1,815

258

248

132

174

137

93

86

681

482

223

156

3,620

2,172

2,313

2,232

Gross Plant, Property & Equipment 9,456 8,902 3,488

12,915

11,921

10,550

Accumulated Depreciation 2,810 2,456

3,198

3,107

Net Plant, Property & Equipment 6,645 6,445

9,427

8,723

7,443

Intangibles Other Assets 31

1,171

34 408

122

76

TOTAL ASSETS 8,997

14,218

11,337

9,878

8,954

LIABILITIES Long Term Debt Due In One Year $ 130 $ 40 601 $ 146 $ 206 $

Notes Payable 475 Accounts Payable 505 Accrued Expenses 548 Other Current Liabilities 412 672

524

420

405

362

2,074

495

491

529

649

1,081

621

Total Current Liabilities 1,434 2,239

3,848

2,142

1,723

Long Term Debt 1,327 Deferred Taxes 1,058 Other Liabilities 359 Total Long Term Liabilities 3,098 2,744

1,394

1,700

1,332

1,553

1,896

1,610

1,420

1,227

405

361

351

318

3,695

3,671

3,103

EQUITY Common Stock 767 Capital Surplus 50 Retained Earnings 3,197 Less: Treasury Stock 71 5,449 4,506 4,005 3,509 424 299 258 136 802 790 789 777

TOTAL EQUITY 4,014

6,675

5,524

5,052

4,422

TOTAL LIABILITIES & EQUITY 8,954 $ 8,997

14,218

11,337

9,878

COMMON SHARES OUTSTANDING 789 777 767

793

785

Value Line Financial Report

TABLE 6.

SOUTHWEST AIRLINES

ANNUAL INCOME STATEMENT ($ MILLIONS, EXCEPT PER SHARE)

Dec 2005

Dec 2004

Dec 2003

Dec 2002

Dec 2001

Sales

7,584

6,530 5,042

5,937 4,423

5,486 3,990

5,555 3,630

Cost of Goods Sold 4,563 Gross Profit 992 2,542

2,107

1,947

1,856

Selling, General, & Administrative Expense 1,072 1,338 1,055 916 1,204 1,052 1,031

Operating Income Before Deprec. 784 992

Depreciation, Depletion, & Amortization 361 Operating Profit 631 $ 820 $ 572 $ 483 $ 381 $ 518 483 433 403

Interest Expense 70

122

88

91

106

Non-Operating Income/Expense 34 Special Items 187 Pretax Income 828 874 489 79 -

176

23

45

(18)

271

84

708

393

Total Income Taxes 317

326

176

266

152

Adjusted Net Income $ 511

548

313

442

241

Earnings Per Share Basic 0.31 $ 0.67

0.70

0.40

0.56

Earnings Per Share Diluted 0.30 $ 0.63

0.67

.38

0.54

EPS Basic from Operations 0.26 $ 0.54

0.70

0.42

0.38

EPS Diluted from Ops 0.24 $ 0.51

0.67

0.41

0.36

Dividends Per Share 0.02

0.02

.02

0.02

0.02

Com Shares for Basic EPS 773 763

789

783

783

Com Shares for Diluted EPS 809 807

814

815

822

Value Line Financial Report

TABLE 7.

SOUTHWEST AIRLINES

S&P LONG TERM ISSUER CREDIT RATING CASH FLOW STATEMENT ($ MILLIONS)

CURRENT RATING AS OF:

Jan 2006 A

S&P LT ISSUER CREDIT RATING:

Dec 2005

Dec 2004

Dec 2003

Dec 2002

Dec 2001

Income Before Extraordinary Items 241 $ 511

548

313

442

Depreciation and Amortization 403 361 257

518

483

433

Deferred Taxes 208

184

183

170

Funds from Operations - Other 7 71

(1)

(3)

25

Funds from Operations - Total 820 1,151

1,322

977

1,083

Change in Noncash & Nondebt Working Capital 334 Operating Cash Flow 1,485 2,229 1,157 1,336 520 907 180 253 (300)

Capital Expenditures 998 Free Operating Cash Flow 487

1,210

1,775

1,238

603

1,019

(618)

98

(83)

Cash Dividends 13 Discretionary Cash Flow 473

14

14

14

14

1,005

(632)

84

(97)

Other Sources (Uses) of Cash Prefinancing Cash Flow 473

(75)

1,005

(707)

84

(97)

Current Debt - Changes Long-Term Debt - Issuance 1,089 Long-Term Debt - Reduction 111

(475)

300

520

385

149

207

130

65

Purchase of Common and Preferred Stock 132

55

246

Sale of Common and Preferred Stock 57 44 (1)

88

93

Financing Activities - Other 261

(8)

(270)

Cash and Equivalents - Change (465) $ 1,757

1,232

(560)

50

Value Line Financial Report

TABLE 8.

SOUTHWEST AIRLINES

ANNUAL RATIO REPORT (RATIO, EXCEPT AS NOTED)

Dec 2005 Liquidity Current Ratio 0.94 Quick Ratio 0.72

Dec 2004

Dec 2003

Dec 2002

Dec 2001

1.01 0.73

1.34 1.16

1.56 1.39

1.13 1.05

Activity

Inventory Turnover

35.14 38.46 44.58 46.37 60.39

Receivables Turnover 29.98 34.37 38.75 44.66 53.07 Total Asset Turnover 0.59 0.62 0.63 12 9 20 0.61 10 8 17 0.71 9 8 16 8 6 13 7

Average Collection Period (Days) Days to Sell Inventory Operating Cycle (Days) 10 22

Profitability Pretax Profit Margin (%) Net Profit Margin (%) 7.23 Return on Assets (%) 3.85 Return on Equity (%) 8.21 Return on Investment (%) 11.52 7.49 4.79 2.76 5.67 6.79 7.44 4.47 8.75 4.33 11.93 7.16 4.39 2.69 5.45 6.92 9.2 5.68 12.73 4.03 9.57 14.9

Leverage Interest Coverage Before Tax 8.16 Interest Coverage After Tax 5.49 6.56 4.56 8.78 5.86 4.70 3.27 12.85 8.32

Long-Term Debt/Equity (%) 20.88 30.77 26.37 35.12 33.06 Total Debt/Total Assets (%) 14.03 16.28 15.57 18.80 20.47 Total Assets/Common Equity 2.13 2.05 1.96 2.02 2.24

Shareholder Return Price per share $16.43 $16.28 $16.14 $13.90 $18.48

Earnings per share

$0.70 $0.40 $0.56 $0.31 $0.67

Price-Earnings Ratio 23.47 40.70 28.82 44.84 27.58

Book value per share $8.46 $7.05 $6.45 $5.72 $5.26 Market-to-Book Value 0.51 0.43 0.40 0.41 0.28

Total Shareholder Return (assumes investment of $10)

0.65

0.64

0.63

0.40

0.86

Dividend per share Dividend Yield (%)

$0.02 $0.02 $0.02 $0.02 $0.02 0.11 0.11 0.11 0.13 0.10

Value Line Financial Report