Is Southwest Still the Cheapest Airline Around?

The MIT International Center for Air Transportation released a study in August 2013, suggesting that the "Southwest effect" has weakened considerably in the past five years, as other budget carriers erode Southwest Airlines(NYSE: LUV) distinction as the lowest-fare airline in the skies. But is Southwest really losing its low-price leadership -- and if so, does that even matter?

Price leadership
The "Southwest effect" refers to competing airlines dropping airfares when Southwest enters or competes in a market. It's been traditionally associated with Southwest's price leadership -- but the MIT study instead showed that JetBlue Airways has replaced Southwest as the airline with the biggest impact on airfares among its competitors. In addition, the entry of ultra low-cost carriers like Spirit Airlines means that Southwest no longer offers the lowest airfares.

The MIT researchers found that Southwest and JetBlue raised their average airfares by 25% and 3% respectively from 2007 to 2012, while Spirit's average airfares dropped by 33% during the same period. Based on these numbers alone, it's easy to conclude that Southwest is no longer as price-competitive as Spirit Airlines and other ultra low-cost carriers. But that's a misleading assumption, for two key reasons.

Firstly, the study does not include ancillary revenues such as baggage fees in the comparison. Unlike Spirit, both JetBlue and Southwest don't charge passengers for the first checked bag; Southwest goes a step further by waiving check-in fees for a second bag as well.

A November 2012 Topaz audit of airfares in 100 U.S. markets validated the findings of the "Southwest effect" study, but with a critical caveat. Based on airfares alone, Southwest was only cheaper than its competitors less than 40% of the time. However, if baggage fees were included, Southwest boasted of the lowest all-in fees 60% and 88% of the time for one and two bags checked in, respectively.

Secondly, Southwest and Spirit are not exactly targeting the same customer segment now. Spirit caters almost exclusively to leisure travellers with its focus on tertiary and small community airports. In comparison, Southwest has a fair share of business travellers now, following its move to larger airports in recent years.

Business travellers are typically more willing to pay a price premium than leisure travellers. In addition, they will also value Southwest's free baggage check-in services to a greater extent. In other words, Southwest is not any less competitive than Spirit. It simply practices price discrimination -charging more for those who can afford it.

Maintaining a balance between price leadership and customer satisfaction
Price is one of the various factors that influence airlines, albeit a very important one. Passengers want good service, comfort, and low fares, while airlines desire to maximize revenues and minimize costs. Is there a middle ground? JetBlue and Southwest obviously believe so. While their basic airfares are more costly than that of Spirit, they are differentiating their service offerings to build customer loyalty.

JetBlue announced in September that it will install B/E Aerospace's Pinnacle seats for the economy cabin on its aircraft. These seats are the lightest and slimmest of its kind, providing JetBlue's passengers with more legroom and greater comfort, while reducing fuel costs at the same time. JetBlue also started offering free Wi-Fi access on board its planes this year, in contrast to most airlines which require passengers to pay a fee for Wi-Fi.

Similarly, Southwest's planes are now equipped with its new aircraft interior called Evolve. The new seats come with a fixed-wing headrest and a more comfortable cushion bottom. In addition, Southwest is allowing pet lovers to bring their pets on board. This is only made possible by the space savings achieved with Evolve, which allow passengers to accommodate their pets in pet carriers under the seats.

With its focus on customer service, it is not surprising that Southwest has the lowest customer complaint rate in the industry, according to the 2013 Airline Quality Rating Report published by Purdue University.

Although Spirit has always emphasized that price is the top consideration for passengers choosing an airline, it admits that even its ultra-price-sensitive customers will be happy to have a better flight experience. Therefore, Spirit's passengers can pay anything between $12 and $150 to have larger seats called "Big Front Seats," which boast roughly six inches of additional legroom compared to its standard seats.

This seems to validate Southwest and JetBlue's investments in customer satisfaction, suggesting that people are willingly to pay more to have a better flight experience.

Southwest is my top pick among airline stocks. It remains the price leader for its targeted customer segment, which includes budget-conscious business travellers with check-in bags and higher-value leisure travellers who demand a minimum level of customer service and comforts. At the same time, it continues to deliver on customer satisfaction, with the least number of complaints per passenger.

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