Southwest Airlines Snowballs On Failure Of Epic Proportions (NYSE:LUV)

I have been following the meltdown of the airline flight schedules for the past few days and it almost goes without mentioning that this is something that has rarely been witnessed before. One airline stands out in an overwhelmingly negative way. So, let’s take a closer look at this drilling down from total flight cancellations to addressing the problem specific to Southwest Airlines (NYSE:LUV).

Winter Storm Elliot: Flight Cancellations Hits US And Canada

So, what sparked major disruptions in airline networks is the impact of winter storm Elliot which caused weather alarms across the US and Canada. You can in some way call it a perfect storm for airlines. Weather conditions deteriorated just prior to Christmas which is a busy time for airlines as people head home or visit family or friends for Christmas and New Year’s. While there’s never a good time for disruptions, this was most definitely one of the worst times for it.

Date	Cancellations	Delays
22/12/2023	2,700	11,300
23/12/2023	5,934	10,400
24/12/2023	3,487	6,000
25/12/2023	3,184	7,855
26/12/2023	4,006	9,254
27/12/2023	3,211	7,758
28/12/2023	2,781	1,304
29/12/2023	2,373	–
30/12/2023	40	–
Total	27,716	53,871

Click to enlarge

Yesterday I already covered the disruptions across airline networks and at the time there were more than 21,000 cancelled flights ands 42,414 delays. Roughly a day later, cancellations have climbed to nearly 28,000 with delays on nearly 54,000 flights. So, the cancellations are uncontained at this point.

Data from Dec. 25 onward shows 14,315 flights cancelled. The vast majority of these cancellations come from the Southwest Airlines operations.

So, Southwest Airlines is an outlier, and looking at how much of the scheduled flights is being affected it shows us that Southwest Airlines is not seeing absolute higher cancellations because it’s bigger than some of its peers. It’s clear that as a percentage of its normal operations, Southwest Airlines hit magnitudes larger than its peers. This points at problems specific to Southwest Airlines. All airlines are having issues, like equipment freezing or breaking, but only at Southwest Airlines has this led to mass cancellations affecting more than 60% of its flights. Another difference we see is that while other airlines were able to reduce the impact on their operations in three to four days, for Southwest Airlines things got worse before they got better. That, once again, is an indication that airline-specific elements are contributing elements to the absolute mess for air travelers. The numbers also are not really indicative of Southwest Airlines being active in regions where the winter storm hit hardest.

For instance, in Denver we’re currently seeing rather high cancellation numbers. At Denver, United Airlines (UAL) and Southwest Airlines are the main players and we see that United Airlines cancellations in absolute and relative numbers do not come even close to what we are seeing at Southwest Airlines.

Without doubt, Dec. 23 was the worst for the airlines combined. However, for Southwest Airlines the worst had yet to come as things quite literally snowballed going from 688 cancellations on the 22^nd of December to over 2,800 on the 26^th of December and cancellations remained close to that number for days. Over a three-day period, all airlines excluding Southwest Airlines were able to cut flight cancellations by 75%. Measured from the highest point Southwest Airlines was only able to cut cancellations by little over 15%.

The Snowball Effect For Southwest Airlines

So, the patterns of Southwest Airlines were much different than seen at other airlines. Other airlines had a sudden peak in cancellations caused by the weather disruptions, but Southwest Airlines built toward that which indicates that disruption is propagating through the network and contrary to other airlines the cancellations at Southwest Airlines more or less plateaued at a high level showing that the airline was in a gridlock.

Puns like “perfect storm” and “snowballing” are quite easy to make, but unfortunately for Southwest Airlines they also describe the situation for Southwest Airlines extremely well. Things started to go south, again no pun, for Southwest Airlines on the 21^st of December or probably the day before that. With winter storm Elliot coming in, ramp workers in Denver started to call in sick or requested absence for personal reasons. It sparked Vice President Ground Operations, Chris Johnson, to send out a memo warning ground workers that abuse of sick leave would lead to termination. This also is one reason why things were much worse for Southwest Airlines than it was for its peers.

You could come up with a lot of explanations as to why specifically Southwest Airlines was hit, but I would think it’s partially because new ramp workers are working now which have not yet been through adverse weather and the pay might also not be motivating ramp workers to show up.

Initially, we saw Southwest Airlines do two things:

1. It blamed equipment freezing and breaking down as a reason for network changes and cancellations.
2. It cited creating safe working conditions for its ground workers reducing their exposure to the freezing weather.

Those are valid reasons, but they do not explain at all why the mess at Southwest Airlines was so much bigger than at other airlines. The real reason why this eventually turned into mass cancellations is because Southwest Airlines does not have the technology available to handle its complex network. When cancellations hit, you start rescheduling via your system and start paring your assets (aircraft) with your crews. That’s where things exacerbated for Southwest Airlines. With flight schedules disrupted, Southwest Airlines saw its aircraft and crew out of sync. Simply speaking this means that they have crews that were allowed to fly at Point A and aircraft at Point B making it impossible to recrew the aircraft and operate the schedule. Southwest Airlines does not have the technology to do this via their scheduling software and so they had do to this manually which obviously requires more time than having an algorithm in place that sets out recrewing patterns. The result was that much of Southwest Airlines flight operations came to standstill.

Why are Southwest flights being cancelled?

So, the short answer to why Southwest Airlines flights are being cancelled is:

Due to weather conditions leading to shortages of ground workers, which propagated through the entire Southwest Airlines network in the form of out of sync aircraft and crew and technological capabilities being insufficient to halt this propagation.

History Does Not Repeat But It Certainly Does Rhyme

What’s somewhat alarming is that Southwest Airlines has a bit of a history with flight disruptions. History does not repeat itself one-on-one but it does rhyme. So, in that sense it’s not extremely surprising to see that Southwest Airlines is hit so hard. In 2019, 130 aircraft were temporarily grounded as incorrect weight data forced Southwest Airlines to halt operations until correct weight data was entered in to the system and the system was reset.

Last year, in October 2021 due to bad weather in Florida, air traffic control problems and lack of staffing to adjust the problems, 2,000 flights were cancelled over a period of four days costing the airline $75 million.

What’s Southwest’s strategy to solve the problems?

If there’s anything good coming from this, it’s that Southwest Airlines likely will be pulling forward improvement of its operating quality. For 2023, improving originator performance already was planned which focuses on initiatives to improve on-time performance recognizing that delays propagate through the network. Two areas where I would expect acceleration on development is Network design and recovery. The problems that Southwest Airlines does face today are because that component in particular is underdeveloped.

Additionally, I would expect expansion of the number of station command centers which allows real-life flight monitoring and allows for station command centers to identify problems or potential problems and tackle them in a coordinated way before they disrupt the entire operation. It’s somewhat surprising that Southwest Airlines seemingly does not utilize a coordinated approach more widely and that also has contributed to the problems faced today.

For illustration purposes, KLM has used an Operational Control Center for years tasked with letting planes depart safe and in time and identify possible disruptions, for instance weather disruptions such as snow storms. Based on events monitored, procedures can be started that should safeguard reliability of the operations across the network. Working from such a center with a coordinated approach would certainly have helped Southwest Airlines reduce the impact of the snow storm on its operations. So, Southwest Airlines needs to pull forward this development roadmap and money should not be an issue because the disruptions we see today will cost money that could have been invested in improving operational reliability and quality for years to come.

How will flight cancellations impact Southwest’s outlook?

The big question of course is how this will affect the outlook for Southwest Airlines. On the shorter term, customer confidence is broken and Southwest Airlines’ initial responses have been mediocre at best, blaming the problems on weather and creating a safe environment for its crews and passengers. This only tells part of the story and the lack of a response from the CEO did not make things much better.

What I found alarming is that instead of setting the CEO on the stage to face media and passengers, they sent a spokesperson to become the face of Southwest’s failure creating a travel nightmare for hundreds of thousands of passengers before, during and after the Christmas holidays. Obviously, spokespersons are trained and paid to do this but it would have sent a stronger message to travelers if the CEO would have done this. You can say that the CEO was likely busy solving this mess somewhere from a coordination room. While the job of a CEO is not easy, I don’t believe that a CEO can adequately address and solve the issues or at least not better than flight planners and dispatchers. So, I wouldn’t buy the argument that the CEO was working hard behind the scenes. The CEO responded in a video six days after things started falling apart for Southwest Airlines, six days in which the traveling public saw no leadership and travelers were left stranded with nobody at Southwest Airlines answering to their calls.

While I don’t believe the CEO will lose his job over this, I do know that Dick Benschop lost his job as CEO and president of the Schiphol Group as he was invisible in the months of chaos during the summer at Amsterdam Schiphol Airport. The rumor is even that he wasn’t at the airport at all. So, a lack of visibility in times of chaos erodes trust from stakeholders and could eventually cost a CEO his or her job.

On the short term, I’m expecting the impact on fourth quarter earnings as well as customer confidence in Southwest Airlines. The latter may sound like a huge issue, but history taught us that initially strong sentiments prevail but they fade rather quickly, and especially in a constrained market as we witness today. I wouldn’t expect much of an impact to customer confidence in Southwest Airlines, especially if Southwest Airlines communicates clearly on its implementations to preventing this from ever happening again.

It’s really difficult to talk about how much of an impact this will have on fourth quarter earnings, especially since operations have not normalized and I would not be surprised at all if this doesn’t normalize until next year. Last year 2,000 cancelled flights cost the airline $75 million. Extrapolating carries a high degree of uncertainty as you linearize and scale out any errors but with over 12,000 flights cancelled, and Southwest Airlines paying for accommodation and food for stranded passengers, I would estimate costs conservatively at $450 million.

Where will Southwest stock head in 2023?

Shares of Southwest Airlines have lost 12% in response to the operational meltdown, trading close to 52-week lows. Obviously, I expect an impact on Q4 earnings. The conservative estimate would point at a cost of at least $0.75 in earnings per share. So, I would say that the costs are already more than reflected in the share price. Incorporating the cost estimate in $2.31 consensus EPS gives us $1.56 in earnings per share for 2020 and with an average price-to-earnings of 21.4 that gives us a share price of roughly $33.40. Currently share prices are trading below that. That’s not to say that we see this as a buying opportunity for the short term as the median price-to-earnings suggests further downside to $26 with the total costs being a big unknown.

However, for 2023 I don’t expect major impacts from the winter storm. Travel demand remains high and travelers will return to Southwest Airlines for flights. So, I’m maintaining my Buy Rating on Southwest Airlines with a $54 price target noting that we might see some cost acceleration to improve operational quality but the current depressed share price does offer a longer-term entry point.

Conclusion: Stock Still Deserves Some LUV Despite Crisis

So, things are bad for Southwest Airlines and I would say their lack of technology and coordination to support their complex network and prevent disruption from propagating through the network is self inflicted. However, I do believe that Southwest Airlines will make it a priority to invest in operational quality going forward and that will pay off on the longer term. As a result, I do see the current share price weakness as a buying opportunity because while management has looked extremely weak through this winter storm crisis, they do execute well in other areas and they likely will put that same execution in improving operational quality as they have learned the painful lesson now on scale not seen before.