Subscription Required

Now open to all readers.

By Judson Rollins

June 13, 2024, © Leeham News: Elliott Investment Management announced an activist shareholder campaign against Southwest Airlines’ board and management earlier this week.

The airline’s share price has declined 50 percent in three years and sits near its April 2020 value, one month into the COVID-19 pandemic. Elliott says this is due to poor board governance and day-to-day management.

Source: Elliott Investment Management.

“Southwest’s [board] has failed to hold management accountable for poor execution and has been unable to catalyze (or permit) the necessary strategic evolution,” Elliott wrote in a letter to the Southwest board.

Related Stories

• Elliott Investments takes $2bn stake in Southwest
• “Legacy LCC” Southwest fails to keep up with the times
• Bloated labor expense, difficult fleet strategy
• Could Southwest solve 737 MAX 7 strategy by buying Breeze?

“Instead, the [board] has reinforced an insular culture and outdated thinking in the face of indisputable evidence that change is required.”

To gain a deeper insight into Elliott’s proposed ‘Stronger Southwest’ plan, LNA studied the firm’s letter and accompanying presentation and spoke with sources familiar with the situation.

Summary

• Elliott blames subpar returns on insular, stagnant board and management.
• Keys to restored profitability include curbing cost growth, passenger monetization.
• New board, CEO with industry experience would drive business change.
• Employee resistance is a likely headwind; will improved profit sharing help?

Elliott blames subpar returns on insular, stagnant board and management

According to its public presentation, Elliott has been studying the situation at Southwest for 18 months. It commissioned an independent shareholder survey and extensively studied investment research reports and webcasts.

Sources familiar with the process say the hedge fund also spoke with former executives from other airlines and retained a large consulting firm to assist.

The airline’s board is chaired by former CEO and current executive chairman Gary Kelly, who has 38 years at Southwest. The lead outside director has been on the board for 24 years, while six others have served for a decade or more. No board members have experience at another airline, and most independent directors were personally recruited by Kelly.

Southwest’s CEO, Robert Jordan, has spent 36 years in the company, and just one of the eight most senior executives has experience from another carrier. The other seven have worked at Southwest for an average of nearly 28 years.

Shareholder returns during Kelly’s 16-year term as chairman have been dramatically negative, during an era when other large US carriers and the S&P 500 stock index had strongly positive returns. During Jordan’s tenure as CEO, the company’s total shareholder return has been less than half that of Delta Air Lines or United Airlines, and 6% less than that of beleaguered American Airlines.

An Investor survey commissioned by Elliott ranked Southwest last among the four largest US airlines for cost, monetization, strategy innovation, and management quality. One respondent said, “This company has destroyed more value based on their own inaction than anyone else in the industry.”

Keys to restored profitability include curbing cost growth, passenger monetization

Elliott’s public presentation compares Southwest to legacy carriers Delta, United, and American, not mid-tier or low-cost carriers. Of the four, Southwest’s unit revenue growth since 2012 has been the lowest, and its unit cost increase has been the highest.

The presentation cites a January 2024 Melius Research study saying that Southwest added 23% more employees between 2019 and 2023, versus a capacity increase of just 13.8%. It contains no commentary on employee wage levels.

According to sources familiar with Elliott’s thinking, the firm doesn’t believe Southwest needs to introduce dramatic business model changes, such as long-haul flying. Instead, it believes the airline needs to curb its cost growth, pare back unprofitable routes, and better monetize its existing passenger traffic.

The presentation compares Southwest to its legacy competitors on commercial policies such as assigned seating, premium cabins, “basic economy” fares, and checked baggage fees.

It cites a March interview with Ryanair CEO Michael O’Leary, who said, “[Southwest puts] out all this schlock about, ‘Our passengers are our guests, and you wouldn’t want to charge your guests for their bags,’ but why do you charge for the seats if that’s the case? Give it all away for free.”

New board, CEO with industry experience would drive business change

Elliott contends in its public materials that an improved board would include directors with airline operations, consumer, and hospitality experience.

One source familiar with the firm’s strategy tells LNA it does not plan to push for specific governance reforms, like term limits for directors. Instead, it is focused on installing an independent board chair and experienced outsiders in key roles, such as the chairs of the board’s governance and compensation committees.

An overhauled board would, in turn, select a CEO from outside Southwest, ideally someone with operational experience and a “track record of shareholder value creation.” The new CEO would commission a board-level committee to conduct a “comprehensive business review” with assistance from independent advisors.

Elliott’s letter to the board said the review would “focus on increased customer choice, improved cost execution, and updating outdated IT systems.”

Employee resistance is likely; will improved profit sharing, retirement plan performance help?

Little is said in the letter or presentation about gaining employee buy-in for Elliott’s proposals. This may prove especially difficult at a company where employees have rallied around its culture for decades and where management has sold business decisions like free bags as “culture.”

Elliott’s presentation projects a potential increase of nearly $800 million in annual profit sharing, and a $440 million increase in the value of Southwest’s retirement plan holdings of the company stock. This assumes the company can increase its EBITDAR (earnings before interest, taxes, depreciation, amortization, and aircraft rent) margin from an estimated 8% this year to 19%, and its stock price from $28 to $49 per share.

It remains to be seen whether employees without a finance background will be enticed by such appeals.