(Bloomberg) -- Southwest Airlines Co. will begin offering assigned seats, ditching the free-for-all policy that has been a defining feature of the carrier for more than half a century.
The airline announced the seismic change to its business model Thursday alongside a new premium-class option and plans for redeye flights — shifts the company sees boosting sales and enhancing its appeal. While Southwest said earlier this year that it was reconsidering the seating policy, it’s now facing heightened pressure to revamp underperforming operations from activist investor Elliott Investment Management.
The strains on Southwest’s business were underscored in the company’s earnings report, also released Thursday. While profit last quarter beat expectations, its guidance for revenue and costs in the current period was worse than Wall Street’s estimates.
“We are completely focused on our plan to transform the airline, transform our financial performance,” Chief Executive Officer Bob Jordan said in an interview. In discussions with shareholders, “far and away the piece of feedback we hear most is, ‘Your results are unacceptable and we want you to perform well.’”
Elliott’s pressure “had no impact whatsoever” on the planned steps or the timing of Thursday’s disclosures, Jordan said. The carrier has been working on “transformational” changes for 18 months, he said, and wanted to disclose some details ahead of work with federal regulators that would have made them public soon.
Southwest’s shares reversed an early decline and rose 5.7% at 12:01 p.m. in New York. Other carriers also gained following news of faster-than-expected economic expansion, even as American Airlines Group Inc. reported a disappointing outlook.
Southwest has struggled this year with slowing growth, fewer-than-expected aircraft deliveries from Boeing Co. and a series of flight-safety incidents that triggered a Federal Aviation Administration review of the carrier this week. Its stock has declined modestly this year even as the broader market has gained.
The latest steps represent a strategic shift for the carrier, which has steadfastly maintained open seating while other airlines raked in revenue by charging extra for more-desirable seats. That unfulfilled opportunity is a major tenet of Elliott’s campaign — that Southwest has refused to modernize its business to appeal to today’s travelers.
Adoption of premium seating could open the door for the carrier — which has long appealed primarily to leisure travelers — to potentially offer business- and first-class sections in the future.
Southwest still won’t charge for checked bags and isn’t contemplating a change, Jordan said. The “bags fly free” policy has been a focal point of Southwest promotions and advertisements, and some analysts have speculated charging for bags could cost the airline customers. It’s the only US carrier that doesn’t impose fees to check two.
Redeye Flights
Southwest will begin offering assigned seats and premium seating with more legroom next year. It will start flying overnight, cross-country routes on Feb. 13. Those flights are already on sale from Las Vegas, Los Angeles and Phoenix to Baltimore/Washington International Thurgood Marshall Airport; Las Vegas to Orlando; and Los Angeles to Nashville.
Southwest didn’t provide specifics on potential revenue from the changes, which also include a redesign of its boarding process. But it will be “significantly more than” the $1 billion produced yearly from charges to board early, Jordan said. All seats will be assigned, and about one-third will be premium class, but there won’t be a separate cabin for premium offerings. Changes to the onboard layout will require FAA approval.
The airline said it opted to adopt the updates after its own research found that 80% of current customers and 86% of potential passengers prefer an assigned seat, particularly during the larger number of longer flights operated by Southwest now. Jordan doesn’t expect the changes to drive away long-time passengers who favor open seating.
Southwest Chief Commercial Officer Ryan Green will be moved to a new position to oversee the transformation and other commercial initiatives.
The carrier has studied various seating options in the past, but always rejected a shift to assigned spots, saying passengers didn’t support such a move.
While Southwest has long stood by some of its central policies, it hasn’t been entirely resistant to change. It began routes to nearby international destinations and, more recently, added flights to Hawaii. The airline previously revamped its boarding system, offered early boarding options at an additional cost and developed a corporate booking tool to win more business travelers.
Southwest said in April that it had begun evaluating premium products and others changes, well before Elliott disclosed a $1.9 billion stake last month. But until Thursday, the airline said it wouldn’t disclose any details until an investor meeting slated for September.
Elliott wants to oust Jordan and Chairman Gary Kelly for poor execution and a “stubborn unwillingness to evolve the company’s strategy.” They are “not up to the task of modernizing Southwest,” the activist has said. Jordan reiterated Thursday that he has no plans to leave.
Southwest earlier this month named a veteran airline industry executive to its board to help address other concerns raised by Elliott. The carrier also adopted a “poison pill” shareholder rights plan to discourage the activist from gaining a larger share.
Quarterly Results
In addition to policy changes, Southwest said Thursday that it earned an adjusted profit of 58 cents a share in the second quarter. That topped the 51-cent average of analyst estimates compiled by Bloomberg. Operating revenue of $7.4 billion also beat expectations.
The quarterly results were generally better than the “very negative revised guidance” Southwest had previously issued, TD Cowen analyst Thomas Fitzgerald said in a note. Still, the policy changes may cause some investor unease over “the airline navigating a strategic overhaul during a period of sustained losses/slight profits.”
The carrier also acknowledged challenges from an industrywide capacity glut. Domestic-focused US airlines have had to slash fares to fill planes after the industry added too much capacity in anticipation of a record summer travel season. The discounting has cut into revenue and profit expectations at even the largest US airlines.
Southwest said it’s made changes to better match the supply of seats with demand in the remaining summer, fall and early winter schedules. But fare management issues that reduced unit revenue in the first three months will extend into this quarter.
The recent performance “fell short of what we believe we are capable of delivering,” Jordan said.
Its outlook for key sales and cost measures were worse than Wall Street estimates. Third-quarter revenue for each seat flown a mile, a gauge of demand and fares, will be flat to down 2% year over year, the airline said, while analysts were expecting growth of 4.9%. Non-fuel costs on the same basis will increase as much as 13%, compared with analysts’ estimates for a 6.8% rise.
(Updates with CEO comments beginning in fourth paragraph)
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