Southwest and the MAX 7 – Two failures resonate

Southwest Airlines is in the midst of radical change. It has already changed its “bags fly free” policy to an incremental charge, becoming the last holdout for free bags. It has also changed its strategy. The once small-market, low-cost, quick turnaround operations that the carrier employed for many years can no longer be accomplished with larger aircraft at major airports. The Boeing 737 is the aircraft that made Southwest Airlines, and the carrier employed every major generation of that aircraft in its lifetime, including the 737-200, 737-300, 737-500, 737-700, and later the 737-800 and 737 MAX 8. What is noticeably missing is the MAX 7, for which Southwest is the major customer. Southwest has remained loyal to Boeing, consistently purchasing only Boeing aircraft, despite the crashes and grounding of the 737 MAX 8, serious quality issues, and significant delays to the 737 MAX 7. The 737 MAX 7 was initially planned for 2022, with Southwest leading the order book with 305 aircraft. Those aircraft are well past their delivery dates, and last week’s announcement that the 737 MAX 7 and 737 MAX 10 certifications will be pushed into 2026 is further pushing back those deliveries. Southwest’s aircraft delivery schedule called for 30 737 MAX 7 aircraft per year from 2022-2025, meaning the shortfall of the smallest MAX will be 120 aircraft entering 2026. With no word on an essential exemption for the Stall Management Yaw Damper system needed from the FAA, certification in 2026, despite positive language from Boeing management at earnings calls, remains uncertain for both the 737 MAX 7 and 737 MAX 10 models. Translation - without the exemption, we could be looking at 2028 for certification and entry into service. Southwest Needs the 737 MAX 7 Southwest still services many markets for which the 737 MAX 8 is simply too large. Excess capacity means either lower load factors or additional discounting required to fill empty seats. A 176-seat 737 MAX 8 flying in a market that should be served by a 150-seat 737 MAX 7 has 17.3% excess capacity. As a result, Southwest has not retired previous generation 737-700 aircraft as fast as it would like, and has not benefited from the fuel savings and lower operating costs for the 737 MAX 7. A 16-18% improvement in operating costs cannot be overlooked as a minor detail. Boeing is likely paying Southwest a material sum for missing its delivery commitments. Part of this compensation likely includes 737-700 MRO costs. Southwest serves several airports in smaller cities with point-to-point flights. In many of those markets, it is still flying the aging 737-700, awaiting the delivery of the 737 MAX 7 to replace them. Unfortunately, that won’t be until 2026 at the earliest and potentially 2028 if Boeing’s exemption request is not granted. Southwest’s Strategic Changes Over the last decade, Southwest changed its strategy to better compete with network carriers. As an LCC, Southwest began with differentiated operations. Its hallmarks were point-to-point flying, quick turnarounds, and a focus on on-time performance. The quick turnarounds were aided by an open seating boarding philosophy in which passengers queued to quickly board and grab a coveted aisle or window rather than a middle seat. Baggage was checked for free to minimize the number of carry-on bags and improve the boarding and deplaning process to accomplish quick turnarounds. The 737-300s and 737-700s enabled that to happen with typically 137 or 142 seats, after the introduction of newer slimline seats that enabled an extra row. A 20-30 minute turnaround was the standard at Southwest for many years. But changes were on the horizon. Southwest needed growth for critical mass, and decided to compete not only at satellite airports, but to attack the big cities themselves. They added cities like Boston to Manchester and Providence, La Guardia to Islip, and other major cities to their schedule, using larger 737-800 and eventually MAX 8 aircraft for those routes into more crowded major airports. While those aircraft offered additional capacity, they also made a fast turnaround impossible. It is challenging to enplane and deplane a larger aircraft, handle baggage, and meet schedules in crowded airspace. With more concentrated operations, the carrier made airports like Baltimore into quasi-connecting hubs. But having a connecting flight on Southwest didn’t mean the second leg would honor a boarding priority if the first flight was late, and often business travelers would end up with a dreaded middle seat. The “quasi-hub” at Baltimore became known for late-day operational delays, a common occurrence in the crowded northeast corridor. The majority of passengers preferred point-to-point travel over connecting traffic, finding it easier to transit on legacy carriers that offered assigned seats and eliminated the need to line up 20 minutes before the scheduled departure. More recently, Southwest decided to meet the competition head-on and change its culture to move away from "bags fly free" and offer assigned seating, which starts next January. Those factors will likely mean larger carry-on bags to avoid extra fees and longer turn times for the airline. Southwest Needs Right-Sized Aircraft Southwest is struggling to balance its heritage as a low-cost carrier with the realization that it has transitioned into a major airline, with similar cost structures to the majors. But without the premium amenities of the network carriers, Southwest has a more difficult task to compete effectively. The carrier cannot directly replace older aircraft on many of its profitable routes, which cannot accommodate a 737 MAX 8. But without the 737 MAX 7, Southwest is stuck taking the 737 MAX 8, an aircraft that is simply too large for about half of its routes. The equation is simple: higher cost with similar revenue = lower profitability. Unfortunately, by the time the 737 MAX 7 is delivered, Southwest’s strategy will have changed from an LCC to that of an economy class major, with similar fare and ancillary fee structures for economy passengers, but entirely missing the emerging premium cabin leisure market. Southwest competes with low-cost carriers in product and service levels, but with legacy carriers in costs and fares. In our view, that strategy has a substantial likelihood of failure. One of the reasons for that failure is a higher-than-necessary cost structure from not having the 737 MAX 7 Existing Inventory and Early Deliveries Boeing built 25 737 MAX 7 aircraft in anticipation of certification during 2023 and 2024. Those aircraft will need to be modified and upgraded with any changes added during the certification process, including the new engine nacelle overheating fix, for which a “sticky note” on the dashboard to shut off anti-ice after five minutes won’t cut it with the FAA. Without an EICAS, the 737 MAX series of aircraft lacks a mechanism to display an appropriate warning message, rendering the certification problem more critical and an FAA priority to resolve permanently. To date, Boeing’s efforts have fallen short. Boeing has been holding those 25 737 MAX 7 in inventory for multiple years. Southwest is reluctant to accept these aircraft that have been grounded in inventory for such an extended period, and we can’t find fault with that. Despite fewer hours, they remain older aircraft. With 305 of the 327 undelivered Boeing 737 MAX 7 orders accounted for by Southwest, or 93% of undelivered orders, Southwest is in a position to exert influence, except that backlogs at the competitors are such that it wouldn’t receive new aircraft for quite some time. Boeing and Southwest are effectively married, like it or not. The Bottom Line Southwest’s major failure was loyalty and failure to see the handwriting on the wall with Boeing. If Southwest had chosen Airbus or Embraer after the MAX crashes, it would likely be flying profitably with new technology aircraft and engines. But management stuck to an antiquated single aircraft type strategy, ignoring the realities at Boeing, and ended up paying a very high price. At this point, the question is whether Southwest can turn around and regain profitability, given its need for right-sized aircraft. There is no specific relief in sight from Boeing until early next year at best, as the FAA, and not Boeing, is in control of the certification process. One thing is clear - four years late is too long. Just ask Tim Clark, who is looking at a six-year delay with the 777X. Boeing’s failures contributed materially to Southwest’s financial decline and illustrate the risks of a single aircraft type strategy. With that strategy, if something goes wrong, one ends up in deep trouble, which is where Southwest finds itself today.

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