Southwest will need to offset loss of AirTran ancillary revenue in Atlanta: analyst

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Southwest Airlines will have to raise fares by about 9% in Atlanta or grow average load factors by an equivalent percentage in order to offset the loss of ancillary revenue generated by newly-acquired AirTran Airways, analyst Gary Chase suggests in a new research report for Barclays Capital.

At present AirTran and Southwest's pricing approaches are very different, with the former carrier generating significant ancillary revenues from its network, and the latter distinguishing itself as a carrier that does not charge for checked luggage.

"We believe the industry at large has benefited from ancillary fees. We also believe Southwest has benefited from avoiding them across a large network and in competition with multiple airlines. However, it is unclear whether or not Southwest will derive enough benefit in passenger goodwill to offset the loss of these ancillary fees in Atlanta specifically and, for the most part, in competition with one carrier," said Chase.

"What is clear, is that in order to offset that differential, Southwest would have to raise fares approximately $8, or 9%, on average in Atlanta or would have to raise average load factors by 9% using the power of its network."

Delta Air Lines, which charges for checked luggage, is the dominant inhabitant of Atlanta airport.

While Barclays Capital does not expect to see significant changes in either carrier's pricing schemes in the immediate future, it believes Southwest will make important adjustments over time.

The investment banking division of Barclays Bank also anticipates that changes in network structures are on the horizon since the existing AirTran network operates in ways that are "meaningfully different" than the bulk of Southwest's network.

For example, noted Chase, AirTran has run Atlanta with a more classic banked hub structure while Southwest, "even in cities where it has a huge presence, like Chicago", operates more of a point-to-point focused operation. Also, AirTran carries far more connecting traffic and focuses on smaller cities. And the distribution of AirTran capacity to smaller cities is greater than that typically observed in major Southwest cities.

"In our view, these differences in network structure are more fundamentally important than the difference in pricing approach noted above. While we do not expect immediate changes along these lines, we can envision a very different network structure in Atlanta several years from now than the one that exists today," said Chase.

"We suspect the most significant of the differences will be a greater emphasis on local traffic and larger cities."

Among the challenges faced by Southwest as it works to integrate AirTran are labour cost headwinds of about $178 million, which includes some degree of AirTran pilot cost increases, said Chase.

After realizing various cost savings, however, such as on aircraft lease rates, contracted maintenance expenses and general and administrative expenses, Southwest will only face minor net headwind from costs - estimated at about $45 million - upon full integration.

Barclays Capital expects the acquisition of AirTran will dilute Southwest earnings per share in 2011.