Southwest Keeps it Simple

Aggressive growth and conservative management have kept Southwest on top and new CEO Gary Kelly doesn't aim to change the formula

By Perry Flint
In Dallas
Air Transport World, April 2005, p.26     Buy this issue

"There's an old saying around here that you never go bankrupt with too few seats or too few airplanes," Southwest Airlines CEO Gary Kelly tells ATW at the airline's Dallas headquarters.

That may seem like an odd remark, coming as it does from the CEO of a carrier that historically has grown at a rate of 10% per year and will take 85 new aircraft between 2005 and 2007. But it captures perfectly the balance between conservative management and aggressive expansion that has kept SWA profitable over 32 of the last 33 years as it has grown to become the largest US domestic airline in terms of passengers and departures, operating 2,900 daily flights with a fleet of 417 aircraft to 59 destinations in 31 states. For Kelly, who assumed the chief executive position last summer and has 19 years with the company, the toughest job may be maintaining that equilibrium when, in his words, "Growth opportunities have become more precious."

Perhaps this helps to explain why he has resurrected the issue of the Wright Amendment, a 26-year-old federal law that limits airlines operating at Dallas Love Field to serving destinations in Texas and seven nearby states. Absent the law, which was written to protect the new Dallas/Ft. Worth International Airport after deregulation, SWA potentially could offer nonstop service to many more cities from Dallas including key bases such as Baltimore, Chicago, Las Vegas, Los Angeles, Oakland, Philadelphia and Phoenix.

In spite of the restrictions, Love still is SWA's seventh-busiest airport with 123 daily departures. Recently, however, Kelly has warned that unless the amendment is repealed, Southwest's long-term future here is uncertain because traffic has been shrinking steadily since 9/11, largely owing to security rules that have extended total trip times significantly, making auto travel an alternative on many short-haul routes from Love.

It's not the kind of talk one would have heard from legendary former CEO Herb Kelleher, who remains a very active executive chairman, nor from Kelly's immediate predecessor, Jim Parker, who retired unexpectedly last year. Kelleher always used to say that he was "profoundly neutral" in the debate over the Wright Amendment.

But the environment has changed dramatically over the past 12-18 months. Larger legacy rivals have achieved significant labor restructuring agreements, eroding SWA's once considerable wage-rate advantage. Overcapacity, particularly in the East, is pushing passenger yields lower than SWA would prefer. Moreover, other LCCs including JetBlue, AirTran and Spirit have carved niches, reducing the number of "underserved and overpriced markets" that form the heart of the airline's commercial strategy.

"If you go back to 1990, we were 90% of the low-fare offering in the US, if not more, and we could afford to be more complacent-or more patient-and now we're half of the low-fare capacity," Kelly observes. "We can't afford to be caught flatfooted in terms of our expansion. We have to be mindful of what we're doing."

SWA continues to be North America's most successful airline. Earnings rose 5% in 2004 to $313 million if special items are excluded, on a 10% increase in revenues to $6.5 billion. The foray into US Airways' Philadelphia hub has by all accounts been a rip-roaring success and the carrier is up to 41 daily departures to 16 cities, the fastest build-out in its history. It enjoys a No. 1 share in 90 of its top 100 O&D markets and a 66% share overall in these markets and has built a diversified network in which no city accounts for more than 7% of departures and no region more than 27%.

The balance sheet is a financial manager's dream. "We ended the year with $1.3 billion in cash and our leverage, even including our operating leases which are off-balance sheet, is well under 40%," notes VP and Treasurer Tammy Romo.

Still, Kelly is feeling the pressure: "There is a lot of competition. There is a weakened air traffic demand environment. And that's before you even get to the cost side of the equation." He points out that without fuel hedges, Southwest would have lost money in the fourth quarter. SWA aims to achieve an annual net profit margin of 7.5%-8%, a target it hasn't reached since 2000.

All of which helps to explain last December's unprecedented agreement to share codes with ATA Airlines as part of a broader transaction that included the purchase for $40 million of six of that carrier's 14 gates at Chicago Midway, where Southwest already was the largest tenant with 19 gates. The deal, which was negotiated after ATA filed for Chapter 11 bankruptcy protection in October, also calls for SWA to supply $40 million debtor-in-possession financing and purchase $30 million of convertible preferred stock representing 27.5% of a reorganized ATA. Although it has purchased other airlines on two previous occasions-Morris Air in the 1990s and Muse Air in the 1980s-until Feb. 4, 2005, never had it placed its code on another US carrier.

Kelly is candid that the codeshare went against his gut feelings. "My whole theory right now is let's 'de-complicate.' Let's get as simple as we can." But the alternative was to risk losing out to rival LCC AirTran, which had agreed to pay ATA $88 million for all 14 gates at MDW, a move that would have catapulted it into a major player at an airport Southwest has been building up for two decades.

"Arguably Chicago is the second-largest travel market in the US next to New York, so for us it's our largest opportunity . . . The last thing we wanted was to be stymied in our growth [there]," Kelly explains. That's where the idea for codesharing came in. "Herb [Kelleher] and I said, 'This is it. We need to do this.' We knew we could win because AirTran couldn't possibly match the value that we could with the codeshare." It became "the trump card for us to win the gates."

As of this month, SWA will offer 170 daily departures from Midway, up from 153 in February. Kelly says, "We'll continue to add flights this year and next year." With 25 gates, "We'll have a capacity in theory for 250 daily departures, which would easily be our largest operation." Currently that honor rests with Las Vegas, where the airline offers 196 daily departures.

Hello Hawaii The codeshare, which has an initial term of eight years, links 11 ATA cities to more than 40 SWA destinations from MDW. The biggest benefit for SWA customers may be the opportunity to fly ATA to Hawaii, although the two do not yet have reciprocal frequent-flier plans. From a passenger service standpoint, the airlines have two significant physical differences: ATA assigns seats and SWA does not, and although an LCC, ATA has a two-class cabin and SWA is all-coach. Kelly dismisses the possibility that this could create passenger confusion or unhappiness. Southwest, after all, is at least 10 times as large as ATA and its passengers are quite familiar with its boarding practices.

Although he says it is easily feasible from a technology standpoint, Kelly stresses that SWA will not introduce assigned seats simply because of the codeshare. Are they possible at some point in the future? He is skeptical, stating that among customers who have expressed an opinion, the preference is to retain open seating; "The biggest issue that I have is that if we went to the added cost and inefficiency of assigning seats, it wouldn't satisfy every customer." He emphasizes that "adding cost in this environment is the exact wrong thing to do."

A more serious issue is whether SWA passengers will receive the same level of friendly, efficient service on ATA flights. Kelly points out that there are standards both have to meet or the codeshare can be terminated. In January, he said he had been "pleasantly surprised" by the positive attitude among ATA employees.

SWA estimates the codeshare could add $25-$50 million per year in annual revenue for each airline. Kelly is particularly pleased at the speed at which it was accomplished: "I understand this is the fastest implementation of a codeshare from execution of a codeshare agreement to first travel date." It's a tribute to Southwest's amazing workforce and also to investments in technology. "I don't think five years ago we could have entertained anything as exotic as a codeshare. Our technology has advanced dramatically."

He emphasizes that the partnership with ATA is a one-time event and is not reflective of a new direction or philosophy. "With all that flight activity [at MDW] we simply said, 'We can make these flights eligible for codeshares.'" Similarly, "We will not be promoting the codeshare itineraries over our nonstops."

Focus on Nonstop Approximately 80% of SWA passengers are on nonstop flights, with perhaps 14% connecting and 6% through. Although there is some shifting in the latter two categories, the nonstop number has remained consistent. "We focus on nonstop traffic," Kelly states. "We'd prefer fewer connections. It's what customers want least. It raises the bar. It is extra work for no more money. It's a lot cheaper for us to fly you nonstop." Likewise, he says SWA, which has seen its average passenger trip length rise from 521 mi. in 1994 to 753 mi. today, remains committed to short-haul markets. The addition of longer routes "is not so much strategic as it is geography. As our route system has expanded to the East Coast, it just offered more long-haul opportunities."

Of course long-haul flying improves aircraft utilization and helps to lower unit costs by spreading fixed expenses over more seat-miles. Theoretically, that could push Southwest toward more such flights because its labor cost advantage has eroded. JP Morgan's Jamie Baker recently estimated that the hourly pay for an experienced SWA 737 captain is now the third-highest in the industry. Additionally, the 2003 agreement with cabin staff "will make [them] the industry leaders over the life of the contract," according to the attendants' union.

While agreeing that "our wage rates are up there relative to our competitors," Kelly insists that "labor is but one component [of costs] and the labor rates are even further a [sub]component." He has a point. Even on a non-stage-length-adjusted basis, which penalizes short-haul airlines like SWA, its 2004 CASM of 7.77 cents was lower than all competitors except JetBlue. Although CASM excluding fuel and special items rose 1.4% last year, that largely was owing to expenses incurred in the first half of the year, as CASM excluding fuel was flat in the third quarter and declined 4.5% in the final period. It was expected to fall further in the first quarter of 2005.

Much of the improvement is the result of a little-noticed 5.6% reduction in workforce, from 32,847 employees at the end of 2003 to 31,011 a year later. The cuts were accomplished without layoffs through a combination of attrition, a soft hiring freeze and generous severance and early out programs. "It was time to put the brakes on our spending and really get serious about cost controls," Kelly says, citing advances in technology that made personnel reductions possible.

For example, as customers migrate to its website, which now accounts for 59% of transactions, SWA needs fewer reservations agents. Last year it closed three of its call centers, offering agents the opportunity to transfer to other locations or accept generous severance packages. "We had 7,000 reservations agents at our peak and now we're down to around 3,000," he says.

Likewise, the airline has been able to do more in the airport environment with the same or fewer customer service agents owing to automation including the introduction of ticket kiosks, boarding passes-a federal requirement following 9/11-and e-check-in. The result is that SWA now has around 74 employees per aircraft, down from 85 in 2003 and against an average of around 100 for legacy airline rivals, according to investment bank Raymond James & Assoc. Revenue per employee rose 16.4% to $210,570 and ASMs per employee soared 26% to 2.5 million last year.

Citing these improvements, Kelly declares, "I don't think that our competitors will be able to beat us by having lower labor rates." At the same time, he agrees, "We're going to have to be very cautious about wage rate increases that we commit to in the future." The good news on that front is that SWA will not face an open labor contract until 2006.

Kelly professes to be more worried about another issue: "My main cost concern is not labor because I believe in our people. I think they'll take care of business. But nobody can control energy prices." Well, almost. SWA has the best hedges in the industry: 85% of this year's fuel budget is hedged at $26 per barrel and in 2006 it's 65% at $32. Additionally, the carrier has installed Aviation Partners Boeing Blended Winglets on its 737-700s, "which is saving us 3%-5% fuel burn per aircraft."

Growth Year Notwithstanding fuel prices, 2005 will be a growth year for Southwest. Next month it launches service to Pittsburgh-another US Airways hub although one that carrier has deemphasized in recent years. In addition, Kelly says it is quite possible SWA will add a second city later this year. Given that Pittsburgh is only the second new city it has added since 9/11 (Philadelphia was the first), this represents a resumption-perhaps an escalation-of its traditional 10% annual growth profile. On the other hand, it is ending service to George Bush Houston Intercontinental Airport, a destination it served for 25 years, citing lack of profitability. It remains committed to the Houston market but will concentrate entirely on Houston Hobby, where it recently opened a new concourse and offers 139 daily flights.

An item Kelly claims not to worry about is Delta Air Lines' SimpliFares reform through which that carrier has capped its one-way walkup fares at $499. Noting that SWA never charges more than $299, he says he is seeing no impact. "Will their fare change move things around? It's bound to. But that in no way is a threat to our niche."

That "niche," if being the largest US domestic airline is indeed a niche, may be extended into the international arena someday via a future codeshare with ATA. "I think we probably will look at it more seriously in the next two-three years," Kelly says. "It's just a matter of managing priorities."

SWA also continues to study inflight entertainment options. It has "evolved" its thinking on the matter, but IFE remains a low priority, he says. "The issue right now is that there is a glut of seats, there is an energy-price crisis for our industry and it's a time to get through as opposed to making a lot of bets on what customers do or don't want." Or as he might say, a time to simplify, not complicate.

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