One thing is certain: Gary Kelly has big shoes to fill. Herb Kelleher, the predecessor of this rookie CEO, invented Southwest Airlines' vastly influential low-cost model, and is one of the best-loved and most respected managers of modern times. He created the ingeniously informal culture that energized the carrier's employees and made Southwest a great place to work. Basically, Kelleher brought common sense, simplicity, and a sizable streak of personality to the aviation business.
How, then, is Kelly dealing with the pressure to follow Herb's act? Aggressively. Since he took over the top job last summer, Kelly's added planes to Southwest's fleet, brought new cities into the route network, and overseen the airline's first passenger-sharing deal with another carrier. His fingerprints are on new aviation legislation being introduced in the U.S. House of Representatives, and he's constructed a convincing plan for weathering the industry's fuel crisis. What's more, Kelly gets out of the office every week to meet with employees face to face—and he still finds time to paint his own face and wear black tights for costume parties. In many ways, he may be the next Herb Kelleher.
A Little History
In 34 years of doing business, Southwest has grown from two planes to 460 and has broken nearly every airline-industry tradition along the way. "When Southwest came on the scene, it was just a small regional carrier," recalls Terry Trippler, a veteran airline analyst based in Minneapolis, MN. The start-up was derided by the larger airlines: "We called it the 'Greyhound of the air' because it had no frills," he notes.
But the seven major carriers that survived the deregulation of the airline business in the late '70s would end up taking cues from the small Dallas-based start-up. "Southwest Airlines has singularly focused on keeping travel affordable, and in doing so it has created an all-economic-weather business model," explains airline analyst and consultant Robert Mann, of RW Mann & Company in Port Washington, NY. "It's a focus on simplicity and productivity." The model that Southwest invented is indeed simple: Keep costs as low as possible, and pass those savings along to customers in the form of lower fares.
As it turns out, the most important operational expression of that philosophy lies in the way the airline's network of routes is structured: Southwest operates a point-to-point network based on direct flights, while other major carriers run highly choreographed hub-and-spoke systems that focus on connections.
"With the Southwest model, planes come and go when the highest productivity dictates. But the converse is true for the traditional hub-and-spoke carriers, where the airplanes are waiting for connections," Mann explains. "In those heavily peaked systems, 30 or 40 planes meet in an airport at once. And then those planes have to wait around for bags and people. This increases costs tremendously."
And beyond the efficiencies of its point-to-point route network, Southwest has kept its costs down in many other ways. It has never served meals on flights. Its airplanes are all Boeing 737s, which saves on training and support equipment. Southwest distributes its tickets through its own call centers and Web site, rather than employing the more costly services of the third-party global distribution systems other carriers use. Finally, Southwest has stuck to secondary airports and domestic routes, which has kept gate costs low.
The control of costs pays off for Southwest's customers and employees. The airline's average ticket prices are considerably less than its competitors', and its workers are the highest-paid in the airline industry. They've never seen any layoffs, wage cuts, or furloughs.
Tough Times
But even with all the advantages of this low-cost business model, the airline has not been immune to the challenging conditions that have persisted since the late 1990s. "The past four years have been probably the worst period in history for us," says Kelly. "We've had recession, we've had 9/11, we've had record-high energy prices, and now we're also facing a glut of capacity, which has been supported by federal bailouts, bankruptcies, and corporate bailouts."
Kelly insists the carrier is off to a great start in 2005. "But," he says, "to put it in perspective, last year, we earned $313 million in net income, and our all-time record is double that: We earned $625 million in 2000. This shows the impact that the glut of capacity and the soft revenue environment, coupled with high energy prices, are having on us."
Right now, the biggest trouble facing Southwest and its competitors is the increasing price of fuel. "What we are faced with here at Southwest are record-high energy prices. We hedged our fuel costs by prepurchasing for five years, so we are paying 26 dollars a barrel right now, versus a market price of about 55 dollars a barrel," Kelly explains. But even though this places Southwest in a far better position than any of its competitors in this area, the carrier's hedging coverage diminishes over time, and its costs will go up.
But Kelly has a simple plan for how Southwest will beat stubbornly high energy costs. "There are only a few things to do," he says. "We can work on improving our fuel efficiency, and consume less as time goes by. We have programs in place to do that. And we can work on the rest of our cost structure. Fuel accounts for about 18 percent of our total costs, so we have to work on the other 82 percent. And finally, we have to find ways to improve our revenues to cover these costs, ideally by carrying more customers per departure."
Making Its Own Way
If Herb Kelleher was a master of controlling costs, the new CEO seems equally intent on growing revenues. Kelly is leading the airline into a new period of expansion, and under his leadership, "Southwest has become very aggressive," says analyst Trippler, who operates an online booking engine called cheapseat.com. "Southwest now seems to be saying to the traditional carriers: 'We're here. Now, get the heck out of our way.' "
Southwest is adding new planes, flights, and cities to its point-to-point network. It launched service to Pittsburgh earlier this year and is expected to announce new service in another city this fall. In January, it activated its first code-share arrangement with another airline, and began to share customers with the struggling ATA Airlines. Kelly estimates that the new agreement will add $50 million to Southwest's annual revenues.
"We have 29 airplanes that we are adding to the fleet in 2005. We have 34 that we're adding next year, and then we'll add comparable numbers right through 2012. So we're growing," Kelly explains. "We've exceeded my expectations so far for the year."
But Southwest's conquests have not all come easily. US Airways has maintained a position of strength in Philadelphia despite Southwest's move into that market last year. And Southwest has seen some traffic dilution in Baltimore, Boston, and some Florida markets, admits Kelly.
Add to this the Texas-sized fight Kelly is leading at home in Dallas, as Southwest attempts to overturn the Wright Amendment—federal legislation which sharply limits the number of cities that Southwest can serve from its gates at Dallas Love Field. American Airlines, which operates a hub at Dallas-Fort Worth International Airport just across town, has vehemently opposed Southwest's plan, as a repeal would likely further erode American's shrinking market share. The outcome of this battle is still far from decided, but Southwest recently won a key victory when two lawmakers introduced in the U.S. House of Repre-sentatives a bill to immediately repeal the Wright Amendment.
Competition Heats Up
Indeed, the hub-and-spoke carriers haven't been sitting idly by while Southwest took over the industry, and since they have regrouped from the shocks of September 11, 2001, the intense competition in the airline industry has become even more cutthroat. In order to compete with Southwest, many of the majors are stealing pages from the low-cost carrier's playbook. "They're trying to become lean, mean, flying machines like Southwest," says Trippler. "For instance, hardly any of the airlines are serving real meals any more."
Led by Alaska Airlines in 2002, and followed by American in 2003 and Delta in 2004, many of the major carriers have engaged in de-peaking, which means they have spread out their flights during the business day to make their hub-and-spoke systems more like Southwest's efficient point-to-point network. "The legacy carriers have figured out the problem, and now they're trying to solve it by making passengers wait a little longer for their connections. The result is greater utilization of planes and ground facilities," explains Mann.
And now, those carriers are seeking to mimic the simple pricing systems used by Southwest. "Starting with Delta in January, many carriers lowered their short-term fares to compete with the low-cost outlets. This has caused them some pain, but it has generated a huge increase in demand," Mann says. "The bad news is that not everybody can carry on at those prices and still make a profit."
Kelly is confident of Southwest's ability to maintain its edge, but he's preparing for a long battle. "[The majors' recent moves to lower their fares] has been a nonevent for us," he says. "They've taken their very high walk-up fares and reduced them to what are still high levels. We continue to enjoy a significant fare advantage." But over the long term, Kelly admits, "There is a more important question, which is: How do we compete with more and more low-fare carriers? I'm expecting that over time every carrier will be a low-cost producer, every carrier will be able to sustain low fares comparable to ours. That's what we have to prepare for."
Right now, all eyes in the airline business are on the America West-US Airways merger, in which a somewhat healthy low-cost carrier is combining with a bankrupt hub-and-spoke carrier. An insider to the deal, Mann is advising the pilots' union at America West to monitor progress of the merger with regard to the pilots' interests. "If the deal closes as it is presently proposed," he says, "the combined firm will be far better able to withstand the pressures of the market than either of the individual firms could previously."
Once the deal closes, as it is expected to sometime this fall, new flight schedules and pricing will be rolled out. "From a customer's perspective, it should look like a new company very shortly after the deal closes," says Mann. "The new company will try to take some of the low-cost practices at America West and apply those to US Airways, which has always had trouble with costs." Simultaneously, it will use the hub-and-spoke carrier's extensive route network to try to grow revenues.
If things fall into place, the combined carrier could threaten Southwest's primacy. "What you could see is the emergence of the first low-cost network carrier," says Mann. "It'll have an international network and a first-class cabin, things that Southwest doesn't have." In theory, those revenue generators could offset the cost disadvantages that the combined carrier faces.
If the new US Airways finds success, it's possible that the airline industry will see a spate of hybrid carriers emerge. "There are a lot of people watching this deal," says Mann, adding it's likely that potential investors are eyeing another bankrupt hub-and-spoke carrier, United Airlines. "There may be some parties who are interested in [acquiring or merging with] United," he says. "But United is a much bigger operation than US Airways, with a much larger network. The government's antitrust concerns would be much stronger. It's a wait-and-see situation."
SIDEBARS
Southwest's Corporate Culture: Keeping It Together
The interpersonal relationships that develop at face-to-face meetings are key to Southwest's famously upbeat corporate culture, says CEO Gary Kelly, and keeping things informal and fun is the goal. "The culture here is very informal, it's very friendly, everyone is on a first-name basis," he says. "In anything you do, you perform better if you're loose. I don't mean loosey-goosey, I just mean not tense. You hit a golf ball better if you're not tense. You deliver a speech better if you're not tense. And you develop human relationships better if there's not tension there."
For communicating business goals and motivating employees, meetings are the key to Southwest's success. And fun is always part of the recipe. "We try not have it be so formal and stiff and tense that you loathe the thought of going to our events. We take time out for a few minutes of fun at just about every gathering we have."
Southwest employs a variety of events for teambuilding, from annual president's award banquets to anniversaries to holiday parties, held "just to get together and make new friends, and see old friends," says Kelly. Halloween parties are a favorite; at last year's gathering, the CEO donned black tights in homage to Gene Simmons from the rock band Kiss. "You can do all these fun things and still be successful," Kelly says. "When we get in the cockpit and fly the airplane, we're serious about it."
But seeing that Southwest has a large, dispersed workforce, the company utilizes a number of techniques when employees cannot meet in person. "We use the phone, the Internet," Kelly says. "But I do expect our leaders to be out among the people. I am out traveling every week. I don't have a big entourage—I just show up and just see how things are going. It's my technique for staying in touch."
Southwest's Take on Business Travel and Groups
Since Southwest has taken its own approach to almost every other aspect of its business, it's no surprise that the carrier has a unique yet successful approach to corporations and other groups.
"Right now our corporate focus is primarily built around the five-year-old Swabiz product, which is a free corporate online booking tool that allows people to track spending through Web-based reports," says Rob Brown, director of corporate sales and multicultural marketing for Southwest. Unlike traditional corporate discount programs that stick to negotiated fares built around volume-based discounts, Swabiz gives corporate travelers access to the airline's standard rates, as well as Internet-only deals and sale fares at the Swabiz site.
In 2004, says Brown, Southwest decided to discontinue its underutilized call-center-based meeting program. There were two reasons for this, he explains. First, the call-center technology that the program was based on had become outdated. Second, the program added to the administrative costs that Southwest always seeks to minimize. Now, meeting planners use Swabiz for group travel, Brown says, adding that the program offers the same benefits to groups as it does to transient travelers.
The stripped-down system works well for Southwest, he says. "Corporations and groups trust Southwest. They are very knowledgeable about the brand and what we represent: low fares, reliability, and great customer service. Those are the things corporate customers are looking for, and that's what we provide," he explains, adding that Southwest's corporate clients have contributed to quick growth in new markets like Pittsburgh, and continued success in Dallas, Houston, Chicago, and California.