Pushing 40, Southwest Is Still Playing the Rebel

JAD MOUAWAD | The New York Times | 20 November 2010

It’s halftime at Southwest Airlines’ annual Halloween party – a ritual meant to celebrate the
carrier’s exuberant employees and freewheeling culture – and Gary Kelly is feeling a bit
wistful. “As long as you don’t mind being ridiculed all day,” he says of his Halloween
outfits, “it’s part of the routine.”

Nearby, Mike Van de Ven, the chief operating officer, is rolling on the floor, posing for
pictures, and greeting children and parents with a wide grin in his Buzz Lightyear
costume. “This shows you how little we have to do to run the airline,” says Mr Van de
Ven. “The less we do, the better it runs.”

Southwest doesn’t quite fly on auto-pilot, but as it prepares for its 40th birthday next year, it
is flush with success. Last year, it flew 86 million passengers, more than any other airline
within the United States. It operates 3,200 flights a day, owns a fleet of 544 planes and
serves 69 domestic cities from Seattle to Fort Lauderdale, Florida and from Lubbock,
Texas to Buffalo. When rival airlines were bleeding billions of dollars, Southwest was
churning out consistent profits as a low-cost carrier – even when fuel prices soared.

And in September, in its boldest corporate move since it started flying outside of Texas,
Southwest announced that it would buy AirTran Airways for $1.4 billion, increasing both
its revenue and its capacity by nearly 25 % in a single stroke.

Yet Southwest finds itself at a pivotal moment. Its success was built on a signature cocktail
of low costs, low fares, frequent flights and a rapid expansion into new cities. But with
high fuel prices, growth has been harder to find, and analysts have questioned whether
the airline can sustain its singular operating style.

Battered in part by Southwest’s growth, traditional airlines have restructured their operations
over the last decade – often through painful bankruptcy proceedings – and have
narrowed the gap.

Through mergers and global alliances, Delta Air Lines, which acquired Northwest in 2008,
and the more recently merged United Airlines and Continental are now more formidable
rivals. They can offer their passengers access to cities across the United States along
with connections to the four corners of the world – something Southwest cannot do.

Newer rivals, meanwhile, often modelled after Southwest, are thriving at the other end of the
spectrum. Thanks to efficient operations, lower costs and an attention to customer
service, these carriers – such as JetBlue Airways and Allegiant Airlines – are threatening
Southwest’s dominance in the low-fare trade.

“Southwest’s business has become more complicated than the simple model that served
them so well for 39 years,” says William S. Swelbar, a research engineer at the
International Centre for Air Transportation at MIT. “They are at an inflection point. They
are not a young and nimble corporation anymore. This is now a mature company.”

No longer the fiery start-up, Southwest now has the best-paid pilots, mechanics and flight
attendants in the industry. Its unit labour cost – how much it pays its employees to fly
one seat for one mile – rose 22% from 2002 to 2009, while the same measure dropped
34% at United, 7% at Continental, 26% at Delta and 11% at American Airlines.

Southwest’s 5,600 pilots earned $171,000, on average, in 2009, or 20 to 40% more than the
average salary for pilots who fly bigger planes at those other airlines. The flip side, says
Carl Kuwitzky, the president of the Southwest Airlines Pilots’ Association, is that the
company expects its employees to be more productive.
Since Southwest typically flies shorter routes and schedules more daily flights, pilots can fly
one hour longer each day than at other airlines, he says. This efficiency becomes a
crucial component to the airline’s edge. “We work very hard for our company,” says Mr
Kuwitzky. “And we recognize that we succeed if our company is successful.”

Despite labour, Southwest still has lower overall costs than its traditional rivals. In the second
quarter of 2009, Southwest’s advantage could be seen in its total costs per available
seat-mile. Those costs were 6 to 14% lower than at US Airways and American. (JetBlue
and AirTran, on the other hand, have lower costs than Southwest.)

Still, Wall Street remains sceptical. Southwest’s stock price, like those of most other airlines,
has languished. It has dropped 18% in the last five years – a generally rough period for
the industry as oil prices surged and the economy slowed. In an investment research
note, analysts at Morgan Stanley recently asked a provocative question: “Is Southwest
becoming a legacy airline?”

“Remember what it was like before there was somebody else up there who loved you?”

In an ad from the early 1970s, a Southwest “hostess” – that’s what they were called at the
time – wearing skimpy hot pants stood in the middle of a runway while a low-flying jet
whizzed by and made a simple case for the new airline: We’re affordable.

Until then, air travel was largely the province of a smaller, affluent class of American
travellers and business types. Fares, regulated by the government, were high.

Then came Southwest. From its modest beginnings, linking Houston, Dallas and San Antonio,
it revolutionized air travel. Since 1971, the year of Southwest’s first flight, the number of
air passengers has risen fourfold.

Larded with much higher costs, incumbent airlines immediately recognized the threat posed
by the scrappy new competitor, which once famously offered a fifth of Chivas Regal
scotch to entice customers to pay a $26 regular fare from Dallas to Houston. (That was
instead of the discounted $13 ticket that was priced to compete with Braniff International
Airways, now defunct.)

“It was personal,” says Ron Ricks, a Southwest senior manager who witnessed some of the
airline’s early struggles to expand into new airports. “But I realize now that it wasn’t
really personal for them. It was survival.”

The airline also prospered by remaining relentlessly focused on low fares. “Southwest had a
very profound impact on the industry,” says Robert Crandall, who led American Airlines in
the 1980s and ’90s. “They disproved the notion that customers preferred service to low
prices. And to their credit, they have sustained that.”

In the two decades after airline deregulation in 1978, Southwest developed a “cookie cutter”
method of moving into a new city, sharply cutting fares and driving up traffic, says Mr
Ricks. “We are so consistent, it’s boring,” he says.

The “Southwest effect” became a major reason that overall fares dropped in its new markets,
and the phenomenon was studied in business schools and the halls of government. The
Department of Transportation marvelled in a 1993 report: “The principal driving force
behind dramatic fundamental changes that have occurred and will occur in the U.S.
airline industry over the next few years is the dramatic growth of low-cost Southwest
Airlines.”

Southwest continues to have that impact when it enters a new airport. After it began service
to Baltimore-Washington International in 1993, fares dropped by 70% and passenger
 traffic increased 7-fold. Traffic between Philadelphia and Providence increased by more
than 800%, and one-way average fares fell to $44, a drop of 83%, in the year after
Southwest entered Philadelphia in 2004.

The company started flying to Denver in January 2006. It now has 141 daily departures
there, reflecting the fastest growth in its network. Frontier Airlines, based in Denver but
wedged between Southwest and rising fuel costs, couldn’t keep up. It filed for
bankruptcy in 2008, though it kept flying. In Las Vegas, Southwest effectively drove out
most competition from US Airways, which retreated to Phoenix. With 212 daily flights,
Las Vegas is now Southwest’s top city.

Competitors see Southwest as cold-blooded and ruthless.

“Their approach is to search out weak companies and contest them out of business,” says
Bryan Bedford, the chairman and chief executive of Republic Airways, which bought
Frontier out of bankruptcy last year. “It’s no different than Wal-Mart plunking a big-box
store near a local family-owned grocery store; you either respond to the competition, or
you get out.”

Robert Jordan, Southwest’s vice president for strategy and network planning, sees things
differently. “We never like to say we kicked somebody out of the market,” he says.
“Everybody makes their own choices. But we can go into a new market, charge attractive
prices and, given that people love our products, gain new customers.

“At some point, it becomes very hard for others to compete because they can’t make money
at the prices we charge, and we can.”

There’s also the whole Southwest road show that is a feature of nearly every trip: Some
flight attendants joke with passengers, others play games and sing, or, in the case of
one flight attendant made famous in a YouTube clip, break into rap songs. On one recent
flight to Las Vegas, when a flight attendant learned that a couple were going to marry,
she dimmed the cabin lights and led the whole plane in a loud toast.

Despite the fun and games, Southwest continues to deliver on its basic promise, says Walt
Rose of New Orleans, who travels on the airline occasionally. “They can get comical at
times – and that’s a major understatement – but we don’t mind it,” says Mr Rose, on a
Southwest flight from New Orleans to Midland-Odessa, Tex. “They are on time, they are
reliable, and they fly where we want to go.”

As it reaches adulthood, Southwest insists that it can hold on to its teenage ways. “We still
have an underdog mentality,” says Mr Kelly, the C.E.O. “It’s not a comfortable country-
club environment for us.”

But some analysts say the airline has been slow to adapt in recent years, by failing to update
its reservation software, for instance, or not scheduling flights to some leisure
destinations favoured by Americans, such as Cancun, in Mexico, or the Caribbean
Islands. That has allowed others, particularly JetBlue, to build a lucrative franchise in the
Caribbean.

“They were too paralysed in their in-the-box thinking about their airline,” says Mo Garfinkle,
an airline consultant. “Maybe they got a little too comfortable in their niche. They didn’t
appreciate that the world around them had changed.”

While shunning radical change, Mr Kelly rejects the notion that Southwest has been standing
still. He points out that in the last year, the company has been in talks with its pilots to
expand the fleet with Boeing 737-800s. These new planes offer 40 more seats than the
airline’s current 737s and will allow Southwest to fly longer distances. The move is
 significant because it helps pave the way for the airline to fly to Hawaii, and, for the first
time, to destinations outside the United States.

But getting overseas requires a tremendous amount of work for Southwest. Pilots need to
endorse the move because it would mean a change to their contract. (Flight attendants
agreed to the change last week.) Southwest also needs to update its software so it can,
among other things, sell international tickets and provide passport information to federal
authorities – something that its antiquated system cannot do.

While Southwest has ridden out spiking oil prices, it’s still an expense that could hamper
growth, especially as oil prices rise above $80 a barrel again. Initially, the company
negotiated the spike better than most. It bought complicated financial hedges intended
to mitigate the impact of high fuel prices, and gained a precious advantage over its
competitors as oil prices soared.

But the bet backfired in the fall of 2008, when the economy slowed and oil prices collapsed.
The company lost $120 million, its first quarterly loss in more than 17 years. (It still
turned a profit, however, for the full year.)

Given its low operating costs – and an engrained philosophy not to furlough or lay off
employees or cut salaries – Southwest found that it could not cost-cut its way out of the
crisis. Instead, it needed to bolster revenue while keeping its capacity flat. So the
company followed a wider industry trend, by aiming to attract more business travellers
with more perks and by getting passengers to pay for new services, such as priority
boarding.

But here, too, Southwest sensed an opportunity to showcase its difference. While baggage
fees generated roughly $1.7 billion for the industry in the first half of the year,
Southwest drew the line. It made its “Bags Fly Free” policy a centrepiece of its
advertising and marketing campaign.

“A lot of people have been trying to pickpocket and nickel-and-dime their customers,” says
Kevin Krone, the company’s head of marketing. “We don’t think it’s right.”

The policy turned out to be a good business move.

Southwest’s revenue rose by $1.6 billion in the first nine months of 2010, compared with
that period in 2007, even as its capacity declined by 1%. Part of that growth in sales,
Southwest believes, came from new customers fleeing bag fees. Mr Kelly calls his rivals’
approach “a gift.”

The policy yielded another advantage. It allowed Southwest to subtly shift the focus away
from its fares. Although it still offers low fares to many destinations, Southwest doesn’t
always have the lowest fares every day on every flight, says Bob McAdoo, an airline
analyst at Avondale Partners.

“Southwest can offer pretty good prices on their Web site, but if you buy in the traditional
business markets, 6 to 10 days in advance, it is not inexpensive,” according to Mr
McAdoo, who says he recently saved $350 to fly from Kansas City to Portland, Ore., by
taking Continental instead of Southwest.

To attract more business travellers, Southwest also ironed out its chaotic boarding process,
which had often been derided as a “cattle call.” While it still does not assign seats,
Southwest set up new boarding groups, giving priority to people who have checked in
online. This allowed it to start charging to be in the earliest group to board.

SOUTHWEST’S biggest challenge will be in merging with AirTran, which Mr Kelly described as
“the single best idea we have for the next years.”
The acquisition fits into the company’s drive to attract more business travellers. It opens the
door to Atlanta, the world’s busiest airport, provides expertise on international flights
and expands its foothold in New York and Washington. It also brings the carrier into
more direct competition with big players like United and Continental, as well as American
and Delta.

But as Southwest enters more congested airports, especially in the Northeast corridor,
analysts say it may suffer the same kinds of delays and performance shortfalls that
plague its rivals. Today, about a third of all Southwest’s passengers connect somewhere
along its network. That is well below the 50 or 60% connection rates at the more
traditional hub-and-spoke airlines, but analysts point out that Southwest’s figure is
growing.

Earlier this month, the Justice Department requested more information about the merger,
which would cement Southwest’s lead as the top domestic carrier. Southwest still expects
the deal to close in the first half of next year.

“Southwest got two big pluses from AirTran – 37 more destinations and taking out the
lowest-cost carrier in the business,” says Robert Herbst, an independent analyst and a
former commercial pilot.

The takeover will also mean some fundamental changes to another aspect of the vaunted
Southwest model. The airline currently flies a single type of airplane, the Boeing 737,
which allows it to minimize maintenance costs and pilot training.

With AirTran, Southwest will inherit a fleet of 86 Boeing 717s that it will have to integrate
into its operations. Mr Kelly says those planes will provide more flexibility, allowing
Southwest to serve lower-traffic cities that would be uneconomical to serve with the
larger 737. Southwest will also have to absorb AirTran’s 8,000 employees into its highly
unionised work force of 35,000.

That aspect has prompted considerable worries among Southwest employees, who fear that
the merger will somehow dilute the company’s specific culture. Pilots often help clean up
a cabin to speed up operations. Flight attendants have been known to lend a hand on
their day off. Thom McDaniel, the president of the Transport Workers Union Local 556,
which represents the company’s flight attendants, says the issue is among the most
discussed among his members. “When we wear the same uniforms, we need to be part
of the same company,” he says.

Mr Kuwitzky, the pilots’ union president, says, “The Achilles’ heel of this transaction is how
our company will be able to maintain our culture, and keep it alive for the next 40
years.”

Few companies – and certainly fewer airlines still – have managed to foster such feelings of
loyalty from their employees. In the 1990s, at a time of rapid growth, it set up “culture
committees” that helped propagate the “Southwest way” through the company.

It still strives to preserve its ethos by keeping a close eye on its hiring. Last year, for
instance, it received 90,043 résumés but hired a mere 831 people, making it harder to
get a job at Southwest than to get into an Ivy League college.

“Our culture is our biggest competitive strength,” says Mr Van de Ven, the chief operating
officer. “But we want to grow it, not protect it.”

Southwest wears its history on its walls. The headquarters here in Dallas features wall-to-
wall displays of about 100,000 photographs celebrating the airline’s history, follies and
successes. This bond culminates at Halloween, the biggest party of the year, and one of
eight corporate functions Southwest deploys to bring its employees together.
Now it’s a question of whether Southwest’s culture will continue to liberate it or will hold it
back. “The traditions can hobble you; I absolutely concede that,” says Mr Kelly. But he
says Southwest is just as scrappy as ever. “We’re still a maverick,” he says.