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No-frills Southwest gains altitude but faces mounting challenges

By Chris Walsh, Rocky Mountain News (Contact)

Published September 13, 2008 at 12:05 a.m.

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"In terms of economic cycles, this is certainly the toughest we've ever been through," said Gary Kelly, Southwest Airlines' CEO.

Photo by Rex C. Curry / Special To The Rocky

"In terms of economic cycles, this is certainly the toughest we've ever been through," said Gary Kelly, Southwest Airlines' CEO.

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Maybe it's the sand volleyball court in the parking lot or the snow cone machine that several employees set up near the lobby on a recent afternoon.

Perhaps it's the summer deck parties - complete with $1.50 beers, snacks and sometimes even live music - or the casual dress code, where even top executives opt for short-sleeve shirts over suits.

It could be the eccentric collection of decorations adorning the hallways: employee baby pictures, trophies, a jacket made out of tiny bags of peanuts and even snapshots of the company's legendary co-founder - cigarette perched between his lips - arm-wrestling another executive over the rights to a trademarked slogan.

Whatever it is, Southwest Airlines' headquarters feels more like a college campus than the corporate offices of a Fortune 500 company.

The party atmosphere is understandable.

Southwest ranks as one of the nation's most successful airlines over the past few decades, cobbling together an impressive string of yearly and quarterly profits, developing a cultlike following among fliers and employees and, more recently, expanding into cities such as Denver while its competitors cut back.

It's been a remarkable run, but some experts question how much longer it can last.

Southwest faces its biggest challenges yet amid high oil prices, a slumping economy and a potentially severe slowdown in leisure and business travel. Several experts warn that the airline could even post a quarterly loss later this year, which hasn't happened since 1991.

With that as the backdrop, the company known for its predictable, streamlined business model is undergoing significant change - and risk - to raise revenues and blunt the cost of fuel.

Its strategic decisions will ultimately set the stage for whether the party rages on or starts to fizzle out. And that will determine if Southwest can continue to grow in Denver, where the carrier has added flights at a faster pace than in any new city in its history.

"In terms of economic cycles, this is certainly the toughest we've ever been through," Gary Kelly, Southwest's chief executive officer, said last month in his Dallas office. "At the same time, we've also never been stronger than we are today. We don't want the (quarterly) profit string to end, but while it can happen and it might happen, I don't think we can get so uptight about it that we do something dumb. We need to be careful in how we approach our decisions."

Lone star

If you're searching for a case study on how to run a successful airline, look no further than Southwest.

In an industry continuously plagued by challenges related to fuel, the economy and geopolitical events, Southwest has been a model of stability and growth. The carrier hasn't lost money on an annual basis in 35 years, and in the past two decades it has recorded more than $5 billion in profits.

That's no small feat.

Commercial and cargo carriers in the United States lost a collective $14.9 billion during the past 20 years, according to the Air Transport Association, a Washington-based industry trade group. Most of Southwest's competitors have filed for bankruptcy protection along the way or gone out of business entirely.

And while other airlines are bleeding cash and wobbling on the edge of bankruptcy, Southwest has ample reserves and a solid balance sheet.

"Through all the ups and downs they've been through, from the early 1980s oil-price shocks to 9/11 to the current fuel crisis, they've always managed to make a profit," said Peter Cohan, who runs a management consulting and venture capital firm in Massachusetts and wrote about Southwest in a book on leadership. "Considering the billions of dollars the industry loses on average, to make a profit is amazing and to do it consistently is even more impressive."

No frills

Southwest has thrived for more than three decades by sticking to a no-frills, streamlined business model focused on low fares, low costs and operational efficiency.

The carrier, for instance, flies a single type of aircraft, which keeps maintenance and training costs down. It primarily targets smaller airports with lower fees and charges. It can quickly load, unload and clean aircraft, allowing it to fly each plane as much as possible each day. And it has largely shied away from code-share agreements and regional partnerships with other carriers, which can dampen profits.

But one of Southwest's greatest advantages, observers say, is its loyal worker base, which has translated into what many say is superior customer service.

The carrier has a unique corporate culture that encourages employees to work hard and have fun at the same time. Workers are known to crack jokes during in-flight announcements, and the company holds legendary Halloween parties where even top executives don costumes.

Southwest puts prospective employees through a rigorous interview process to ensure that each new staff member, from baggage handlers on up to pilots, fits its customer-centric focus and character requirements.

Although Southwest has the lowest costs in the industry, it also pays its workers some of the highest wages of any U.S. airline. A few flight attendants and other longtime workers made millions of dollars off of stock options but continue to show up for work every day.

"The key point is that they do a lot of things well," Cohan said. "That's the beauty of what they do. If you're a competitor trying to figure out how to do what Southwest does, you wouldn't be copying one thing. You'd be copying 10 or 15 things, even though they have a pretty simple business model. That's what makes it very difficult for other airlines to copy them."

Hedges fuel profits

The carrier, however, owes its profit streak over the past decade to one thing above all others: fuel hedges.

Southwest has had an uncanny ability over the past decade to essentially lock in its future fuel prices at low levels. Using financial tools such as options and futures contracts, Southwest cements contracts in which it agrees to buy fuel for a certain price at a later date, often a year or two out.

The carrier saves money if fuel prices rise, which is exactly what happened in recent years.

Oil rocketed to more than $140 a barrel in July and now stands at about $100 a barrel.

Southwest, though, has about 80 percent of its fuel needs in 2008 hedged at crude oil prices of between $58 and $61 a barrel. It expects to save an estimated $2 billion this year through its hedging program. The carrier also is reasonably well-protected next year, with about 70 percent of its fuel needs hedged at an average of $66 a barrel.

Aside from the obvious financial benefits, the hedges - coupled with Southwest's overall low-cost model - give the carrier an invaluable advantage over its competitors: time.

"Our philosophy is that if you can take the volatility out of fuel prices, you can build the rest of your business around that," said Scott Topping, Southwest's vice president and treasurer, who also oversees the carrier's fuel-hedging program. "These hedges have given us time to adapt to higher fuel costs in general, whereas others don't have that luxury."

Storm clouds on horizon

Southwest might not have that luxury much longer, and the storms clouds are gathering quickly.

The fuel-hedging contracts Southwest cemented when oil was much cheaper will run out in coming years. In 2011, for example, Southwest currently has about 20 percent of its fuel needs hedged at $77 a barrel.

The carrier could find itself crushed under billions of dollars in additional expenses if fuel prices stay at current levels or rise even further.

Southwest also is paying much more today for fuel that isn't covered by its hedging program, which eats into its bottom line. In the second quarter, for instance, Southwest's fuel costs rose 35 percent over a year earlier despite its hedges. And although oil prices have declined recently, they're still up significantly from last September.

Another serious challenge revolves around industry demand, which is tapering off after several years of growth. Southwest recently reported that miles flown by paying passengers in August dipped 5.2 percent compared with the same period a year earlier - the biggest decline among major U.S. carriers.

The company has been able to hike fares several times this year, which from a financial perspective helps counter the loss in traffic. But the trends are worrisome, particularly considering that Southwest's labor costs have been rising.

"I think their biggest challenge right now is nonfuel expenses, primarily labor costs," said Bob Mann, a New York-based industry consultant. "Historically they've been generous to their employees but they've been able to earn it back in the form of rapid growth. In a no-growth or slow-growth mode you don't get that productivity benefit."

Many experts think demand will fall precipitously in coming months when major airlines start rolling back flights as part of previously announced capacity cuts. JPMorgan analyst Jamie Baker estimates that Southwest will need its revenues to grow by 8 percent just to break even in the fourth quarter.

Boosting revenues by that much is "not impossible, in our view, but this likely represents the best-case outcome," Baker wrote in a note to clients in late July.

'Not sailing along blindly'

Southwest's challenges are just now rippling to Denver, where the carrier had been adding flights at a rapid clip.

The company still plans to move forward with plans to add 20 daily departures and two new cities in November. But its recent decision to terminate three flights here in January and scale back systemwide might signal the end of Southwest's rapid expansion at Denver International Airport.

Southwest admits that its challenges are more severe than any it has faced. But the carrier has defied gloomy predictions before, and its executives are intent on doing so again.

The company is now aggressively revising its business model to stay competitive in the age of $100-a-barrel oil prices. Officials describe it as a "repositioning" and a "reinvention" of the company.

"I think this is easily the most change in our history in a compressed period of time," said Bob Jordan, Southwest's executive vice president of strategy and planning. "Southwest has always changed and has always been able to adapt to whatever is in front of us, but a lot of change in the past has been related to growth. The circumstances are different this time around."

The primary goal is to continue to reduce costs, of course, and to find new ways to raise revenue aside from increasing ticket prices. The airline has set a goal of adding $1 billion in annual revenue by 2010.

Southwest already has implemented some changes, such as revising its boarding process, offering new services for business travelers and striking a partnership with WestJet that will expand the carrier's reach into Canada.

It's also moving to reduce its capacity by nearly 200 flights - including the three in Denver - in early January. The carrier said the cutbacks give it "operational flexibility" in the slow winter months, and it has indicated that some of those flights could return later next year.

Southwest CEO Kelly said the carrier will focus on several other major initiatives in coming months and years, including changes to its frequent-flier program, more partnerships with other airlines and possible on-board Internet availability.

"We have ambitious but realistic plans to overcome these challenges so that we are prosperous in the near future," Kelly said. "We're not sailing along here blindly. We just want to be cautious on how we get from here to there."

Fee-free

Experts say Southwest has some formidable challenges and that it risks diverging from the model that has kept it profitable for all these years.

Aside from issues related to labor costs, Southwest is increasingly having to enter large airports with high costs to fuel growth.

At the same time, though, Southwest has some unique opportunities.

The carrier has thus far avoided implementing fees and charges for checking bags, cashing in frequent-flier rewards and flying standby on an earlier flight. It's a tack nearly all of its competitors have taken, and it's one the carrier said it will try hard to avoid. It's also a distinction the carrier glowingly points out in advertisements.

"They have been very cavalier toward that practice in their brand position, saying that they think these fees silly and insulting," said Jay Sorensen, president of Wisconsin-based aviation consulting firm IdeaWorks. "It's a bold departure from the rest of the industry, but it's been largely fueled by the fact that they are very well-hedged."

Although it is cutting flights early next year, Southwest also might be able to capitalize on the struggles of its competitors. Most airlines are planning double-digit percentage declines in capacity, and many likely will give up gates and other assets.

In Denver, for instance, United Airlines and bankrupt Frontier Airlines are both scaling back considerably.

Southwest said it still hasn't decided on its overall capacity plans for next year. While it has indicated that it might not expand at all, it also has held out the possibility of limited growth depending on the circumstances.

"Denver will remain a focus city for us in 2009, but I would not expect to see the same rate of growth in 2009 as we had in 2008 in Denver," Kelly said. "That said, we will continue to look for opportunities to build our service in Denver."

walshc@RockyMountainNews.com or 303-954-2744

Comments

  • September 14, 2008

    7:35 p.m.

    Suggest removal

    ghoax writes:

    if only more companies were as bright as SW...things would be quite a bit different. too many MBA's can't figure out the simple formula, take care of your people, they take care of the customers, customers keep coming back...shazaam profitable.

    instead what we get is, limited customer service, high prices, companies cutting corners on service and quality, customer service from foreigners who can't speak English, business run by shareholders, followed by union intervention, followed by higher costs, lower quality..get the picture?,