Even mighty Southwest Airlines is finding it tough to make money with fuel at such high prices says the carrier’s chief executive Gary Kelly, as Americas Editor David Field discovers.

GARY KELLYAnyone trying to follow the noted if not notorious Herb Kelleher has a tough job, but Gary Kelly (pictured left), the soft-spoken chartered accountant who now heads Southwest Airlines, sees a far tougher challenge than putting on an public persona to live up to Herb’s chain-smoking bourbon-tippling, arm-wrestling legend. Kelly, who moved up from finance chief to the top slot just over a year ago, says Southwest is in a fight to survive.

Visiting Washington, he said the carrier’s record profits, traffic and consumer popularity face a deadline: without its extensive fuel hedges, Southwest would not be making money and has to grow – and grow aggressively – before its hedges expire in a year.
Kelly, now the airline’s vice-chairman and chief executive, told an Aero Club audience that “even with great fuel hedging next year, our costs will go up by $500 million, to $600 million. Had we not had hedges in 2005, it would have wiped out most, if not all, of our profits. Our earnings projections for 2005 are below that of 2000, even though we have since grown our fleet by 50%.”

Kelly pointed out that it will be well below the 2000 figure despite a 50% larger fleet. Yet, “our return on invested capital is below what it should be for a solid Fortune 500 company”, he says. Kelly also says Southwest has far less hedging in place for 2006 than 2005 and “to remain profitable, we must continue to grow our route system with more destinations and more frequencies”.

A key part of the growth comes in January when Southwest begins service at Denver, a major hub for United and one of the few markets that Southwest has entered and then exited. But in the 20 years since Southwest left Denver, the city has a new airport “that has done a good job in getting its costs down”. He thinks Southwest will be able to board a passenger there for “below $9, with a little bit of luck, below $8,” which is below the enplanement cost cap it sets for itself, but above its systemwide $5 average. It will initially serve Las Vegas, Phoenix and Chicago Midway from Denver.

Speaking to a small group of reporters after the club’s luncheon meeting, Kelly said the need to grow is behind its hard-pushing campaign to eliminate the Wright Amendment. This 1979 federal regulation limits nonstop routes from Southwest’s home base of close-in Love Field Dallas to other cities within Texas and in the four states that directly neighbour Texas; non-stops between Love and Mississippi, Alabama and Kansas cities have been allowed since the 1980s (the so-called ‘Shelby Amendment’ states).

After decades of what Kelleher used to call “strict agnosticism” or neutrality on Wright, Southwest began its repeal campaign earlier this year. At the time Kelly was firmly in place after taking over from chief executive Jim Parker, Kelleher’s short-term successor who resigned suddenly in July 2004. Technology, Kelly says, has made Wright wrong now that the Boeing 737-700 and -800 can fly nonstop pretty much anywhere in the 48 states.

But under Wright, if a flier wants to go on Southwest from its East Coast cities such as Philadelphia, for instance, the law makes the airline fly them somewhere else first, often Houston’s close-in Hobby Airport, where they transfer to a Love-bound flight. The most important issue facing the US airline industry today is excess capacity, says Kelly, endorsing the consensus, but adds: “Federal bailouts are exacerbating the problem.” The Wright Amendment is just “another federal bailout”.

Kelly’s insistence that Love must grow points up a fundamental change in the Southwest network philosophy: it is a network carrier now with connecting hubs. Houston Hobby became a de facto hub as Dallas-bound fliers changed there, just as Southwest’s booming operation at Chicago’s close-in Midway is in effect a hub.

While the airline is still true to its original philosophy of heavy reliance on point-to-point traffic such as Phoenix to Seattle or Baltimore to Orlando, it is becoming a carrier that can exploit network strengths. Kelly just wants to be able to build the nodes where the markets wants them – at Love rather than a connecting point such as Hobby, which may make some sense, or Tulsa, which probably doesn’t.

Kelly stresses that network growth, not revenue growth, is the only way to survive: “You can’t do it with fare hikes. We just can’t do a big fare hike and our customers wouldn't accept anything more than 1% or 2% increases.” Fuel surcharges, too, are out of the question: “Add-ons and things like that, they make things complicated and if you look at your ticket (with fare explanations and taxes) it’s complicated enough already.”

If things got even worse, Kelly says: “The first thing I would do if I was losing money would be to stop buying airplanes.” But with its incredibly strong track record of profitability, few believe Southwest will be forced down this road.

What the carrier would like to see is an even more cost-efficient 737. Southwest has told Boeing that “we would like to see them adopt some of the features of the 787” to its 737 line or any newer generation of the 737. “We want to work with them – when they’re ready,” says Kelly. Southwest was the launch customer for the 737NG program and the first customer for the -700 model of the 737.

Source: Airline Business