Southwest Airlines chief executive Gary Kelly is celebrating the low-cost giant's 40th birthday with its landmark take-over of AirTran, providing it fresh scope for growth and further challenging the world's top 10 global carriers

Near a cluster of executive offices at Southwest Airlines' headquarters minutes away from Dallas Love Field sits the "Guadalupe" conference room. It is not a surprising name to crop up in the halls of a company based in Texas to celebrate one of the state's popular rivers, or often-used street name featured prominently in some Texas cities. But in the past few months the name has served a dual purpose for the USA's wildly popular low-cost carrier. Guadalupe was the holding company formed by Southwest to carry out its acquisition of and merger with AirTran Airways, which just happens to be the largest merger of two low-cost carriers to date.

Combined revenues for the two carriers in 2010 were $14.7 billion, which has the enlarged Southwest knocking on the door of the top ten global carriers. Operating income exceeded $1.1 billion. Net annual synergies are estimated to exceed $400 million by 2013. In terms of passengers carried, the merged airline is second only to Delta Air Lines, having transported over 110 million in 2010.

But the celebrations of the transaction's official closing are underpinned by a Southwest team anxious to delve into AirTran's operations and take the best elements to expand its low-cost formula that has built it into an industry legend during the past 40 years.

Not far from Guadalupe sits the mastermind behind US low-cost consolidation - Southwest chief executive Gary Kelly.

His signature relaxed demeanour remains intact as he describes Southwest's approach to the largest transaction in its history. "When we bought Morris [Air] back in 1983 we were very determined that we were going to take Morris and quickly convert it to Southwest Airlines. I think that all worked fine. In this case, I think we want to move a little bit more judiciously and take this opportunity to understand how another airline works."

AirTran customers and employees are likely to see little change throughout the rest of the year, Kelly explains. But the next AirTran schedule that is published now that Southwest has assumed ownership is "where I think one should look for changes", he says.

The acquisition was completed on 2 May and the aim is to gain a single operating certificate in the first quarter of 2012. The full integration, and the retirement of the AirTran brand, is likely to take 2-3 years.

Southwest's chief is well aware that during the integration period the airline needs "to be clear in setting the right expectations for customers on AirTran flights to avoid as much confusion as possible, especially when we start exchanging passengers. With a Southwest segment and an AirTran segment for at least a period of time you're going to have a little bit of a different product on board."

Another milestone of the AirTran acquisition is the abandonment of one of Southwest's cardinal rules replicated the world over by successful and unsuccessful copycat carriers - keep it simple by operating a single fleet type.

Almost immediately after Southwest revealed its intent to acquire AirTran, Kelly and the Southwest team fielded a barrage of questions over the fate of AirTran's 88 117-seat Boeing 717s. Yes, Kelly declared, Southwest would keep the smaller aircraft and remains excited over the small-city prospects those aircraft open up to Southwest, which has for the past five years concentrated much effort on legacy-dominated markets of Denver, Minneapolis, San Francisco, New York LaGuardia and, most recently, Newark.

Kelly admits Southwest needs an aircraft the size of the 717 to grow into markets that cannot support the current mainstay of the Southwest fleet, the 137-seat Boeing 737-700. "As we stand today, it's difficult to muster up the effort to make one small city work, because it is so small and it just requires a lot of attention," he explains. "In this particular case AirTran will bring us several dozen cities that are up and running, generating revenue and profits. So it is now worth the management effort to make that fit into the Southwest brand and Southwest culture."

Kelly believes there are several dozen additional small cities a combined Southwest-AirTran could grow into, and while the company now has the equipment to penetrate those cities, he admits Southwest will need to focus its attention at some point on a 717 replacement.

Citing the size of the 717 fleet Southwest gains from acquiring AirTran, Kelly says clearly that is too large a number "for that not to be a question. So we're going to have to figure out what the successor aircraft will be". Ideally, it is a conversation Southwest would like to have with its lone aircraft supplier Boeing, but Kelly says the airframer has not expressed any real interest in pursing the market for that sized aircraft.

Admitting during his 25-year tenure at Southwest the carrier has spent very little time with any other airframer besides Boeing, Kelly believes "that's got to be different in the future. Bombardier is clearly bringing something new to the market and the fact that we are inheriting these 717s just demands that we take a good hard look at all the options we have".

But before Southwest turns its attention to examining its 717 replacement options the carrier must tackle the distinct hub and spoke operation AirTran has built at its largest airport, Atlanta. Gaining access to Atlanta was a driving force behind Southwest targeting an acquisition of AirTran, with Kelly emphasising to analysts, "I think the real story here is Atlanta".

All eyes are watching how point-to-point stalwart Southwest plans to execute an operation at the world's busiest airport. "It will be interesting to see how dependent some of these small cities are on the hub and spoke system," says Kelly. "So they're tied to Atlanta today. We could leave those cities tied to Atlanta if they're performing well, or perhaps we could have additional frequencies going west, and we have a number of cities in the west and Midwest that are candidates for supporting small city service like that".

Given the choice, "there's no question you'd rather have nonstop than connecting traffic", Kelly says, and he believes Southwest might have an ability to generate more local demand in Atlanta than that currently produced by AirTran.

However, Kelly is quick to pronounce that there is no reason to pre-judge a strategy for Atlanta. "If nothing else we'll learn a lot more about a hub operation than what we currently have or know."

As debate continues over the level of concern Delta should have over Southwest entering into its fortress hub, some observers believe Delta could gain some AirTran business customers opting to shun Southwest's open boarding policy and single-class aircraft. Southwest has emphatically said that it has no plans to adopt AirTran's assigned seating or two-class aircraft configuration.

There appears to a bit of general acceptance by Southwest that some of AirTran's corporate share could be lost once the business amenities are eliminated. "I'm prepared for some turnover here," says Kelly. "Very strong brands never get everybody. Coca Cola doesn't get 100% of the soft drink market."

Still, an underlying self-assurance exists at Southwest that the number of corporate customers lost will not be dramatic. "I'm very confident that we will earn a substantial number of business travellers in the Atlanta market, and of course we already serve a substantial number of business customers in the non-Atlanta markets," Southwest's chief says.

Despite Southwest's aggressive push during the past few years to bolster its corporate traffic Kelly says there is still a misconception the carrier does not target business travellers. "If we do 100 million O&Ds [origin and destination] trips in a year, there's a good 35% that are flying us on business. That's 35-40 million business trips, that's more than any other airline."

He also quickly points out claims by legacy competitors of carrying 50% business traffic are somewhat misleading - since they have shrunk their domestic capacity so dramatically, they are only "carrying half of what we carry in the United States", he says.

Most airlines round the world embarked on 2011 ready to put "the lost decade" behind them, and despite remaining profitable in that time, Southwest is no different. Kelly continues to see Southwest benefiting from the ever-shrinking networks of legacy carriers as they decide certain segments of the market are not worth pursuing. "Our growth is somewhat dependent on taking share and I do think there are opportunities to do that," says Kelly, pointing to Southwest's ability to become a dominant carrier in Denver only four years after entering a market that was for years a battleground between United and Frontier.

"I think the legacy carriers will continue fine-tuning their systems, because more and more they just can't compete economically for a large subset of customers that we serve. Our competitors don't want those customers," he says.

For Southwest, in addition to acquiring AirTran, opportunities still exist to grow the old-fashioned way. "That's where I see us going for the next decade," Kelly explains, which means rounding out its domestic route system to include Alaska and Hawaii, and the introduction of transborder service to Canada, Mexico and the Caribbean.

Or, said in a different way: "I don't really see an acquisition of another carrier as our strategy for the next decade."

The acquisition of AirTran joins the planned introduction of the larger Boeing 737-800, a revamped loyalty programme, and new transborder service as one of many pillars of Southwest's business strategy in the next few years.

Obviously AirTran is the most significant element of Southwest's evolving business model, but what is often lost in the excitement is that the purchase of AirTran alone does not get Southwest to the 15% return on capital investment target it last enjoyed in the 1990s.

"It's a big one but it doesn't quite get us there," Kelly explains. "We're paying $3.4 billion for AirTran so that alone has to have a return, but fortunately it has a return that's beyond our normal hurdle rate that helps address the deficiency that we have overall at Southwest in hitting our return on capital."

Airline analysts at CRT Capital are endorsing Southwest's strategy and believe it positions the carrier to "achieve its long-standing, but elusive, goal of 15% pre-tax return on invested capital on an ongoing basis".

Yet Southwest does not always receive ringing endorsements from Wall Street. As much as its model has been copied the world over, at times Southwest is criticised for its strict adherence to the baseline low-cost scheme. "I think there have been critics who have been frustrated by the pace of change and perhaps our unwillingness to do things like bag fees, so that's probably a dark cloud over some of those aspects," Kelly says.

Southwest garnered critics in the financial realm over its decision not to charge for checked bags as carriers like US Airways rack up $500 million in ancillary revenues that are largely driven by bag charges. Southwest did study the concept, but ultimately decided that "it's just not responsible on our part to argue that we won't lose customers by instituting bag fees", Kelly says. He believes Southwest vice-president of marketing Dave Ridley captured the carrier's bag philosophy most accurately. "We're working hard to get people to fly on Southwest. We feel like it is reasonable to let them bring their bag with them too."

Kelly recollects participating in a panel early on when carriers were instituting bag fees with a fellow chief executive from a legacy airline. That particular chief executive said he hated the bag fees, but felt like his carrier had no choice but to start charging for checked baggage. An animated Kelly exclaims: "He's the CEO of the company and he doesn't like his product!"

The criticism of Southwest's decision not to charge for checked bags has largely died down as Kelly declares the airline is "winning customers hand over fist while everyone else is shrinking. There have been a lot of mea culpas. People said they were right, we were wrong. We're glad we were right, but we could have been wrong and you just have to be mentally prepared if that's not the right overall move."

In January 2010, Kelly cited several calculations by the airline's management team of a roughly 1% domestic US share shift to the carrier, which translated into "somewhere to a half a billion and a billion dollars of additional customers".

Kelly is staunch in his belief the carrier's brand resonation is as strong as ever. "We still have a very compelling, competitive low-fare brand to argue," he says. The move by competitors to the "dreaded fees" has actually improved Southwest's image, says Kelly.

"Everyone can match your fares. But it's hard to match our no bag fees, no change fees. They can't match it. And I love that."

Only time will tell if the AirTran acquisition enlarges Southwest's brand loyalty. But Kelly highlights AirTran's profitability gives Southwest a huge advantage from the start. "It's not like we need to acquire them and repair them right out of the box. Part of the excitement with AirTran is they really do extend our model, they are very small relative to the overlap of Southwest Airlines. That allows us an opportunity to grow in every way."

Plus, says Kelly, "the bigger we get, meaning the more we have to offer, the more it seems to strengthen our brand."

Growing up at Southwest

This month Gary Kelly and Southwest are celebrating the carrier's 40th anniversary. Kelly's tenure at the carrier spans 25 of those 40 years, and the carrier's chief intends to stay put for the foreseeable future.

Kelly has been at the helm of Southwest for seven years, and he believes there is no magic cut-off at say, 10 or 15 years.

"I have no desire to serve in another company. I've grown up here and intend to stay here," he says, and as long as he feels effective in his role, "it makes sense for me to continue. The board could obviously have a different view and I'll honour whatever they choose."

Kelly is no different from most in enjoying a challenge, and he believes the airline industry still offers ample stimulation. He says: "Herb [Kelleher] always called it kaleidoscopic. I always thought he was just colourful, but he was right. It's a very exciting business."

A famous call

In April 2010 Gary Kelly decided to ring his counterpart at AirTran, Bob Fornaro, to gauge his interest in the airline being acquired by Southwest. The impetus for the phone call was an in-depth thought process by Southwest's management team over how important it was to the carrier's future to contemplate an acquisition.

"I had really gotten to the point where I'd made up my mind that it was important for us to find a way to grow. And you could continue to debate the merits of this airline or that airline or what have you," says Kelly.

With the completion of Southwest's financial analysis showing that AirTran was a compelling opportunity, and rather than to continue debate on the subject, Kelly says: "I just called Bob to see if they were even interested in having a discussionbecause there's no sense in continuing to churn on that question internally if there's not an opportunity there."

Kelly says he felt comfortable broaching the subject with Fornaro. "I trust him. I consider him to be not only a very admirable competitor but a good friend. And if the answer was 'no we don't want to talk about that', then we'll shake hands and remain friends."

While Kelly sees himself very much as a part of Southwest's executive management team, he did not feel a need to canvass the team's members before calling Fornaro. "There's plenty of time to decide later when we agree to move forward," he says. After Fornaro said he was open to discussion, Kelly says, "It's easy to say that among our senior leadership team it was unanimous, we wanted to pursue the idea."

Check out our video interview with Southwest chief Gary Kelly in the low-cost interactive Airline Business special at:

Source: Airline Business