CEO: Southwest's strategy shifting

June 29, 2007

Jun. 28--For 36 years, Southwest Airlines has pursued two basic principles. Rule 1: Keep everything simple. Rule 2: Don't do anything that violates Rule 1.

The result has been an anti-corporate flying experience for passengers, with no frills, low ticket prices and first-come, first-served seating.

But even the airline industry's most profitable carrier cannot escape the pressures that have bedeviled its rivals for years, particularly rising fuel costs and competition from other low-cost airlines. Part of the solution, Southwest says, is to pursue the higher-paying corporate passenger.

As a result, longtime customers may notice Southwest becoming more like every other airline, even as it strives to keep its distinctive flavor.

On Wednesday in New York, Southwest chief executive officer Gary Kelly told Wall Street analysts that the Love Field-based airline will have to do things in the future that it hasn't done in the past as it tries to dig out of a rut in its profits and stock price.

Those things could include international flying, first through partnering with other airlines, and then by itself. They could very well involve some form of assigned seating.

Southwest also is looking at selling products online and onboard, including a test of wireless services on some flights in 2008.

"For 36 years, we relied on a very conservative, focused and tried-and-true strategy of carrying passengers point to point, from A to B. There's been a beauty in that simplicity, as our history and the results attest," Mr. Kelly said in a speech to investment analysts in New York City.

"But necessity is the mother of invention, and this decade has presented us with the imperative to make some adjustments and to overcome record-high energy prices and more low-cost, low-fare competition."

At the start of this decade, Southwest was "not well prepared as a company to deviate from that very focused model," he acknowledged. "Since 9/11, though, we have been very busy transforming our capabilities."

Longer flights

As Southwest passengers have noticed, change has already begun. The plastic boarding passes, long a symbol of Southwest's simplicity and frugality, went by the wayside several years ago.

That change allowed Southwest to use airport kiosks and its Web site to let customers check in and get paper boarding passes. It lessened the load on ticket and gate agents, even as it helped the airline meet new security requirements to track customers and their bags.

Southwest had eschewed exchanging passengers with other airlines, fearing that it would slow its highly efficient airport operations. But it began code-sharing with ATA Airlines Inc. as part of a 2004 deal that gave Southwest an expanded presence at Chicago's Midway Airport.

Southwest made its reputation as a short-haul carrier focusing on overpriced markets, starting with flights June 18, 1971, between Dallas, Houston and San Antonio. Its first major expansion came when it duplicated its Texas service in California cities and in Phoenix in 1982.

But as Southwest expanded through the country, those average hauls got longer, as did the average trip by passengers.

In 1993, the average Southwest passenger flew 509 miles; by last year, the average trip had increased to 808 miles. In 1993, the average Southwest flight went 376 miles; in 2006, it flew 622 miles.

Southwest has pointedly not participated in most industry reservation systems. But in an effort to appeal more to corporate travel departments, Southwest last month announced it would begin selling its flights through the Galileo reservation system.

"The decade has been one of very dramatic change for our industry," Mr. Kelly said, "and seven years into it, Southwest is a very different airline than where we were in 2000."

At the core of Southwest's philosophy has been steady growth, and it rarely reins back that growth. But in an uncharacteristic move, Mr. Kelly announced Wednesday that the carrier will reduce its growth in capacity -- available seats per mile -- to 6 percent in the fourth quarter and for 2008, compared with the 8 percent it had planned.

That means it will need only 19 of the 34 new Boeing 737-700 airplanes it had scheduled to receive in 2008.

Southwest, which usually has had to beat the bushes to find enough airplanes, will have to adjust to getting rid of airplanes -- by selling or leasing surplus jets, possibly its less-efficient Boeing 737-300 airplanes.

"After being surprised coming into the year by slowing demand in the first quarter, we're now more wary and cautious about the rest of this year and next year," Mr. Kelly said.

In the fourth quarter, Southwest plans to drop flights on some routes, ending nonstop service between Philadelphia and Los Angeles, for example. That capacity will be moved to other routes that have a better chance of making money, Mr. Kelly said.

"The resulting schedule we think will be more profitable," Mr. Kelly said.

But even with only 6 percent growth in 2008, Southwest will still be one of the fast-growing major airlines, particularly on domestic routes.

In light of recent complaints from some analysts, investors and competitors that Southwest has been growing too aggressively, Mr. Kelly defended taking the 19 airplanes in 2008.

"And if things improve, we can always pursue options to accelerate our growth," he said. "Our long-term plan remains to grow the fleet every year."

In all, Southwest has set a target of increasing its revenues by $1 billion annually with the new initiatives by 2010, Mr. Kelly said.

Rather than leisure travelers, he said, the airline's market research says "road warriors" -- frequent business travelers -- offer the best chance of bringing in new revenue.

"Any way you look at it, from every segment, we have a tremendous brand ranking," Mr. Kelly said. "Our conclusion, though, was that the greatest upside capability for us lies with the business customer, as long as we continue to offer low fares, a reliable, convenient schedule, with the best customer service."

To target business travelers, Southwest intends to improve its Rapid Rewards frequent flier program, with minor changes now and more drastic ones later. It is also improving its "revenue management," the pricing of fares to get the most money, and launching a new advertising campaign aimed at road warriors.

Southwest, which tested a variety of boarding methods in San Diego last year, including assigned seating, will change its boarding and seating process by the end of the year, Mr. Kelly said. It will announce its decision on assigned seating then, he said.

In airline industry parlance, Southwest has been known as a low-cost carrier, or LCC, while older competitors such as United Airlines and Delta Air Lines were called legacy carriers.

The legacy carriers were launched before the industry was deregulated in the 1980s. They carried built-in costs such as high union salaries and hefty pension plans, which Southwest never had.

But those differences are disappearing. Many of the legacy carriers have jettisoned their pensions in bankruptcy court and extracted salary reductions from employees.

In a recent interview, aviation consultant and journalist Scott Hamilton said Southwest needed to change the way it operated because of mounting problems that made it more like the old-line carriers.

"They are what I call the first legacy LCC," Mr. Hamilton said. "With the term legacy comes all the implications that I intend."

Southwest's labor costs now are "the highest in the industry," Mr. Hamilton said. "Something like 45 percent of their expenses are labor now. They make up for it by being efficient in other ways, but nonetheless, it's still the highest in the industry now."

In addition, other low-cost carriers, such as JetBlue Airways and AirTran Airways, are "nipping at its heels from below, like Southwest used to nip at the heels of the legacies," Mr. Hamilton said.

Southwest has also had the advantage of fuel hedging that kept its net fuel costs far lower than its competitors, but that advantage is disappearing over time as fuel prices remain high and Southwest's older hedges mature, Mr. Hamilton said.

"Southwest has for years added capacity to take advantage of the weakness of the LCCs, but it's caused the profits to stagnate," Mr. Hamilton said. "The analysts certainly know full well that the profits have been generated by the fuel hedging. Therefore, you see them not buying into the stock."

Southwest shares, which rose 19 cents to $14.83 Wednesday in New York Stock Exchange trading, have risen steadily for much of their history.

But prices have been stuck in a $14-to-$18 range for several years, despite Southwest's repurchase of 83.5 million shares from early 2006 through March 31 as part of $1.8 billion in buybacks authorized by the Southwest board.

As Southwest adjusts, it is having to consider adding products, which can add complexity to its operations. But industry analyst and consultant Michael Boyd, in a May 29 comment, warned that "bare-bones product offerings" are not the trend among low-cost carriers.

"In fact, the most pressing challenge facing Southwest today is that they're competing with LCCs like JetBlue, AirTran, and Frontier (not to mention restructured comprehensive network carriers such as Delta) that are offering a higher value-to-cost product perception -- things like seat assignment, free snacks (nutritional value notwithstanding) and in-flight entertainment -- at the same fares," Mr. Boyd wrote.

To keep its revenue share in "some very key markets," Southwest "will need to at least add seat assignment to their product," Mr. Boyd said.

Such a move would attract the higher-paying business travelers who prefer to know in advance where they're sitting. But assigned seating could slow Southwest's traditionally quick boarding process.

Mr. Kelly, in his comments to analysts, said Southwest has been profitable for 34 straight years and had record profits last year.

"We have a very strong balance sheet, we have lots of liquidity, we have the best fuel hedge, low operating costs and very prudent growth estimates. But because of escalating costs, our profits are lagging and we intend to adjust and fix that," he said.

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