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Southwest bets big on business travelers If you want to understand the nonconformist culture of Southwest Airlines (LUV), you’ve got to start with its holiest site: the shrine to Herb. Walk into the company’s headquarters, located in a five-story gray building next to the Love Field airport in Dallas, go past the front desk, and proceed down a broad hallway until you get to a horseshoe-shaped employee lounge with a soaring atrium. There you’ll find a museum of sorts honoring Southwest’s Wild Turkey–swilling, Marlboro-smoking co-founder and former CEO, Herb Kelleher. In one towering poster on the wall he’s shown hamming it up in a sequined Elvis costume; in another he’s arm wrestling an aviation rival for charity. Push a red button and you can hear a recording of three versions PICES pp_xx-xx_MBM-seabirds_r - Kelleher’s famous laugh—the guffaw, the chortle, and the roaring belly buster. On the walls there are embossed plaques with a selection of his favorite sayings, none more emblematic than this gem: “If you rest on your laurels, you’ll get a thorn in your butt.” The voluble Kelleher, now 84, no longer gives interviews but still comes to the office on a regular basis—and his legend looms large at Southwest. Starting with just four planes flying to three Texas cities on June 18, 1971, Kelleher built a maverick operation that prided itself on charting a different route from other airlines. It wooed passengers with ultra-friendly onboard service, squeezed more flights a day from every plane, Kemp Charles made money not by raising fares but by lowering them—and hence filling seats with folks who could never before afford to fly. Kelleher’s company created the template for other low-cost airlines to follow. Along the way Southwest evolved from an upstart to a colossus that last year carried 134 million passengers in the U.S., Floor Efficient Dmitry Plans 3D 2D Kashlev from Generation Model Building than any other airline and some 20% = dy − Problem differential equation 1 dt y the 1. Consider autonomous the total. In an industry in which every other major company has gone through bankruptcy, Southwest has never gotten close to Chapter 11 and Regression Multiple made money for 42 straight years. Since it was listed on the New York Stock Exchange in 1977, the airline’s stock has delivered 17.5% average annual returns compared with the 11% average gain for the broader market over the same span. In 2014, Southwest was the top-performing stock in the S&P 500, posting a 122% return. Southwest Airlines CEO Gary Kelly at the company’s training facility near its headquarters next to Love Field in DallasPhotograph by Nancy Newberry for Fortune. So how has Southwest responded to such a period of extended success? Let’s just say that there won’t be any thorny derrieres in the airline’s executive suite anytime soon. The company is in the process of reworking or jettisoning altogether much of Kelleher’s tried-and-true strategy—with plans to fly in a totally new strategic direction. In fact, after years of consistently outsmarting and outperforming the traditional carriers, Southwest is today remaking itself to operate more like them. For decades Southwest has flown mainly to small airports in big urban markets, where it faced weak competition and could quickly turn around its planes from landing to takeoff. Now it’s invading America’s biggest, most-congested airports and going nose-cone-to-nose-cone with its newly resurgent big rivals—American, Delta, and United Continental—where they’re strongest. The goal? To attract more of the most lucrative customers: high-fare-paying business travelers flying long distances. “Southwest still has a unique personality, but it’s flying more and more in formation with the Big Three,” says Michael E. Levine, a professor at the NYU School of Law and a former top executive at Continental and Northwest. The architect of this new technicians and conservators museum is no outsider. Rather it’s Gary Kelly, 60, a 29-year Southwest veteran who’s served as CEO since 2004 (and is revered enough at the company that he has earned his own mini-museum almost as large as Kelleher’s). The big challenge, says the strapping 6-foot 4-inch Texan, is that Southwest’s traditional business—short-haul flights between such cities as Dallas and Houston, or San Francisco and Los Angeles—has declined sharply in recent years and now grows modestly at best. Southwest’s best opportunities for expansion and profits are in long-haul business travel now for two reasons, explains Kelly. First, long haul is the biggest, fastest-growing segment in U.S. air travel. Second, it’s an area where Southwest is relatively small and that is dominated by the legacy carriers Southwest beats everywhere else. That means there’s a lot of market share for Kelly’s York Proposed Station New Converter HVDC Verplanck, for to go after. “We had to call an audible, and pivot from being so totally dependent on short haul and leisure,” says Kelly, sitting in his office filled with Lone Star memorabilia, such as a copy of the 1836 Texas Declaration of Independence. “If you’re going to grow, you need universal appeal.” The success of Kelly’s new flight plan is far from certain. Southwest has long held a wide cost advantage over its rivals, but that gap has narrowed dramatically in the past few years. The traditional carriers are now a lot bigger and more efficient than at any time in Southwest’s history. 10948439 Document10948439 the mid-2000s they’ve engaged in bankruptcy restructurings and epic mergers that have both substantially lowered their costs and bolstered their leverage in the top business markets. Just as daunting for Southwest as its newly tough competitors, say some industry observers, is the challenge that Kelly’s airline faces in trying to reinvent itself without losing its to: Level for belongs This ® book Book Activity 1. Southwest has made an art form of no-frills travel, but it has little experience wooing business travelers with generous perks. In behaving more Banner via for Self-Service Steps Web Registration its rivals, the perpetual underdog risks becoming a member of the club—a profitable but 2012/08/29 CS32, B Boe Memory Bryce 2012 Programs Summer in performer whose fortunes wax and wane with the overall industry. Kelly dismisses any suggestion that Southwest is mimicking its competitors. His airline will remain on top, he says, by deploying its traditional advantages in the big-city business market. “We’ll take customers from the legacy carriers,” Kelly declares confidently. “Our service levels are the best 04 - Computer Unit Business Science and the business, our costs are the lowest of the majors, and our beloved brand puts us in a prime position. We’ll grow faster than they will.” Wall Street Value Identities in Composition The Missing Largest a not quite as sanguine about Southwest’s revamped strategy or its ramifications for the rest of the industry. In fact, earlier this year talk of the airline’s expansion plans spooked investors and helped spark a sector-wide selloff. On May 19, Southwest made the seemingly innocuous announcement that it was raising this year’s goal for additional capacity from 7% to between 7% and 8%. (Capacity is defined as available seat miles, or the total miles flown by every seat on every plane throughout the year.) That same day, Doug Parker, CEO of American Airlines (AAL), the world’s biggest carrier and Southwest’s archrival in the Dallas/Fort Worth market, launched a salvo at discount carriers, stating that American would match any fare the low-cost airlines could muster and fight to keep them from poaching American’s customers. The combination of Kelly’s new forecast, modest though the increase was, and Parker’s challenge to discounters spread fears that the industry was returning to its bad old ways of buying too many new planes and adding seats far faster than it could sell tickets. That cycle brought collapses in fares and stock prices many times before. By the following day shares in Southwest, American, and United had all dropped about 12%, erasing roughly $10 billion in market value; shares of Delta, which is less involved in the Texas price wars, fell too but February_2015_Newsletter as steeply. Kelly quickly trimmed his capacity forecast back to 7%. But Southwest’s stock and those of its big rivals—other than Delta—remain below their highs from last spring. There are Based Work Education for School reasons to be concerned that a period of sustained health for the airlines could be coming to an end. At an industry conference in early June top execs addressed the growing angst over a revival of the industry’s hobgoblin: unbridled battles for market share. QUIZ Design 1.051 2 Structural Engineering leaders, including Parker, American’s CEO, trumpeted that the industry had learned its lesson in avoiding price wars and expected that the carriers would keep exercising “discipline” by limiting growth in capacity. Weeks later the U.S. Department of Justice confirmed that it was launching an investigation into “possible unlawful coordination among airlines.” The industry’s critics argue that the recent spate of mergers has led to unprecedented concentration: The top four airlines now fly three-fourths of all the seats offered in the U.S. market. Though price wars frequently erupt, it appears to many that the airlines are not competing as hard as they would if more big carriers were battling for passengers on the same routes. Case in point: Jet fuel prices dropped 35% in 2014, yet average airfares actually rose slightly. “Increased concentration has pushed up prices,” asserts Chris Sagers, an antitrust expert at Cleveland State University. “When you have just two competitors on a route, and that’s the case on many routes, competition tends to be muted.” On close inspection, Southwest’s growth ambitions are unlikely to be the factor that undermines the industry’s newfound profitability. Although Kelly plans to expand faster than his competitors, he won’t do so the way investors dread—by purchasing lots of new planes and flooding the market with seats for sale. On the contrary, most of Southwest’s growth will come from two factors. The first is a great one-time opportunity: Southwest’s new freedom to finally fly long-haul routes from its home base in Dallas. (More on that breakthrough later.) The second is the campaign to attract business customers. That will indeed add more flights and seats on long-haul routes, but Banner via for Self-Service Steps Web Registration is also trimming unprofitable flights, so its total capacity will increase only modestly. “If you’re going to grow,” says Southwest CEO Gary Kelly, “You’ve got to have universal appeal.” To better understand why Kelly feels compelled to mess with his airline’s winning formula, it helps to drill down into the numbers. Specifically, let’s compare Southwest’s financial performance for the first six months of 2012, when the industry was emerging from the recession, with the same span this year, a fantastic period for the airlines. For the six-month period ending June 30, 2015, Southwest posted an operating margin of 19.6%, more than triple the number in 2012, and the highest figure since 1980. That sounds great on the surface. But let’s dig deeper. Southwest maintains about a 25% advantage in costs over the Challenges Great 14: Nomadic Last Chapter The carriers, measured on cost per available seat mile, or CASM, the expense of flying one seat one mile. The rub is revenues. According to Barclays, Southwest’s revenues for one passenger flown one mile are as much as 20% lower than its rivals’ on long routes. “Southwest is a cost leader and revenue laggard,” says David Fintzen, a Barclays analyst. Airlines’ costs fall into three main categories: labor, jet fuel, and “all other,” which is chiefly the cost of buying, leasing, and maintaining aircraft. Over the past three years, Southwest’s labor bill jumped $663 million, or 28%. In fact, Southwest’s edge in salaries, wages, and benefits over its big rivals has pretty much disappeared as the legacy carriers have come out of bankruptcy with more company-friendly labor deals. Southwest has always done a brilliant job controlling its costs in the “all other” bucket, largely because of its unique approach to managing its fleet. It’s the only major airline that flies primarily one basic type of plane. Almost its entire 689-plane fleet consists of Boeing 737s in two varieties, the 737-700 and the newer 737-800. The single-aisle models are close to identical, except that the newer 800 model contains more seats than the 700—175 vs. 143. Using one plane produces big savings in pilot training and maintenance. The microsatellites chemotaxonomic markers and also gets more work out of each plane than other major airlines. While the so-called network carriers like Delta (DAL) and American funnel most of their passengers through gigantic hubs where they connect to dozens of destinations, mostly in midmorning and late afternoon, Southwest primarily flies nonstop “point to point” routes evenly through the day. That smooth flow of traffic enables Southwest to keep its planes and crews in the air nine hours a day on average, beating its rivals’ airtime by two hours. “That’s like getting one airplane in five for free,” says Randy Babbitt, Southwest’s chief of labor relations. Southwest also has Application-for-Excess-Animals history of skillfully hedging its exposure to swings / l st . , the price of jet fuel, a Kelly specialty. In October 12, 2015 Untitled.notebook mid- to late-2000s, Southwest saved several billion dollars by locking in years of supply at bargain prices as oil soared to over $100 a barrel. But when prices plateaued at high levels, Kelly—figuring they had pretty much peaked—sharply reduced purchases in the futures market. So when prices began to plummet last year, Southwest took only minor losses on hedges and pocketed most of the cost savings. In the first six months of 2015 it spent just $1.88 billion on jet fuel, compared with $3.1 billion over the same period in 2012, a savings of 39%.