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Southwest's leader in catbird seat

With his airline protected from soaring fuel prices that are straining US rivals Gary Kelly targets expansion

Jul 06, 2008

Amid the airline industry's stomach-churning plunge, Gary Kelly, chief executive of Southwest Airlines Co., already is plotting course for the next upswing in air travel.

While United and American Airlines park planes, retreat from cities and lay off employees, Southwest is flying high. Seeking to capitalize on his competitors' weakness, Kelly is buying dozens of jets to accommodate higher passenger loads and planning the budget carrier's first overseas expansion.

Chicago is Southwest's second-largest base but could become its biggest operations center as Kelly steers the Dallas-based carrier into Canada, Mexico, Hawaii and the Caribbean, and eventually Europe and Asia, via marketing alliances. The foray would be Southwest's first outside the U.S. in its 37-year history.

Kelly, 53, has an enormous advantage over his peers: about $2 billion that Southwest will gain this year from complex financial hedges he put in place to offset rising fuel costs. As oil prices hit the stratosphere, Southwest's bounty continues to grow, while airlines without similar hedges buckle under the financial strain.

The pressure is on Kelly not to blow it. And the responsibility is his alone now that Herb Kelleher, the chain-smoking iconoclast who molded Southwest over nearly four decades, retired as chairman of its board in May.

"He's got to evolve the airline much more rapidly than Herb ever had to because of the changing market, changing costs and changing fuel prices," said Capt. Carl Kuwitzky, head of Southwest's pilots union.

Kelly, a lanky Texan, is measured and deliberate, while Kelleher is outspoken and impulsive, say people who know the two men. But he shares Kelleher's ability to connect with employees and to make the most of a competitive edge.

Among longtime colleagues, Kelly is known for his practical jokes and guitar mania, sometimes cranking out "Smoke on the Water" at company parties. He participates in Southwest's elaborate Halloween festivities, the annual pinnacle of a freewheeling culture that makes its employees the most productive in the industry. Kelly's get-up last year: Edna Turnblad, the John Travolta character in the movie "Hairspray," complete with shaved legs and women's shoes.

Kelly is also a fierce competitor. In his first months as CEO in 2004, Kelly engineered a deal to take over troubled ATA Airlines' gates at Midway Airport, establishing Southwest's dominance there. He later launched an assault on Denver International Airport, a hub for United and Frontier Airlines.

As American, United and other carriers pare flight schedules because of rising fuel costs and a slowing economy, Kelly's team is looking for openings to strategically grab market share. One day after United said it planned to stop flying to Ft. Lauderdale in late June, Southwest added five daily flights to the Florida vacation spot.

"They're the nightmare of every airline out there," said travel expert Tom Parsons.

Kelly expects to expand Southwest's hold on Midway as the nation's two largest airlines pull back at O'Hare. American plans to trim its flights at the congested airport by 13 percent this fall; United is expected to make a similar cut as it grounds about 20 percent of its fleet over the next 18 months.

"Midway will be impacted dramatically by what happens at O'Hare," Kelly predicted. "If you see a downsizing at O'Hare, which I expect, then we will probably have an opportunity to grow Midway."

He has no intention of establishing a presence at the larger airport as other carriers retreat, but he won't rule out that possibility.

Winning 'war of attrition'

Kelly sees the steps by competitors to reduce fleets by 10 percent to 15 percent as a futile exercise that will fail to give them pricing power to offset soaring fuel bills.

"It's not radical enough," he said.

He's part of the reason. Southwest's low fares, subsidized by its fuel hedges, make it difficult for rivals to boost prices, analysts said.

"That $2 billion allows [Southwest] to keep fares lower than they otherwise would," said Vaughn Cordle, CEO and chief analyst of AirlineForecasts LLC, a Virginia-based market research firm. "That's a strategic decision that forces other airlines to match fares and lose significant amounts of money, or retreat. So Southwest wins the war of attrition."

The strategy isn't winning Kelly any new friends among his peers. A senior executive at a major airline, who asked not to be named, described Southwest as a "significant destructive force in the industry."

If other carriers falter, Southwest will scout cautiously for acquisitions. Kelly said he is open to a wholesale purchase of another airline, although he thinks the probability of it happening is low.

"Would we be open to buying a handful of airplanes from a competitor, along with some gates? Well, yes. I think that's much less risk, much more appropriate to think about," he said.

For the first time in its history, Southwest is preparing to venture outside the U.S., to Canada, via a marketing alliance that will be announced this summer, Kelly said. Analysts peg WestJet, a Canadian carrier modeled after Southwest, as the likeliest partner.

Southwest spokeswoman Brandy King would say only, "We're talking to several carriers about several code-sharing opportunities."

Next up: Mexico, Caribbean and Hawaii, not necessarily in that order, through code-sharing pacts to be rolled out next year and possibly into 2010. After that, Kelly will look for alliances that take Southwest passengers to Europe and Asia. Southwest also will explore its own shorter-haul international flights.

Chicago figures high in Kelly's expansion plans. He said Midway will serve as a gateway for Southwest's Canadian partner, which will funnel a host of new flights into the city and Southwest's network.

"It's a hub-like effect, without us having all the trappings and inefficiencies of a hub-spoke system," Kelly said. "So you could have many more destinations being added to Midway by one or two code-share partners."

Risks of success

Kelly is trying to alter a business model that Southwest has operated to near perfection, turning an annual profit every year since its third year in business, without destroying it. The discounter once known for its zany promotions is now the largest domestic carrier, looking for ways to boost sales and to connect with customers disillusioned with other airlines.

Kelly joined the company in 1986 and was named chief financial officer three years later, at age 34. He convinced the carrier's board to begin buying fuel hedges on the eve of the first Persian Gulf War in 1991, then to adopt costlier but more comprehensive hedges as oil prices plunged at that decade's end.

As Southwest reaps the benefit of hedges worth $5 billion, Kelly must take care not to stretch resources, erode profits or spawn a bureaucracy that kills innovation or stifles Southwest's quirky, customer-driven culture, analysts said.

"The risk for Southwest is the same as it has always been for any airline that started small: overreaching," said Aaron Gellman, a professor at Northwestern University's Transportation Center.

While some gripe that Southwest's market-share gains haven't translated into a higher return for shareholders, Kelly refuses to budge from a strategy emphasizing long-term goals over stock gains.

"It just won't happen quickly," he said. "We don't make apologies for that."

Southwest's stock is up 7 percent this year, while the Dow Jones airline industry index has fallen 46.5 percent. But despite Southwest's rapid growth this decade, its shares still trade about $10 below their January 2001 peak.

Kelly is planning for the day when Southwest's fuel advantage will disappear, either over time or if oil prices drop as rapidly as they have risen. Eventually, the rest of the industry will recover. Those that survive the tumult likely will be lean and hungry and threatening to Southwest.

But with hedges in place through 2011, Southwest has years to hone its strategy. Other U.S. airlines don't have that luxury.

"We bought the time, and the others have not," Kelly said. "They're just going to have to move much more rapidly, and it creates a significant amount of risk for them."

With his airline protected from soaring fuel prices that are straining US rivals Gary Kelly targets expansion

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