CEO: Secrets of Southwest's Success

July 23, 2008 — -- Last Friday, I sat down for a special one-on-one interview with Southwest Airlines CEO Gary Kelly, and I thought I'd share some of it with you -- words of wisdom, pride and frustration from the man behind the country's only major domestic airline that's making any money.

Southwest has come a long way from its start-up days, when the "little airline that could" was luring business travelers with $26 fares and a free bottle of Chivas Regal.

Kelly told me, with justifiable pride: "We have money in the bank, have very little debt and, after 37 years, we still have the lowest cost structure."

But the lanky Texan isn't blind to what's going on in the industry; he expects to have to raise prices.

Kelly insisted, however, that Southwest's fares will always be a bargain and he'll never change the carrier's DNA.

"We're not trying to be a premium airline with china and onboard meals in first class," Kelly said. "That's just not who we are and not what our customers want from us."

Just don't call Southwest "cheap."

"Our customers don't have low expectations," Kelly said with just a touch of exasperation. "They have the right expectations."

Besides, he said, what with all the other carriers dropping their so-called frills left and right, the flying experience for most of us these days is pretty similar no matter what airline we fly (or, as Kelly put it, "coach is coach").

But there's still something of a mystique to Southwest's determinedly cheerful and unabashedly frugal functionality -- its fans are passionate and they come from all walks of life.

Just this past Sunday on "Meet the Press," after Tom Brokaw gently teased Al Gore about all those carbon foot-prints (wing-prints?) left behind from Gore's private jet flights, the former vice president proudly stated: "I'm flying on Southwest Airlines again today."

So what is the future of Southwest and, indeed, what is the entire airline industry going to look like? According to Kelly, it's going to look a lot like … Southwest. The strong (and the lean and the efficient) will survive: "It's not such a dire scenario, but you are going to need more 'Southwest-like' carriers out there and … it may be that all the inefficient carriers and all the high-cost structures get purged from the U.S."

That wouldn't surprise a lot of people; after all, betting on the next airline's demise has become the water cooler talk of the financial community. One thing for sure, it won't be Southwest. According to Fitch Ratings, the airline "has ensured its position as the 'last airline standing' in any far-reaching industry shakeout linked to a prolonged and extreme fuel shock scenario."

And that's because much of Southwest's "magic" is based on fuel hedging. But wait a minute. Why is Southwest the only one with the foresight to do that? Why were the other airlines caught with their pants down when it came to hedging? Why didn't they do it?

Well, they did, Kelly said, and airline execs who say otherwise are being "disingenuous."

"They've all hedged, they've all hedged," he said. "We had two of the bankrupt airlines that had equal hedging positions this decade to ours, and they decided to liquidate them."

OK, so they hedged but, obviously, didn't do it long enough.

So how did Southwest come to hedging? Easy, Kelly said; he and another executive followed proper risk management fundamentals -- partly, it seems, because they didn't know any better.

"The CFO and I were both new to the airline industry [in 1986] and we weren't hampered by, 'Well, this is how you do it.'"

They started hedging during the first Gulf War in 1991 and, after a brief hiatus in the late-90s ("Gosh, I think jet fuel got down to 29 cents a gallon"), they resumed hedging and never looked back. Southwest has been 80 percent hedged every year of this decade.

Meanwhile, the drumbeat for a return to regulation of the airline industry is sounding louder and louder. Kelly hears it and doesn't pay much attention to it because he's more concerned with other issues. Like airports -- what Kelly called "monuments" that communities lust after and the airlines get stuck paying for -- and the need to improve the nation's air traffic control system.

He also said the Transportation Security Administration is flawed (charging airline passengers "for what is a national security issue").

To Kelly, it's simply a matter of first things first: "You can regulate all you want but until you address those fundamental issues, what are you going to do, raise fares to the point that nobody's going to fly?"

Which brings us to the matter of loyalty programs. With reduced flight capacity, higher fares and more fees, loyalty programs are changing, too, Kelly said. And when it comes to a lot of airlines, it's getting harder and harder to use your loyalty awards to get a seat. Kelly voiced what everyone else is thinking. "It just begs the question," he said, "what good is the loyalty program for the industry?"

But back to those rising airfares. Yes, Kelly said Southwest will continue to offer fares that are lower than other airlines, but they will rise -- and people will accept a certain amount of increases.

"As a business traveler 15 years ago, I wouldn't think of paying over $100 for a room night, and now -- $300 to $400? The point being that people do adjust."

Right now, what could the airline industry do to improve? If you expect Kelly to say, "be more like Southwest," you'd be right. But he's mostly thinking in terms of one specific area, and that's customer service.

"I just think most airlines treat their customers very shoddily," he said.

That doesn't happen at Southwest, he said, because -- in his words -- the airline hires good people, treats them well and they, in turn, treat Southwest customers well.

But Kelly said that the key to overall customer satisfaction is really, really simple and it won't cost airlines a penny.

"Most customers are 'satisfied' when you tell them the truth," he said. "They want to know what's going on. I think most people understand weather and mechanical delays; they understand that safety is the top priority. So it's when you don't provide any information or the information is untruthful, that's what creates the greatest 'routine anxiety'."

The current economic aviation woes? Kelly said we will get through this, stating emphatically that "there's going to be an airline business" when it all shakes out.

But it may not look much like the old one. In fact, it may bear a slight resemblance to a nearly 40-year Texas carrier that once gave away free booze.