Baba Bluey

A cloud or 2 for Southwest
Airline on way to 33 straight years of profit, but higher fuel costs and new labor contracts loom

By Mark Skertic
Tribune staff reporter
Published November 6, 2005


DALLAS -- Founded in the early 1970s with a business plan for low-cost service sketched on the back of a cocktail napkin, Southwest Airlines these days is eating its competitors' lunches.

The no-frills airline is the country's most successful, the only carrier adding flights and moving into new markets, all the while posting the biggest profit in the business. Along the way Southwest's market value has soared to nearly $13 billion. To put that in perspective, the market value of all other major U.S. carriers together is slightly more than $8 billion.

But clouds loom on the horizon for the Dallas-based carrier.

Next year the first of its union contracts will expire, and its labor costs already are higher than nearly all competitors, most of which have used bankruptcy, or the threat of bankruptcy, to cut wages and benefits. Southwest does not intend to press for concessions, but it also can't afford to be at a cost disadvantage to rival airlines.

"We can't be way out of bounds with what our competitors are paying, because we'll end up a high-cost carrier," Chief Executive Gary Kelly said in a recent interview. "And we can't let that happen."

What's more, Southwest won't be able to shield itself from rising fuel prices as it has in the past. It expects fuel to cost at least a half-billion dollars more next year.

Then there's the issue of amenities. AirTran Airways, a discounter based in Florida, has first-class seating and XM satellite radio. JetBlue Airways and others have added television or personal entertainment systems at each seat.

Southwest passengers do not even get seat assignments: It's first-come, first-serve boarding.

And as mainline airlines cut fares to keep Southwest at bay, some competitors are able to draw on other strengths. As one analyst put it: "Southwest's frequent-flier program can get you to Lubbock. With United's, you can get to London."

But there are no signs that Southwest will dramatically change.

"Our strategy is to be the low-cost producer," Kelly said. "To put lots of flights into the markets that we serve, to have the best people and, therefore, the best customer service, and focus intensely on execution. High on-time performance. Get the bags there. Cancel the fewest number of flights."

Southwest remains known as a scrappy competitor, a highflying David that enters markets and fells aviation Goliaths with low prices and good service. But that underdog reputation is misleading.

In January Southwest is expected to report that 2005 delivered its 33rd straight year of profitability. In 2004, Southwest earned $312 million, while nearly all U.S. carriers lost money, and many are forecasting that trend will continue in 2006. Kelly said he hopes to see Southwest's profit rise 15 percent next year in spite of predicted increases in fuel costs.

Dreamliner version sought

Fuel continues to be an issue. With its strategy of keeping costs as low as possible, Kelly recently told Boeing Co. that his airline wants a smaller 737 version of Boeing's 787 Dreamliner, expected to be among the most fuel-efficient commercial aircraft available.

Southwest has the clout that comes with being the largest customer of Chicago-based Boeing. Southwest boasts a fleet of more than 400 737s and has ordered new ones through 2008.

A new generation of 737s incorporating Dreamliner technology is years away, but Kelly said it is technology his airline needs.

"We're looking for everything we can to keep our finances healthy and not just ride on the backs of our customers with higher fares," he said. "So, clearly, a more fuel-efficient aircraft would be very desirable."

Although fuel prices have fallen in recent weeks, they remain about 70 percent higher than a year ago. Using an array of financial derivatives, Southwest has about 70 percent of its fuel needs hedged at $36 a barrel. Crude oil prices hovered around $60 a barrel on the New York Mercantile Exchange last week.

Southwest has used hedging since 1990 to control fuel costs, a strategy Kelly likens to insurance coverage. Other airlines stopped and sold off hedges when fuel prices dropped several years ago, but Southwest opted to stick with it, a decision now worth hundreds of millions of dollars annually

Despite such efforts, however, the portion of fuel that isn't hedged will push Southwest's fuel spending to record levels next year. Costs will be $500 million to $600 million higher next year, Southwest said.

"If we're going to overcome record high energy prices, we're going to have to be innovative, we're going to have to be aggressive," Kelly said. "We're going to have to think outside the box, we're going to have to execute well."

Not all aggressive moves have been successful, and in some circles they have resulted in Southwest being tagged a bully.

In Seattle, for instance, Southwest proposed moving from Seattle-Tacoma International Airport to Boeing Field, a smaller airport closer to downtown Seattle that has no commercial service. By leaving Seattle-Tacoma, Southwest could reduce its operating costs significantly.

But Southwest's plan was rejected in the wake of vociferous opposition. Detractors argued Southwest would prompt an exodus from the larger airport, as other carriers sought lower costs at Boeing Field. Worse, opponents argued, Southwest would be reneging on promises to pay for improvements at Seattle-Tacoma.

Opponents "forgot that we were the ones offering to take the financial risk to open a new airport," Kelly said.

Caught up in Love

Southwest also finds itself hamstrung at Dallas' Love Field, home of its corporate headquarters. The cause in this case is the Wright Amendment. Named for its sponsor, former House Speaker and Texan Jim Wright, it restricts direct commercial flights to and from Love to Texas and six other southern states. On the books since 1979, its purpose was to ensure the growth of nearby Dallas-Ft. Worth International Airport.

But for Southwest, the Wright Amendment prevents the airline from offering an array of destinations from Love, including direct flights from Dallas to Chicago's Midway Airport as well as Las Vegas, Phoenix and many other popular destinations. Freed of the Wright Amendment, Southwest would draw passengers away from Dallas-Ft. Worth because Love sits much closer to the downtown business community.

Southwest's opposition to the law, and the support of rival American Airlines to keep it in place, are evident throughout Dallas, where billboards proclaiming "Wright is Right" or "Set Love Free" dot the landscape.

American, the dominant airline at Dallas-Ft. Worth, argues that lifting the law would have consequences rippling beyond Texas. American and others would be forced to shift operations to Love to remain competitive, and smaller markets likely would lose service as airlines redeploy operations.

Southwest could move some operations to Dallas-Ft. Worth, freeing itself of Wright Amendment restrictions about where it can fly, but the airline has been reluctant to do so.

In Seattle and Texas, said Will Ris, American's senior vice president for government affairs, Southwest has asked for "a change in rules that will benefit one airline, the biggest domestic airline in the United States, the airline with so much money it could buy the entire industry and still have cash left over." .

Higher wage scales

Southwest is known for being low cost, but that does not translate into low pay for its employees. United, American, Delta, Northwest and other airlines have extracted wage concessions from their workers, pushing labor rates down. In contrast, Southwest, whose wages once trailed most in the industry, is among the most generous.

For example, a Southwest captain with 10 years experience makes $186 an hour. An American Airlines captain flying the same aircraft makes $156 an hour, while a United captain is paid $126 an hour, according to the Airline Pilot Central, a Web site that tracks pay and benefits industrywide.

Southwest's "salary costs are remarkably high, but better work rules and efficiencies keep overhead costs in line," according to an analysis by Roger King of CreditSights. As contracts expire, the lower wage rates driven by United's and US Airways' bankruptcies "should keep a lid on contract increases," King found.

Southwest can afford its pay levels because productivity is high, Kelly said. The pilots union contract is up next year, and five other unions contracts expire in 2008. Nearly all major carriers have asked employees for wage concessions in recent years, but Kelly said he believes Southwest can avoid that.

"In the days when they were much higher than our wage rates, we said that's ridiculous to pay that kind of money when we can't afford that," he said. "Likewise, when they're bankrupt, and the rates come crashing down, I don't think we should penalize our people just because [competitors] can't afford their pay rates and are having to use these draconian measures, including bankruptcy, to reorganize.

"Still, we have to be the low-cost producer. That's a mandate here for Southwest Airlines. We get that by being more productive. Our view is to look at unit labor cost, which, clearly, pay rates are a component of.

"We're showing really good revenue growth, and we're trying to gradually build our momentum to overcome that kind of a hurdle because we're not going to cut $500 or $600 million [the additional cost for fuel next year] out of a cost structure," Kelly said.

"There's just not that much fat in Southwest Airlines, not unless I want to go ask our employees to take a 25 percent pay cut. And I think they've earned better than that."