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Southwest Airlines: Soaring To New Heights?

On May 3 the Hospitality and Travel Industry Club hosted its final speaker of the year at HBS, Gary Kelly, CEO of Southwest Airlines. Kelly was the last in a special series of airline speakers over the year, following in the tailwind of the Presidents of JetBlue, Eos and Delta Song, the Founders of Maxjet and EasyJet and the Chairman of British Airways. Gary Kelly has spent 20 years at Southwest Airlines, becoming CEO two years ago.

The subject of 13 HBS case studies, Southwest is probably the most successful airline of all time. It began on a cocktail napkin more than 30 years ago and it has been profitable every year since 1974. Herb Kelleher and Rollin King created what would become the “Texas Triangle,” a route structure connecting Dallas, Houston, and San Antonio. The new service created the low fare category in the airline industry. Today, more than 70 million passengers travel annually on Southwest – making it the largest domestic air carrier in the U.S.

Mr. Kelly began by highlighting the difference of Southwest’s strategy. “We offer a no-frills product at a great price with high customer service.” Southwest typically enters a market with fares that are two-thirds lower than competitors and they increase traffic three or four fold in these markets. Southwest is in the interesting position of setting the prices for a large section of the industry, as it is the price leader and other airlines are normally forced to match them. The airline is built around serving non-stop point to point traffic, which Kelly believes gives it a productivity advantage over other airlines that must attract connecting traffic to fill their planes.

Southwest is also different, on distribution. It does not use internet travel agencies such as Expedia because it wants to own the customer relationship. “Once a third party sells your product and owns the relationship, you cannot ever leave them.” However, he noted that Southwest has to invest more in advertising of the website as a result to pull people to the site. He is pleased that 70% of bookings are now made on-line.

However, on loyalty rewards, Southwest is forced to toe the line. Kelly sees loyalty programs as “a cost of doing business – to be in the game you have to have it.” Southwest’s loyalty program is 20 years old and is actually profitable for Southwest, with the credit card alone generating $50M of fees. He is comfortable giving away 7% of their seats for free, so long as that number does not rise.

Looking to the future, Kelly says that Southwest may struggle to maintain profitability. “Other airlines are cutting their costs and prices to our levels, but they also provide amenities.” He said the airline was thinking about whether it would have to add amenities to be able to compete. Fuel prices are also a big concern for Southwest. If it was not for fuel hedging, Southwest would have recorded losses over the last two years. However, these hedges are now running out and Southwest will struggle to record profits this year if oil prices remain high.

Southwest’s future growth strategy has two main thrusts.
First, as the industry shrinks Kelly hopes to add more frequencies to existing markets. The legacy carriers are increasingly redeploying aircraft to international markets, opening up capacity in the domestic market. Secondly, he believes there are another 20 cities which are great opportunities for Southwest to serve. Southwest has 300 airplanes on order between now and 2014 (or with options to buy) and he thinks these can be deployed in these new markets as well as existing markets. “At some point we will exhaust 737 opportunities, but then we could put up with a new aircraft type.” He could eventually add a smaller aircraft type, like JetBlue’s Embraer 190, to grow the number of smaller markets that the airline can serve. However, he is holding out from that strategy because it grows revenues proportionately less.

On competition, he does not see JetBlue as a direct threat because the two airlines do not compete in the same markets and have different products. He believes that AirTran and JetBlue only have similar overall costs to Southwest because of their lower wages. “These lower wages are not sustainable in the long-term. As any airline grows older, it has to pay more.”

Kelly is not worried about new entrant Skybus, based in Columbus, Ohio that is promising “ultra-low fares” – lower than Southwest. Skybus is adopting the Ryanair business model and launching early next year. Passengers will fly to secondary airports and be charged for food. There will be no jet bridges, all bookings will be online and all check-in will be self-service. Kelly thinks Skybus would not choose to take on Southwest directly and “.if they did we wouldn’t give up any of our passengers to them or hesitate in matching their fares.” He thinks markets like Columbus or Milwaukee are “slim traffic markets anyway,” so is not at all concerned.

Mr. Kelly was warmly received by the 150 students attending the event. After the speech, there was a large prize draw, with prizes ranging from two free airline tickets, baseball caps and golf balls to coasters, fishing hooks and flip-flops! The author wishes to thank Southwest for their generosity.

May 8, 2006
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