Forbes Is There Such a Thing as Nonstop Growth? Daniel Fisher, 07.08.02 Under a new chief executive, Southwest Airlines is facing its toughest challenge in a decade. The luck has never run out at Southwest Airlines. Recently it very nearly did. Just months after James Parker replaced the irreplaceable Herb Kelleher as chief executive last June, along came the Sept. 11 attacks. Southwest's planes were grounded for three days, while Parker, mindful of the company's no-layoff tradition, continued to pay 31,000 pilots, flight attendants, desk clerks and reservationists $5.2 million a day. This, while revenue was falling for the first time ever at the airline, down 2% to just under $5.6 billion for the year. Was Parker up to the job? That's what Kelleher--who, as chairman, still plays an active role--wanted to know soon after the attacks. "I told Herb I had put too much of my life into Southwest Airlines to walk away from a chance to try and move it ahead," recalls Parker, who joined the carrier in 1986, after seven years as a partner in Kelleher's former law firm. Parker is no Herb Kelleher; he'll tell you that himself. A University of Texas-trained lawyer who looks like he'd be more comfortable writing wills in a country town than running an airline, Parker is a stark contrast to the cigarette-smoking, Wild Turkey-swilling Kelleher. But the new chief is no pushover. He has been Southwest's lead labor negotiator for years, and his opponents say he pursues the company line forcefully, if politely, in talks. "He will surprise you because he doesn't look like he's tough," says Steve McPhail, a pilot and former vice president of the Southwest pilots' union. "But he doesn't give anything away." Parker's immediate challenge is to contain operating costs. If he can't, expenses may outpace earnings as air travel slowly recovers. If he can, perhaps Southwest can resume its growth trajectory. Until disaster-scarred 2001, its revenue was zooming ahead at a compound annual rate of 15%--triple the industry's average--while earnings per share was increasing 27%. Southwest has long been the low-cost flier. It cuts out all the frills (like meals for passengers); it runs a streamlined point-to-point (rather than hub-and-spoke) network using a single model of aircraft; and its rah-rah employees--many getting rich off stock options--simply deliver more bang for the buck than their counterparts at other lines. Southwest's Internet ticketing saves it $50 million a year, or 1% of revenue. But Parker is facing some big challenges this year. Liability insurance for the airline's 364-plane fleet has soared to $100 million a year from $20 million. And Southwest's largely unionized workers have been agitating for raises to match the rich contracts negotiated at other carriers before Sept. 11. Southwest's 4,100 pilots want to renegotiate a ten-year contract, due to expire in 2004, this summer, to close a 35% pay gap over the next five years. A veteran Southwest pilot makes $142 an hour, or $135,000 a year. Profit sharing and stock options for the most tenured can add another $80,000, but Southwest's pilots still trail 737 jockeys at Delta, United and American. With Southwest's stock down 27% from its high of $23 in January 2001, pilots are unlikely to accept more options in lieu of cash. "We're not going to break the company, but we're not going to work for less than scale ever again," vows Jon Weaks, president of the Southwest Airlines Pilots' Association. Parker's opening offer was a 20% raise over three years, according to Weaks (Parker won't say). He might be able to keep it in that range, with US Airways threatening bankruptcy and United close to the brink. But then he has to deal with the machinists and flight attendants, who will probably follow the pilots' lead. Add it all up and labor expenses at Southwest, which traditionally have run about 3 cents per available seat mile, might be headed closer to the 4.2 cents at Delta or 5.1 cents at United. Stow the hanky. Parker still has some powerful advantages over rivals, even if he has to pay his employees a bit more in coming years. James Parker (no relation), an analyst at Raymond James & Associates in Atlanta, says a 20% pilots' raise will cost Southwest 5 cents a share by 2004. It can cover that if airfares and its load factor--industry jargon for the percentage of seats filled--return to pre-Sept. 11 levels. A recovery to a 70% load factor and revenue of 12.5 cents per passenger mile flown, half a cent below its peak in 2000, would boost earnings by 28 cents, analyst Parker says; Southwest is currently operating at 62.9% and 11.7 cents per passenger mile flown. Meantime Southwest continues to grow. From 3 cities in 1971 (all in Texas), the airline has expanded to 58, in cities as far-flung as Seattle, Providence and Fort Lauderdale. While no new cities will be added this year, Southwest will take delivery of 18 new Boeing 737 planes at about $30 million each--another 436 planes are on order through 2012--and fly those on nonstop routes between cities it already serves with connecting flights. It's a strategy Southwest's Parker calls "connecting the dots," and, like a lot of things there, other airlines can't execute it easily. Traditional carriers operate hub-and-spoke networks where 60% of passengers hop on connecting flights to get to their final destinations. Adding nonstops to such a network siphons off traffic from connecting flights and hurts the economic advantages of the hub. Southwest doesn't have that problem. About 80% of its passengers get off at each stop. So Southwest can overlay its Chicago-to-Las Vegas-to-Los Angeles route with a nonstop flight and the revenue is almost entirely incremental. "We think of it as a new market," says Parker. "Our share of the Chicago-L.A. market is so infinitesimally small that we are really appealing to a new group of passengers." Southwest will add more than 30 routes this year by connecting the dots, as Parker says, and exploiting the longer range of new Boeing 737-700 jets to fly a transcontinental route for the first time. (Passengers will have to figure out for themselves how to survive the five-hour flight on peanuts alone--another Southwest hallmark.) Next year it plans to start adding cities again, working from a backlog of 40 or so it has determined will respond to its combination of low fares and frequent flights. That's bad news for other carriers: When Southwest moves into a market, it tends to drive fares down. After initiating Baltimore to Providence flights in 1996, Boston area fares fell. Now passengers forgo Logan Airport, landing instead in Providence where tickets average $46, down from $104. Traditional carriers can still make money on passengers catching connecting flights to destinations Southwest doesn't serve, but they must cede lots of the local market to the low-cost competitor. In many cases Southwest doesn't even have to charge the lowest fares. By blitzing a route with up to 60 flights a day, the airline bets that passengers will rate convenience above cost. It can take the risk of flying half-empty planes in the afternoon if the 8 a.m. and 5 p.m. flights are full; after all, the pilots and flight attendants are still on the clock. "Southwest no longer has to be the price leader, which is rather ominous for the other airlines," says Michael Roach, an associate at Unisys R2A Transportation & Management Consulting. "Sooner or later they will replace the other carriers." Southwest could accelerate growth if US Airways throws its East Coast markets up for grabs. But don't look for Parker to deviate from Southwest's cautious strategy of adding just three cities a year, even if provoked by another carrier's demise. Southwest is a funny place. Few of the top executives have worked for another airline, and they blissfully ignore strategies like complex fare structures that are commonplace elsewhere. Much of the industry, in fact, has tried to imitate Southwest, down to its 737 jetliners, but can't seem to get it right. Parker thinks he knows why. "There are a lot of people who have said they are going to duplicate what Southwest does, but it's always Southwest with 'improvements,'" Parker says, smiling malevolently at the word "improvements." He adds, almost unnecessarily, "And the improvements haven't proven to be successful." Charts Wal-Mart of the Sky http://www.forbes.com/forbes/2002/0708/082chart.html