Southwest Airlines’ CEO faces future of higher costs

David Koenig

Wednesday, Aug. 4, 2004 | 9:23 a.m.

DALLAS -- Over the past two years, Gary Kelly made a series of bets that the price of jet fuel would rise, a hunch that has saved Southwest Airlines millions -- possibly the difference between a profit and loss in some quarters.

That was one of Kelly's biggest achievements as Southwest's chief financial officer. Now he will try using that same cost-cutting prowess as the airline's new chief executive.

Kelly, in an interview with the Associated Press, said air fares aren't going to rise, so carriers will have to learn to live with lower costs. Even for Southwest, the leader of low-cost airlines, there is room for cost-cutting, he said.

Kelly, 49, was named last month to replace James F. Parker, 57, who unexpectedly announced his retirement after only three years as CEO.

In his first days on the job, Kelly chatted with Wall Street analysts and reached out to Southwest's labor leaders. He said his top priority will be keeping employees happy -- even as he works to keep costs, including salaries, under control -- and hopes that will lead to better customer service, higher ticket sales and grateful shareholders.

As the airline's longtime financial wizard -- he was named chief financial officer in 1989, at age 34 -- Kelly is eager to dispel any notion that he might be unfamiliar with the operations side of the business. He said that as CFO, he spent more time on operations and customer-service initiatives than purely financial ones.

"You can't just talk about cost and not understand how the operation works," Kelly said.

Southwest's cost per mile is much lower than older airlines -- about 20 percent below Fort Worth-based American Airlines, the largest U.S. carrier -- but rose in the first six months of this year while everyone else was cutting costs.

Controlling costs is unavoidable, Kelly said, because customers have spoken: They won't pay higher fares. He said Southwest will cut costs by increasing efficiency.

Southwest is using technology such as the Internet and airport kiosks to replace ticket agents and call center operators. It is also tinkering with changes in purchasing and payroll practices to shave a few more dollars.

Beyond that, Kelly indicated that future pay raises for employees will be more modest than recent deals, such as a tentative contract that would give flight attendants an average 31 percent raise over its 6-year term. The attendants' deal, with raises retroactive to 2002, was a factor in Southwest's second-quarter earnings falling short of Wall Street expectations.

"We've had some wage rate inflation over the last year or so that has been higher than normal," Kelly said. "We're pushing the boundary of what we can afford with our wages."

Kelly said he won't personally be involved in the negotiations over future contracts. That's in contrast to Parker, who personally handled all of Southwest's labor contracts for a decade until this spring, when he stepped away from the increasingly bitter talks with the flight attendants. Kelly said the airline has other people who are more talented at that sort of work.

Southwest has been the only carrier to remain profitable since 2001, making it a favorite on Wall Street. However, the shuffle in upper management did make investors uneasy; Southwest's stock has fallen about 5 percent since Kelly succeeded Parker.

"I don't know him, but I know he has been responsible for the fuel hedging that helped us remain profitable," said Thom McDaniel, president of Transport Workers Union local 556, which represents Southwest's 7,400 flight attendants and fought with Parker.

Airlines consume huge amounts of fuel every day. Fuel is the second biggest expense for U.S. carriers, behind only labor costs.

To smooth out volatile prices, airlines sometimes buy options that let them purchase fuel far in the future at set prices. The practice, called hedging, is an insurance policy against sharp price increases. Kelly has hedged aggressively in recent years.

For this year and next year, Southwest has hedged for 80 percent of its fuel needs at prices equivalent to $24 or $25-a-barrel oil. Oil has been trading at more than $44 during the past week -- more bad news for the nation's airlines.

Kelleher indicated late last month that Kelly had been in line to succeed Parker all along, and that only the timing of Parker's exit was a surprise.

Kelly said nobody told him he would become CEO until three days before his promotion was announced, when he got a call from Kelleher. Kelly said he only knew he was a candidate to follow Parker, 57, who was widely viewed as a transition figure when he replaced Kelleher as CEO in 2001.

Kelly admitted to anxiety before taking the job, "but I made up my mind this was something I wanted to do. But I was happy as chief financial officer, if that's what Herb and the board wanted me to do."