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It Must Be the Peanuts

Why is Southwest, alone among U.S. airlines, healthy and thinking about growth again?
A CFO Interview, CFO Magazine
December 1, 2001

Southwest Airlines has always flown solo among its competitors. But since the September 11 terrorist attacks, it has been absolutely flying circles around them. While the rest of the U.S. airline industry was axing thousands of workers and threatening bankruptcies, the low-cost leader kept all its flights aloft, and laid off no one. It even added a new destination--Norfolk, Virginia- -several weeks after the tragedies, and posted a third-quarter profit.

For CFO Gary Kelly, there was never a question about Southwest's course. With more than $1.5 billion in cash and the industry's lowest debt-to- capital ratio, drastic changes were not called for, he says. While the Dallas-based airline did delay the receipt of 11 Boeing jetliners, Kelly points out that none of the 436 on order have been canceled. In addition, while Southwest--now grown into the nation's fourth-largest airline in passengers flown, with a market capitalization that tops the combined equity valuations of its six main rivals--initially froze head count, it is now actually looking to hire 400 new flight attendants.

Where the 45-year-old Kelly did stand shoulder-to-shoulder with his CFO peers was in the industry's remarkable petition for federal aid. Together, the CFOs drafted documents that company top executives, including Southwest chairman Herb Kelleher, used to request a $24 billion industry bailout. What was finally approved amounted to $15 billion--$5 billion in cash and the rest in loan guarantees.

Going forward, Kelly sees Southwest poised to take advantage of any shakeout that hits the industry. After what he calls a "temporary crisis," Southwest's "long-term opportunities are as good as ever," he says, thanks to its low-cost model and conservative financial philosophy. And, to capitalize on those opportunities, Southwest intends to continue the light and breezy style that has won it fans since its start as a Texas-only carrier in the 1970s, when it introduced its "peanuts fares."

Recently, Kelly sat down with CFO deputy editor Lori Calabro to discuss Southwest's reaction to the travel crisis that began on September 11, and the company's priorities for the future. "Our country is grappling with terrorism, but so far we haven't seen anything that is going to shut down our business," he says. In fact, Southwest's operating strength, and the resiliency of traffic, suggest the opposite. "We've recovered quite nicely," says Kelly. "Now we just need to make some profits."

Third-quarter results show Southwest remains the most profitable U.S. airline, but there's a big difference between this year and last. How can you separate the negative impact of the poor economy in general from the industry damage the attacks caused?
We had two full months under our belts before the attacks occurred. And since last January, we'd seen a steady decline in revenue production, right up through the date of the attacks. Our earnings were on track to be down close to 20 percent from 2000. The attacks probably cost us a good 9 or 10 cents a share. That was offset, of course, by our federal grant. If you exclude those proceeds, and special charges related directly to the attacks, we earned 10 cents a share. In fact, it was still the second-best third quarter on record. So we were profitable, just not nearly as much as we would have been.

What trends have you been seeing lately for air travel in the United States?
We have satisfied ourselves that there is demand for air travel. The first full week after the attacks, we had a 38 percent load factor, which is very bad. The second week was 52 percent. But every week in October, we have had load factors of more than 60 percent. Those are very satisfactory levels, historically. We've just had to discount heavily to achieve them.

Where were you when you heard about the September 11 attacks?
I walked into the office a few minutes before 8 a.m. [central time] and heard that an airplane had crashed into the World Trade Center. We turned on the TV. It took a couple seconds to understand that this was an attack. At that point, I went down to our president's office and we convened our emergency plan and immediately undertook the effort to get all of our aircraft on the ground. We have a fleet of 358 airplanes, and at one point there were 150 in the air. It was 10:05 before we got all the planes on the ground and accounted for. That's when a cheer went up.

What was the primary question you faced as a finance professional that day?
Do we have cash? Most of our cash is invested in commercial paper, and if we wanted to access fungible cash at that point, there was nowhere to buy commercial paper. All the markets were shut down. Luckily, we have several hundred million dollars in the bank, so there was no immediate problem. But it was an exercise of figuring out what bills we owe immediately, what refunds we're likely to have to fund extraordinarily, how long we'll shut down, and when we will be selling tickets again.

You did tap your $475 million revolver, though.
We had never, ever drawn it before. We didn't know how to do it. It took 15 minutes to figure it out. Then we wondered, will the banks fund it? Fortunately, we were able to check that objective off the list very quickly. Our cash was stable. We paid our bills on a current basis, and we offered a very generous refund policy.


There must have been some unknowns about making those refunds.
We have about $500 million of tickets purchased in advance of travel at any given time. The immediate thought was, are we going to have to refund $500 million in the next week? It wasn't anything close to that. It was probably $40 million to $50 million, compared with probably $5 million normally-- still a substantially higher volume, but not nearly as much as I was concerned that it might be.

When was the decision made to continue to fly your full schedule and forgo layoffs?
Early on, we had an emergency meeting with our officer group, and a directive went out to suspend all nonessential capital spending, to freeze head count, and to cut any nonessential operating expenses. We had needed to hire several hundred flight attendants and pilots, and we suspended that temporarily, not knowing yet whether we would cut the schedule. But we just didn't feel a layoff was the right thing to do. We didn't know what was going to happen next, but we are a strong company with a strong balance sheet. We've never had a layoff, and it just didn't seem appropriate as the first consideration here.

Were you surprised that you were the only airline to make such a decision?
I wasn't surprised in this respect: This is a very difficult industry to operate in. We've got energy risk, labor risk, economic cycles. It's a capital- intensive business, a fixed-cost business, and it just doesn't argue for being aggressive financially. And almost 100 percent of the other airlines are very heavily leveraged, with very high cost structures and less liquidity. They don't have access to the capital markets, and they're just in a much more desperate situation than we are.

What was Southwest's involvement in the industry's call for government aid?
We were very heavily involved. I worked with a CFO group to prepare a report for the CEOs of what the industry's economics would look like for the next 3 to 12 months. One of the issues for our industry is that it is very heavily taxed. We pay in excess of a 10 percent excise tax right off the top to the federal government, and most of it goes to the aviation trust fund [which provides user-fee funding for airport capital improvements] . In addition, because we are so capital intensive, we have an enormous property tax burden, and, of course, we are all subject to income taxes. The industry lobbied very heavily for tax relief in some form, and some immediate access to cash. That is how the grant evolved.

Who was involved in the CFO group?
It was through the Air Transport Association, essentially all the major airlines and some of the smaller airlines. All of the CFOs were involved in a conference call. There were several different efforts. The first effort, which was led by American Airlines CFO Tom Horton, was to simply say, these are the cash deficiencies we are facing over the next 12 months. Second, there was an effort led by Northwest's Mickey Foret to define what the industry's needs were with respect to the loan guarantee. The CFOs drafted a document for the CEOs to debate, so they could ultimately agree on what to recommend to Washington. What we didn't want was to change the competitive balance. The CFOs agreed unanimously on this. Ultimately, the industry worked very well together. It was an extraordinary thing to watch. You'll recall the CEOs made presentations during at least one congressional hearing. Those were based on those recommendations.

Southwest received $144 million after tax from the federal grant as part of the bailout. Is that your total payment?
We are estimating we will get somewhere around $288 million, with the balance payable for the fourth quarter. That is less than one year's worth of federal excise payments. Our losses, though, will far exceed the $288 million, from what we would have made before the attack to what we will ultimately realize. We are not whole, but it obviously helps to stabilize our finances.

Critics say the bailout is only going to postpone the inevitable reorganization of the industry. Do you agree with that?
Not from the perspective that it is a form of tax relief, at a time when it's obvious that we need it. I agree that the market forces should take their course, and it's obvious that the industry is in financial peril. In addition to the grants, there is a loan-guarantee program, and it remains to be seen how that will be deployed.

Are you going to tap into that?
We are going to apply, but it's unclear whether we can take advantage of it. A number of requirements may be applied, and it's all subject to negotiation with the federal government. For example, while it's not required that the government receive warrants in return, that's one suggestion to compensate it for the credit risks being taken. But mid-October we priced $600 million of enhanced equipment trust certificates; it's a three-tranche financing, and the overall effective interest rate is about 5.5 percent. So with that vehicle available to us, it wouldn't make sense to consider different financing that would involve warrants.

What has this environment done to your operating growth plans?
We had planned to grow next year about 8 percent, and it's going to be more like 2 percent. Our fleet growth hasn't changed through 2012. We had 436 airplanes on order or option through 2012 before the attack, and we still do. And over that period our average annual growth was projected to be about 8 percent. I still see us in that same mode. We just need a little bit of time to stabilize.


What does this do to your ability to budget and forecast?
Every year I've been at Southwest has been a construction year, a growth year, a healthy year. And that really gets all our employees charged up. To change that mindset is hard. To go from adding Norfolk next month to figuring out if we can pay our bills next week is tough. I was really proud of how quickly we came to grips with that, though. There was no whining--just determination to see that we met immediate short-term objectives. Our vice president of financial planning has now proposed that we go ahead and resurrect our 2002 planning on an expedited basis. We've worked out with Boeing a delivery schedule for the latter part of next year, so we know when we're going to get additional airplanes. We do have some uncertainties with security costs, but we can put a baseline in there. That way we can get people reenergized to find ways to improve their operations and cost efficiency.

Those are internal targets. Some of your main stakeholders, on Wall Street, are going to be asking what's on tap for next quarter.
And rightfully so. We try to be as honest and open as we can. We admitted early on that we didn't have a plan. We admitted that if things picked up quicker, we could pick up airplanes faster. And that's consistent with our history. If opportunities come up, we may very well take advantage of them. That's really what our message is to Wall Street. We are still a growth company. We serve 58 airports, far less than other airlines our size. So there are a lot of new places we can fly, and no doubt will over the next 10 years. We're real confident about our future; it's just that we're all worried about the immediate economic uncertainty. When the economy is in recession, our business is, too. Fortunately for Southwest, in the past we haven't suffered to the extent that we have actually lost money--not since 1972, our start-up year. And we won't lose money in 2001 unless something extraordinary happens between now and year-end, and with a little luck we won't be close to losing money next year.

How does this compare to your "worst-case" scenario?
I guarantee that the plan we're presenting is much more pessimistic than our "best-guess" plan. There's no reason to take a chance with it; interest rates are low and it just doesn't cost that much money to carry excess cash, which is what we are doing. But is it the worst possible scenario? If we were planning for that, we'd tell Boeing we never want another airplane.

So you see competitive opportunity in the post-2001 airline industry?
We're maintaining our level of operations, and that's very different from our competitors, who are reducing schedules, laying off employees, and reducing flights in our markets. Our market fare is two-thirds lower than our competitors', so it's understandable that they would be considering reductions in our markets. That has happened before many times. We've always felt like we need to be successful on our own merits, and not because of the failures of our competitors. But the fact of the matter is, they're shrinking and we're not.

One of your other competitive strengths has been your debt-to- capital ratio. It stood at 33.3 percent in 2000, while your closest competitors had close to a 60 percent ratio.
It's a reflection of my philosophy. And I am a protégé of Herb Kelleher, who is an outstanding financial manager. As flamboyant as he is from a marketing perspective, he's very conservative from a financial perspective. We want to grow, but growth is the risky part of the equation. That's where you need more capital to buy more airplanes. And more capital begs the question of whether it is debt or internally generated resources. Do we want to issue more equity? What you see on the balance sheet reflects decisions made over the past 30 years. The decision to grow has always been based on whether or not we could afford it. And if you look back over those 30 years, those decisions were right.

Last year you were something of a hero after recording gains of $113 million from hedging your energy purchases 100 percent. Now the price of crude oil is below what you hedged it at. So there's obviously risk the other way.
We had hedging gains in the third quarter again on the order of $23 million, and at this point we have substantial gains in place for the fourth quarter as well. Our projection is that our fuel costs will be down significantly from last year, but we are about 80 percent hedged for the fourth quarter, so we have really good protection if prices spike. Most of our positions have been converted to options if prices fall, so we'll get the benefit of falling prices, too. Next year is a little tricky. If the economy is weak, demand will be soft and therefore prices will be soft. We're 50 percent hedged through 2002. So if prices spike back up, we'll have that protection.

What's the most important lesson you've learned from these past few months?
It takes one's whole life of experiences to be prepared for something like this. It was stressful. But we survived it, and I think we're well prepared to carry on.




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