South-West Airline Essay

Southwest Airlines 2005 You are now free to move about the country. ™ In 2005, Southwest Airlines (Southwest), the once-scrappy underdog in the U. S. airline industry, carried more domestic passengers than any other U. S. airline. The company, unlike all of its major competitors, had been consistently profitable for decades and had weathered recessions, energy crises, and the September 11 terrorist attacks. In recent years, Southwest had become more aggressive with its growth.

The company entered the Philadelphia market in 2004 and planned to enter Pittsburgh in 2005, two markets that had long been dominated by the financially strapped US Airways. Southwest planned to increase its capacity about 10% in 2005, adding 29 planes to its fleet of 417. In December 2004, Southwest announced a code-sharing arrangement with ATA Airlines, a tactic Southwest had avoided in the past. Along with the expansion plans, Southwest was making internal moves to strengthen accountability and communication between departments and pushing its employees to become even more productive.

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In the fourth quarter 2004, excluding fuel costs, Southwest’s operating costs declined 4. 5% on a per-unit basis. An insight into Southwest’s management philosophy can be found in the company’s 2001 annual report: Southwest was well poised, financially, to withstand the potentially devastating hammer blow of September 11. Why? Because for several decades our leadership philosophy has been: we manage in good times so that our Company and our People can be job secure and prosper through bad times. Once again, after September 11, our philosophy of managing in good times so as to do well in bad times proved a marvelous prophylactic for our Employees and our Shareholders. The U. S. Airline Industry The U. S. commercial airline industry was permanently altered in October 1978 when President Carter signed the Airline Deregulation Act. Before deregulation, the Civil Aeronautics Board regulated airline route entry and exit, passenger fares, mergers and acquisitions, and airline rates of return. Typically, two or three carriers provided service in a given market, although there were routes covered by only one carrier.

Cost increases were passed along to customers, and price competition was almost nonexistent. The airlines operated as if there were only two market segments: those who could afford to fly and those who couldn’t. Deregulation sent airline fares tumbling and allowed many new firms to enter the market. The financial impact on both established and new airlines was enormous. The fuel crisis of 1979 and the air traffic controllers’ strike in 1981 contributed to the industry’s difficulties, as did the severe recession that hit the U.

S. during the early 1980s. During the first decade of deregulation, more than 150 carriers, many of them start-up airlines, collapsed into bankruptcy. Eight of the 11 major airlines dominating the industry in 1978 ended up filing for bankruptcy, merging with other carriers, or simply disappearing from the radar screen. Collectively, the industry made enough money during this period to buy Copyright © 2005 Thunderbird, The Garvin School of International Management. All rights reserved.

This case was prepared by Professor Andrew C. Inkpen and Valerie DeGroot, with research assistance from Jairaj Mashru, Arturo Wagner, and Chee Wee Tan, for the purpose of classroom discussion only, and not to indicate either effective or ineffective management. two Boeing 747s1 (Exhibit 1). The three major carriers that survived intact—Delta, United, and American—ended up with 80% of all domestic U. S. air traffic and 67% of trans-Atlantic business. 2 Competition and lower fares led to greatly expanded demand for airline travel.

Controlling for inflation, the average price to fly one domestic mile has dropped by more than 50% since deregulation (10 cents in 1975 to almost 4 cents in 2003). By the mid-1990s, the airlines were having trouble meeting this demand. Travel increased from 200 million travelers in 1974 to 578 million in 2004, with increases in runway and airport capacity lagging far behind. Despite the financial problems experienced by many airlines started after deregulation, new firms continued to enter the market.

Between 1992 and 1995, 69 new airlines were certified by the FAA. Most of these airlines competed with limited route structures and lower fares than the major airlines. The new airlines created a second tier of service providers that saved consumers billions of dollars annually and provided service in markets abandoned or ignored by major carriers. Although deregulation fostered competition and the growth of new airlines, it also created a regional disparity in ticket prices and adversely affected service to small and remote communities.

Airline workers generally suffered, with inflation-adjusted average employee wages falling from $42,928 in 1978 to much lower levels over the subsequent decades. About 20,000 airline industry employees were laid off in the early 1980s, while productivity of the remaining employees rose 43% during the same period. In a variety of cases, bankruptcy filings were used to diminish the role of unions and reduce unionized wages. In 2005 airline workers at United, Delta, and other major airlines were being forced to accept pay cuts of up to 35%. Industry Economics About 80% of airline operating costs were fixed or semi-variable.

The only true variable costs were travel agency commissions, food costs, and ticketing fees. The operating costs of an airline flight depended primarily on the distance traveled, not the number of passengers on board. For example, the crew and ground staff sizes were determined by the type of aircraft, not the passenger load. Therefore, once an airline established its route structure, most of its operating costs were fixed. Because of this high fixed-cost structure, the airlines developed sophisticated software tools to maximize capacity utilization, known as load factor.

Load factor was calculated by dividing RPM (revenue passenger miles—the number of passengers carried multiplied by the distance flown) by ASM (available seat miles—the number of seats available for sale multiplied by the distance flown). On each flight by one of the major airlines (excluding Southwest and a few other carriers), there were typically a dozen categories of fares. The airlines analyzed historical travel patterns on individual routes to determine how many seats to sell at each fare level.

All of the major airlines used this type of analysis and flexible pricing practice, known as a “yield management” system. These systems enabled the airlines to manage their seat inventories and the prices paid for those seats. The objective was to sell more seats on each flight at higher yields (total passenger yield was passenger revenue from scheduled operations divided by scheduled RPMs). The higher the ticket price, the better the yield. Although reducing operating costs was a high priority for the airlines, the nature of the cost structure limited cost reduction opportunities.

Fuel costs (17% of total operating costs at Southwest in 2004) were largely beyond the control of the airlines, and many of the larger airlines’ restrictive union agreements limited labor flexibility. The airline industry’s extremely high fixed costs made it one of the worst net profit margin performers when measured against other industries. Airlines were far outpaced 1 P. S. Dempsey, “Transportation Deregulation: On a Collision Course,” Transportation Law Journal, 13, 1984, p. 329. 2 W. Goralski, “Deregulation Deja Vu,” Telephony, June 17, 1996, pp. 32-36. A07-05-0006 in profitability by industries such as banks, health care, automobile manufacturing, consumer products, and publishing. To manage their route structures, all of the major airlines (except Southwest) maintained their operations around a “hub-and-spoke” network. The spokes fed passengers from outlying points into a central airport—the hub—where passengers could travel to additional hubs or their final destination. For example, to fly from Phoenix to Boston on Northwest Airlines, a typical route would involve a flight from Phoenix to Northwest’s Detroit hub.

The passenger would then take a second flight from Detroit to Boston. Establishing a major hub in a city like Chicago or Atlanta required an investment of as much as $150 million for gate acquisition and terminal construction. Although hubs created inconveniences for travelers, hub systems were an efficient means of distributing services across a wide network. The major airlines were very protective of their so-called “fortress” hubs and used the hubs to control various local markets. For example, Northwest handled about 80% of Detroit’s passengers and occupied nearly the entire new Detroit terminal that opened in 2002.

And, Northwest’s deal with the local government assured that it would be the only airline that could have a hub in Detroit. When Southwest entered the Detroit market, the only available gates were already leased by Northwest. Northwest subleased gates to Southwest at rates 18 times higher than Northwest’s costs. Southwest eventually withdrew from Detroit, and then re-entered, one of only four markets Southwest had abandoned in its history (San Francisco, Denver, and Beaumont, Texas were the other three). Recent U. S. Airline Industry Performance

Despite steadily growing customer demand, the airline industry in 2005 was in crisis. In 2002 United Airlines filed for Chapter 11 bankruptcy protection, citing liquidity problems. US Airways, after emerging out of bankruptcy in March 2003, filed for bankruptcy protection in 2004. American Airlines, the world’s largest airline, was teetering on the brink of the same fate despite $1. 8 billion in deeply negotiated concessions from its three major labor unions. Delta, with combined losses of $8. 5 billion from 2001 to 2004, was close to bankruptcy.

ATA Airlines, the tenth largest carrier in the United States, filed for bankruptcy in 2004. Airline labor unions were reeling in the face of wage reductions, pension cutbacks, and job uncertainty. Exhibits 1, 2, and 3 provide comparative data for the major airlines. After the September 11, 2001, terrorist attacks, domestic airlines lost about $30 billion. The specter of terrorism cast a long shadow on the global airline industry, exacerbated by the ongoing war in Iraq and the 2003 SARS epidemic. In 2005 fuel costs were rapidly rising, putting a damper on the industry’s return to profitability.

For example, Delta paid an average of $1. 16 per gallon in 2004, up 42% from 2003. Interestingly, in early 2005 overseas demand for aircraft was pushing the costs of aircraft higher and eliminating the glut of used aircraft that arose after 2001. Other Pressures on the Industry In addition to the difficult profit environment for airlines in 2005, the industry was faced with several other issues: 1. Security. The airlines needed increased war risk insurance, and passenger security costs were expected to rise. 2. Customer dissatisfaction with airline service.

Service problems were leading some to call for new regulation of airline competitive practices. 3. Aircraft maintenance. The aging of the general aircraft population meant higher maintenance costs and eventual aircraft replacement. The introduction of stricter government regulations for older planes placed new burdens on operators of older aircraft. 4. Debt servicing. The airline industry’s debt load greatly exceeded U. S. industry averages. 5. Air-traffic delays. Increased air-traffic control delays caused by higher travel demand and related airport congestion were expected to negatively influence airlines’ profitability.

A07-05-0006 3 Southwest Airlines Background In 1966, Herb Kelleher was practicing law in San Antonio when a client named Rollin King proposed starting a short-haul airline similar to California-based Pacific Southwest Airlines. The airline would fly the Golden Triangle of Houston, Dallas, and San Antonio, and by staying within Texas, avoid federal regulations. Kelleher and King incorporated a company, raised initial capital, and filed for regulatory approval from the Texas Aeronautics Commission.

Unfortunately, the other Texas-based airlines, namely Braniff, Continental, and Trans Texas (later called Texas International), opposed the idea and waged a battle to prohibit Southwest from flying. Kelleher argued the company’s case before the Texas Supreme Court, which ruled in Southwest’s favor. The U. S. Supreme Court refused to hear an appeal filed by the other airlines. In late 1970, it looked as if the company could begin flying. Southwest began building a management team, and the purchase of three surplus Boeing 737s was negotiated.

Meanwhile, Braniff and Texas International continued their efforts to prevent Southwest from flying. The underwriters of Southwest’s initial public stock offering withdrew, and a restraining order against the company was obtained two days before its scheduled inaugural flight. Kelleher again argued his company’s case before the Texas Supreme Court, which ruled in Southwest’s favor a second time, lifting the restraining order. Southwest Airlines began flying the next day, June 18, 1971. 3 When Southwest began flying to three Texas cities, the firm had three aircraft and 25 employees.

Initial flights were out of Dallas’ older Love Field airport and Houston’s Hobby Airport, both of which were closer to downtown than the major international airports. Flamboyant from the beginning, original flights were staffed by flight attendants in hot pants. By 1996 the flight attendant uniform had evolved to khakis and polo shirts. The “Luv” theme was a staple of the airline from the outset and became the company’s ticker symbol on Wall Street. Southwest management quickly discovered that there were two types of travelers: convenience, time-oriented business travelers, and price-sensitive leisure travelers.

To cater to both groups, Southwest developed a two-tiered pricing structure. In 1972 Southwest was charging $20 to fly between Houston, Dallas, and San Antonio, undercutting the $28 fares of the other carriers. After an experiment with $10 fares, Southwest decided to sell seats on weekdays until 7:00 p. m. for $26 and after 7:00 p. m. and on weekends for $13. 4 In response, in January 1973, Braniff Airlines began charging $13 for its Dallas– Houston Hobby flights. This resulted in one of Southwest’s most famous ads, which had the caption, “Nobody’s going to shoot Southwest out of the sky for a lousy $13. Southwest offered travelers the opportunity to pay $13 or $26 and receive a free bottle of liquor. More than 75% of the passengers chose the $26 fare and Southwest became the largest distributor of Chivas Regal scotch whiskey in Texas. In 1975 Braniff abandoned the Dallas–Houston Hobby route. When Southwest entered the Cleveland market, the unrestricted one-way fare between Cleveland and Chicago was $310 on other carriers; Southwest’s fare was $59. 5 One of Southwest’s problems was convincing passengers that its low fares were not just introductory promotions but regular fares.

Southwest Operations Although Southwest became one of the largest airlines in the United States, the firm did not deviate from its initial focus: primarily short-haul (less than 500 miles), point-to-point flights, a fleet consisting only of Boeing 737s, high-frequency flights, low fares, and no international flights. In 2004 the average Southwest one-way fare was $88. 57. 3 K. Freiberg and J. Freiberg, Nuts: Southwest Airlines’ Crazy Recipe for Business and Personal Success, Austin, TX: Bard Press, 1996, pp. 14-21. 4 Ibid. , p. 31. 5 Ibid. , p. 55. 4 A07-05-0006

The average Southwest aircraft trip was 576 miles with an average duration of about one hour and 30 minutes. This was up from 462 in 1999 and 394 in 1996. Southwest had about 2,800 flights per day serving 59 cities. Each plane flew about eight flights daily, almost twice the industry average. Planes were used an average of 12 hours a day, compared with the industry’s 8. 6 hour per day average. Southwest’s cost per available seat mile was the lowest in the industry for the major carriers (Exhibit 3) and the average age of its fleet was nine years, the lowest for the major carriers.

Southwest also had the best safety record in the airline business. Southwest was the only large airline to operate without major hubs, although cities such as Phoenix, Houston, Dallas, and Las Vegas were increasingly becoming important transit points for Southwest trips. For example, daily departures from Phoenix, Southwest’s second busiest airport, increased to 191 in 2004. Point-to-point service provided maximum convenience for passengers who wanted to fly between two cities, but insufficient demand could make such nonstop flights economically unfeasible.

For that reason, the hub-and-spoke approach was generally assumed to generate cost savings for airlines through operational efficiencies. However, Southwest saw it another way: hub-and-spoke arrangements resulted in planes spending more time on the ground waiting for customers to arrive from connecting points. Turnaround time—the time it takes to unload a waiting plane and load it for the next flight—was about 15 minutes for Southwest, compared with the industry average of 45 minutes. This time savings was accomplished with a gate crew 50% smaller than other airlines. Pilots sometimes helped unload bags when schedules were tight.

Flight attendants regularly assisted in the cleanup of airplanes between flights. Relative to the other major airlines, Southwest had a “no frills” approach to services: no reserved seating or meals were offered. Seating was first come, first served. As to why the airline did not have assigned seating, Kelleher explained, “It used to be we only had about four people on the whole plane, so the idea of assigned seats just made people laugh. Now the reason is you can turn the airplanes quicker at the gate. And if you can turn an airplane quicker, you can have it fly more routes each day.

That generates more revenue, so you can offer lower fares. ”6 Unlike some of the major carriers, Southwest rarely offered delayed customers a hotel room or long distance telephone calls. Southwest did not use a computerized reservation system, preferring to have travel agents and customers book flights through its reservation center or vending machines in airports. Southwest was the first national carrier to sell seats from an Internet site and was the first airline to create a home page on the Internet. In 2004, 59% of Southwest tickets were booked online.

The company estimated that the online ticketing cost was $1 per booking and $6-8 with a travel agent. Southwest was also one of the first airlines to use ticketless travel, first offering the service in 1995. Southwest was the only airline with a frequent flyer program based on the number of flights taken by a passenger, not miles flown. Over the years, Southwest’s choice of markets resulted in significant growth in air travel at those locations. In Texas, traffic between the Rio Grande Valley (Harlingen) and the Golden Triangle grew from 123,000 to 325,000 within 11 months of Southwest entering the market. Within a year of Southwest’s arrival, the Oakland–Burbank route became the 25th largest passenger market, up from 179. The Chicago–Louisville market tripled in size 30 days after Southwest began flying that route. Southwest was the dominant carrier in a number of cities, ranking first in market share in more than 50% of the largest U. S. city-pair markets. Exhibit 4 shows a comparison of Southwest in 1971 and 2004. 6 7 Herb Kelleher, www. iflyswa. com/cgi-bin/imagemap/swagate 530. 85. Freiberg and Freiberg, p. 29. 5 A07-05-0006 Southwest’s Performance

Southwest bucked the airline industry trend by earning a profit in 32 consecutive years (see Exhibit 5 for Southwest’s financial performance). Even taking into account the losses in its first two years of operations, the company averaged more than 12% annual return on investment. At the end of 2003, Southwest’s 10-year average return to shareholders was 9. 36%. Since 1987, Southwest has ranked first in fewest overall customer complaints as published in the Department of Transportation’s Air Travel Consumer Report. Fortune recognized Southwest as the most admired airline in the world for 1997, 1998, 1999, 2000, 2001, 2002, and 2003.

Southwest accomplished its enviable record by challenging accepted norms and setting competitive thresholds for the other airlines to emulate. The company established numerous new industry standards. Southwest flew more passengers per employee than any other major airline, while at the same time had the fewest number of employees per aircraft. Southwest maintained a debt-to-equity ratio much lower than the industry average and was one of the few airlines in the world with an investment grade credit rating. Southwest had a fleet of 417 737s in 2005, up from 106 in 1990 and 75 in 1987.

Of the total fleet, 322 aircraft were owned and the remainder leased. Herb Kelleher Herb Kelleher was CEO of Southwest from 1981 to 2001. In 2001, at age 71, Kelleher stepped down as CEO but remained Chairman. Kelleher’s leadership style combined flamboyance, fun, and a fresh, unique perspective. Kelleher played Big Daddy-O in one of the company videos, appeared as Elvis Presley in in-flight magazine advertisements, and earned the nickname “High Priest of Ha-Ha” from Fortune. 8 Although Kelleher was unconventional and a maverick in his field, he led his company to consistently new standards for itself and for the industry.

Sincerely committed to his employees, Kelleher generated intense loyalty to himself and the company. His ability to remember employees’ names and to ask after their families was just one way he earned respect and trust. At one point, Kelleher froze his salary for five years in response to the pilots agreeing to do the same. Often when he flew, Kelleher would help the ground crew unload bags or help the flight crew serve drinks. His humor was legendary and served as an example for his employees to join in the fun of working for Southwest.

He was called “a visionary who leads by example—you have to work harder than anybody else to show them you are devoted to the business. ”9 Although Kelleher tried to downplay his personal significance to the company, especially when he gave up the CEO position in 2001, many analysts following Southwest credited the airline’s success to Kelleher’s unorthodox personality and engaging management style. As one analyst wrote, “The oldfashioned bond of loyalty between employees and company may have vanished elsewhere in corporate America, but it is stronger than ever at Southwest. 10 From October 1 to December 2001, Kelleher, CEO James Parker, and COO Colleen Barrett voluntarily relinquished their salaries. Gary Kelly, Southwest’s former CFO, replaced James Parker as CEO in 2004. The Southwest Spirit Customer service far beyond the norm in the airline industry was not unexpected at Southwest and had its own name—Positively Outrageous Service. Some examples of this service included: a gate agent volunteering to watch a dog (a Chihuahua) for two weeks when an Acapulco-bound passenger showed up at the last minute without the required dog crate; an Austin passenger who missed a connection to 8 9

K. Labich, “Is Herb Kelleher America’s Best CEO? ” Fortune, May 2, 1994, p. 45. “24th Annual CEO Survey: Herb Kelleher, Flying His Own Course,” IW, November 20, 1995, p. 23. 10 Labich, p. 46. 6 A07-05-0006 Houston, where he was to have a kidney transplant operation, was flown there by a Southwest pilot in his private plane. Another passenger, an elderly woman flying to Phoenix for cancer treatment, began crying because she had no family or friends at her destination. The ticket agent invited her into her home and escorted her around Phoenix for two weeks. 1 Southwest Airlines customers were often surprised by Southwest Spirit. On some flights, magazine pictures of gourmet meals were offered for dinner on an evening flight. Flight attendants were encouraged to have fun; songs, jokes, and humorous flight announcements were common. One flight attendant had a habit of popping out of overhead luggage compartments as passengers attempted to stow their belongings, until the day she frightened an elderly passenger who called for oxygen. 12 Herb Kelleher once served in-flight snacks dressed as the Easter Bunny.

Intense company communication and camaraderie was highly valued and essential to maintaining the esprit de corps found throughout the firm. The Southwest Spirit, as exhibited by enthusiasm and extroverted personalities, was an important element in employee screening conducted by Southwest’s People Department. Employment at Southwest was highly desired. In 2004, 1,706 employees were hired and 225,895 applications were received. Once landed, a job was fairly secure. The airline had not laid off an employee since 1971. Historically, employee turnover hovered around 7%, the lowest rate in the industry. 3 In 2005, Southwest had more than 31,000 employees; in 1990, Southwest had 8,600 employees and less than 6,000 in 1987. During initial training periods, efforts were made to share and instill Southwest’s unique culture. New-employee orientation, known as the new-hire celebration, have in the past included Southwest’s version of the Wheel of Fortune game show, scavenger hunts, and company videos including the “Southwest Airlines Shuffle,” in which each department introduced itself, rap style, and in which Kelleher appeared as Big Daddy-O. To join the People Department (i. e. Human Resources), employees required frontline customer experience. Advanced employee training regularly occurred at the University of People at Love Field in Dallas. Various classes were offered, including team building, leadership, and cultural diversity. Newly promoted supervisors and managers attended a three-day class called “Leading with Integrity. ” Each department also had its own training division, focusing on technical aspects of the work. “Walk-a-Mile Day” encouraged employees from different departments to experience firsthand the day-to-day activities of their co-workers.

The goal of this program was to promote respect for fellow workers while increasing awareness of the company. 14 Employee initiative was supported by management and encouraged at all levels. For example, pilots looked for ways to conserve fuel during flights, employees proposed designs for ice storage equipment that reduced time and costs, and baggage handlers learned to place luggage with the handles facing outward to reduce unloading time. Red hearts and “Luv” were central parts of the internal corporate culture, appearing throughout company literature.

A mentoring program for new hires was called CoHearts. “Heroes of the Heart Awards” were given annually to one behind-the-scenes group of workers, whose department name was painted on a specially designed plane for a year. Other awards honored an employee’s big mistake through the “Boner of the Year Award. ” When employees had a story about exceptional service to share, they were encouraged to fill out a “LUV Report. ” 11 12 IW, p. 23. B. O’Brian, “Flying on the Cheap,” Wall Street Journal, October 26, 1992, p. A1. 13 Training & Development, p. 39. 14 A.

Malloy, “Counting the Intangibles,” Computerworld, June 1996, pp. 32-33. A07-05-0006 7 Southwest placed great emphasis on maintaining cooperative labor relations: 81% of all employees were unionized. Southwest pilots belonged to an independent union and not the Airline Pilots Association, the union that represented more than 60,000 pilots. The company encouraged the unions and their negotiators to conduct employee surveys and to research their most important issues prior to each contract negotiation. Southwest had never had a serious labor dispute that grounded the airline.

At its 1994 contract discussion, the pilots proposed a 10-year contract with stock options in lieu of guaranteed pay increases over the first five years of the contract. In 1974 Southwest was the first airline to introduce employee profit sharing. Through the plan, employees owned about 10% of the company’s stock. Herb Kelleher summed up the Southwest culture and commitment to employees: We don’t use things like TQM. It’s just a lot of people taking pride in what they’re doing…. You have to recognize that people are still the most important. How you treat them determines how they treat people on the outside. . .

I give people the license to be themselves and motivate others in that way. We give people the opportunity to be a maverick. You don’t have to fit in a constraining mold at work— you can have a good time. People respond to that. 15 Southwest Imitators Southwest’s low-fare, short-haul strategy spawned numerous imitators. Many of the imitators were start-up airlines. The Allied Pilots Association (APA) claimed that approximately 97% of start-ups resulted in failures. According to the APA, only two of 34 start-up airlines formed between 1978 and 1992 were successful, with success defined as surviving ten years or longer without bankruptcy.

Two of the most successful start-up firms, Midwest Express and America West, both went through Chapter 11 bankruptcy proceedings. ValuJet was grounded after its May 1996 crash in the Florida Everglades, reemerging a year later as AirTran. The major airlines tried to compete directly with Southwest. The Shuttle by United, a so-called “airline within an airline,” was started in October 1994. United’s objective was to create a new airline owned by United with many of the same operational elements as Southwest: a fleet of 737s, low fares, short-haul flights, and less-restrictive union rules.

Although offering basically a no-frills service, the Shuttle provided assigned seating and offered access to airline computer reservation systems. United predicted that the Shuttle could eventually account for as much as 20% of total United U. S. operations. United saturated the West Coast corridor with short-haul flights on routes such as Oakland– Seattle, San Francisco–San Diego, and Sacramento–San Diego. Almost immediately, Southwest lost 10% of its California traffic. Southwest responded by adding six aircraft and 62 daily flights in California.

In April 1995, United eliminated its Oakland–Ontario route and proposed a $10 fare increase on other flights. By January 1996, United had pulled the Shuttle off routes that did not feed passengers to its San Francisco and Los Angeles hubs. In early 1995, United and Southwest competed directly on 13% of Southwest’s routes. By 1996, that number was down to 7%, and down to 5% by 1998. Cost was the major problem for United in competing with Southwest. For four main reasons the Shuttle’s cost per seat-mile remained higher than Southwest’s.

First, many passengers booked their tickets through travel agents, which resulted in commission fees. Second, many of the Shuttle’s flights were in the San Francisco and Los Angeles markets, both of which were heavily congested and subject to costly delays. Third, the Shuttle offered reserved seating. Fourth, the Shuttle was unable to achieve the same level of productivity as Southwest. After September 11, United discontinued the Shuttle service and folded the remaining flights into its regular service. US Airways did the same with its Metrojet discount service. In 2003 United started a new discount carrier called TED. 5 H. Lancaster, “Herb Kelleher Has One Main Strategy: Treat Employees Well,” Wall Street Journal, August 31, 1999, p. B1. A07-05-0006 8 Some of the attempts to imitate Southwest were almost comical. Continental Lite (CALite) was an effort by Continental Airlines to develop a low-cost service and revive the company’s fortunes after coming out of bankruptcy in April 1993. CALite began service in October 1993 on 50 routes, primarily in the southeast. Frequency of flights was a key part of the new strategy. Greenville/Spartanburg got 17 flights a day, and in Orlando daily departures more than doubled.

CALite fares were modeled after those of Southwest, and meals were eliminated on flights less than 2. 5 hours. In March 1994, Continental increased CALite service to 875 daily flights. Continental soon encountered major operational problems with its new strategy. 16 With its fleet of 16 different planes, mechanical delays disrupted turnaround times. Various pricing strategies were unsuccessful. The company was ranked last among the major carriers for on-time service, and complaints soared by 40%. In January 1995, Continental announced that it would reduce its capacity by 10% and eliminate 4,000 jobs.

By mid-1995, Continental’s CALite service had been largely discontinued. In October 1995, Continental’s CEO was ousted. JetBlue Airways Morris Air, patterned after Southwest, was the only airline Southwest had acquired. Prior to the acquisition, Morris Air flew Boeing 737s on point-to-point routes, operated in a different part of the U. S. than Southwest, and was profitable. When Morris Air was acquired by Southwest in December 1993, seven new markets were added to Southwest’s system. In 1999 Morris Air’s former president, David Neeleman, announced plans for a new airline to be based at New York’s JFK Airport.

The new airline was called JetBlue Airways. JetBlue had a successful IPO in April 2002, with the stock rising 70% on the first day of trading. JetBlue had a geographically diversified flight schedule that included both shorthaul and long-haul routes. Although JetBlue was viewed as a low-fare carrier, the airline emphasized various service attributes, such as leather seats, free LiveTV (a 24-channel satellite TV service with programming provided by DirecTV) and preassigned seating. In 2005 JetBlue was serving 31 cities in the domestic United States and Puerto Rico, Dominican Republic, and Bahamas.

Jet Blue had a fleet of 68 Airbus A320 aircraft and orders with Airbus for as many as 233 A320 aircraft. JetBlue also had an order with Embraer for a fleet of up to 200 Embraer 190 regional jet aircraft. The first Embraer 190 aircraft was to be delivered in 2005. JetBlue revenue in 2004 was $1. 2 billion, almost 20% that of Southwest. The company was profitable and committed to major expansion over the next few years. Southwest Expansion Southwest grew steadily over the three decades prior to 2005, but the growth was highly controlled. New airports were carefully selected, and only a few ew cities were added each year. As Kelleher wrote to his employees in 1993, “Southwest has had more opportunities for growth than it has airplanes. Yet, unlike other airlines, it has avoided the trap of growing beyond its means. Whether you are talking with an officer or a ramp agent, employees just don’t seem to be enamored of the idea that bigger is better. ”17 In October 1996, with the initiation of flights to Providence, Rhode Island, Southwest entered the northeast market. The entry into the northeast region of the U. S. was, in many respects, a logical move for Southwest.

The northeast was the most densely populated area of the country and the only major region where Southwest did not compete. New England could provide a valuable source of passengers to Florida’s warmer winter climates. Southwest’s entry into Florida was exceeding initial estimates. 16 B. O’Brian, “Heavy Going: Continental’s CALite Hits Some Turbulence in Battling Southwest,” Wall Street Journal, January 10, 1995, pp. A1, A16. 17 Freiberg and Freiberg, p. 61. A07-05-0006 9 Despite the large potential market, the northeast offered a new set of challenges for Southwest.

Airport congestion and air-traffic-control delays could prevent efficient operations, lengthening turnaround time at airport gates and wreaking havoc on frequent flight scheduling. Inclement weather posed additional challenges for both air service and car travel to airports. Nevertheless, Southwest continued to add new northeast cities. A few years later, Southwest was flying to various northeast airports, including Long Island, New Hampshire, and Hartford. In 2004 Southwest began flying to Philadelphia, which was the first major northeast market entry and possibly a sign of a more aggressive expansion posture.

As of 2005, Southwest had not entered any markets outside the domestic United States. Future Challenges With the airline industry in turmoil in 2005, Southwest was in an interesting and unique position. With its strong financial position, perhaps this was the time to expand more aggressively to take advantage of competitor weaknesses. With the major carriers seemingly incapable of fixing their problems, Southwest was poised to grow to new heights. However, there were a few warning signs on the horizon, especially with regard to employee costs and labor union relationships.

In 2005 Southwest had the highest salaries for pilots of narrow-body jets (38% above those at United Airlines), although Southwest pilots flew more hours and were being asked to increase their flying time. Southwest had also recently concluded a difficult and bitter contract negotiation with flight attendants that resulted in a richerthan-expected settlement for the union. As a result of this negotiation, new CEO Gary Kelly created a department focused on labor relations and began meeting quarterly with union leaders to discuss finances and strategy.

Clearly, 2005 and the years following would result in dramatic changes to airline industry structure. Would Southwest be able to maintain its position as America’s most prosperous airline? Could Southwest quickly expand share in the northeast and still ensure that customer service and company performance were satisfactory? Should Southwest look at internationalization options? Would the major airlines finally learn how to compete on cost with companies like Southwest and JetBlue? 10 A07-05-0006 EXHIBIT 1A Airline Operating Data 1989–2003

A07-05-0006 TransWorld Continental 84,685 78,390 80,192 81,270 84,850 80,950 76,120 68,310 61,530 61,006 49,762 49,690 49,143 48,742 48,385 47,107 31,400 37,630 35,590 34,450 36,480 40,590 38,186 27,938 25,044 30,483 29,684 33,942 35,246 Delta Eastern 129,974 120,462 132,133 141,280 147,060 144,650 141,960 138,700 133,610 130,500 98,104 99,852 100,904 94,350 87,748 25,299 82,440 15,489 PanNorthwest American 91,378 88,593 93,417 98,330 103,320 99,410 91,270 96,920 93,900 87,500 52,110 52,623 52,430 48,847 9,042 47,210 12,157 4,372 11,670 Southwest 76,861 71,908 65,295 65,400 59,940 52,900 47,550 44,490 40,710 36,180 29,624 34,759 21,371 18,440 16,456 14,788 United 144,543 135,865 148,698 164,770 175,400 176,540 173,890 169,000 162,650 158,569 95,965 98,652 89,605 88,092 86,085 82,758 US Airways 53,219 51,583 56,360 66,680 66,490 59,120 56,720 58,290 56,880 58,163 58,311 55,918 56,027 56,470 58,014 40,652 Seat-Miles Flown Total All Majors 776,902 815,657 828,550 862,680 833,250 801,390 789,400 763,960 744,804 540,324 551,237 532,984 517,743 536,299 486,683 004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 American 173,835 164,792 172,073 152,920 160,910 158,220 155,170 153,750 152,620 155,300 110,658 117,719 114,418 104,616 102,864 98,638 AmericaWest 30,152 27,888 27,088 26,500 27,080 25,870 24,260 23,460 21,470 19,400 17,852 16,980 18,603 19,460 18,139 13,523 Source: Department of Transportation, Bureau of transportation statistics 11 12

Eastern PanAmerican TransWorld AmericaWest 10 10 10 10 11 11 12 12 11 12 11 11 10 10 11 12 Continental 11 12 12 12 13 12 13 15 15 15 12 12 11 12 12 12 12 10 12 12 11 12 11 13 13 13 13 13 13 11 11 12 12 Delta 11 12 12 12 13 13 14 14 14 14 14 15 14 14 14 14 Northwest 13 11 11 11 12 12 13 14 14 15 14 13 12 13 13 13 Southwest 11 11 12 12 13 12 13 13 13 12 12 12 12 11 11 10 United 11 10 10 12 13 12 14 14 14 13 12 12 12 12 13 12 US Airways 13 13 13 14 16 17 21 20 20 20 16 18 17 17 16 16

EXHIBIT 1B Airline Operating Data 1989–2004 Revenue per passenger-mile (RPM) (in cents) 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 American 12 12 12 13 14 13 15 15 14 15 13 14 12 13 13 12 Source: Department of Transportation A07-05-0006 EXHIBIT 1C Airline Operating Data 1989–2004 A07-05-0006

Eastern PanAmerican TransWorld AmericaWest 77 79 73 72 71 68 67 69 71 69 68 66 62 65 61 58 Continental 77 77 71 73 75 74 72 71 68 66 62 62 63 62 58 60 61 62 61 60 61 66 72 73 71 69 67 66 63 62 63 61 59 59 Delta 75 76 66 69 73 72 73 72 70 66 65 62 61 60 58 64 Northwest 80 76 74 74 77 75 73 74 73 71 65 64 62 63 63 61 Southwest 70 70 63 68 71 69 66 64 67 64 67 68 65 61 61 63 United 78 77 72 71 72 71 72 72 72 71 70 64 66 64 64 65

Passenger Load Factor (percent) 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 American 75 74 70 69 72 70 70 70 69 66 63 59 63 61 61 64 US Airways 75 75 68 69 70 70 73 71 69 65 62 59 59 58 60 61 Source: Department of Transportation 13 14

TransWorld Total All Majors Continental 84,685 7,684 7,249 7,708 8,200 9,449 8,382 7,908 7,090 6,264 5,825 4,091 4,128 3,840 4,014 4,036 3,896 2,633 3,585 3,309 3,259 3,328 3,554 3,320 2,555 2,325 2,510 2,464 2,878 2,918 Delta Eastern 129,974 14,898 14,203 12,410 12,800 15,321 14,901 14,630 14,204 13,318 12,194 9,514 9,653 9,164 8,593 7,697 7,780 1,295 PanNorthwest American 91,378 10,257 9,183 9,151 10,302 10,957 9,868 8,707 9,984 9,751 9,080 5,325 4,928 4,464 4,356 596 4,298 946 3,944 957 Southwest 76,861 6,270 5,936 5,521 5,555 5,650 4,736 4,164 3,817 3,407 2,873 2,417 2,067 1,685 1,314 1,187 1,015 United 144,543 14,844 13,397 13,470 16,087 19,331 17,967 17,518 17,335 16,317 14,943 8,966 8,794 7,861 7,790 7,946 7,463 US Airways 53,219 7,120 6,761 6,971 8,253 9,181 8,460 8,556 8,502 7,704 7,474 6,394 6,364 5,974 5,895 6,085 4,160 81,739 75,217 73,122 81,505 93,900 85,873 83,024 82,003 77,193 72,810 51,307 50,419 46,681 45,810 45,598 43,096 EXHIBIT 1D Airline Operating Data 1989–2004 Operating Revenues in millions of dollars 2004 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 American 173,835 18,303 16,376 15,870 15,639 18,117 16,086 16,299 15,856 15,126 15,501 10,631 10,828 9,902 9,429 9,203 8,670 AmericaWest 30,152 2,363 2,112 2,021 2,036 2,309 2,164 1,983 1,887 1,752 1,600 1,414 1,332 1,281 1,359 1,322 998 Source: Department of Transportation A07-05-0006 EXHIBIT 1E Airline Operating Data 1989–2004 A07-05-0006

TransWorld Continental Delta Eastern 84,685 129,974 -363 -5198 38 -773 -323 1,383 (323) (1383) 589 1,459 449 1,261 621 1,793 646 1,621 472 571 120 340 -145 123 56 335 -183 -225 -218 -115 -191 -176 124 677 -666 -503 (503) -233 -343 -65 -29 -199 -139 -81 -63 -191 -233 -134 10 PanNorthwest American 91,378 -862 248 -395 (395) 664 769 -129 1,203 1,108 1,134 725 268 -203 17 -186 -132 -280 57 -118 Southwest 76,861 554 432 631 631 1,021 782 684 524 350 393 290 281 182 62 82 98 United 144,543 -1721 -2808 -3,743 (3743) 741 1,358 1,435 1,226 1,130 735 262 184 -354 -412 -34 302 US Airways 53,219 -174 -1646 -1,181 (1181) -44 202 990 586 369 -75 -466 -143 -397 -233 -437 -239 Net Operating Income (Loss) in millions of dollars Total All Majors -8614 -5679. 6 -9,775 (9775) 5,427 5,678 7,275 7,387 5,186 3,611 1,286 1,396 -1,686 -1,357 -1,231 1,002 2004 2004 2003 2002 2001 2,000 1,999 1,998 1,997 1,996 1,995 1,994 1,993 1,992 1,991 1,990 1,989 American 173,835 -761 -1228 -2,558 (2558) 1,243 1,003 1,748 1,447 1,316 989 432 357 -251 40 103 709 AmericaWest 30,152 -89 57. 4 -320 (320) -13 197 198 163 69 114 146 121 -64 -79 -32 48 Source: Department of Transportation. 15

Exhibit 2 Airline Performance 2004 Airline American America West Continental Delta Northwest Southwest United US Airways Load Factor (%) 73 76 76 73 77 70 77 72 Domestic Passengers Carried 72,647,682 20,150,587 31,528,695 79,373,578 45,959, 204 81,121,296 60,080,792 37,810,424 Source: Annual Report, Company Web sites, U. S. Department of Transportation. Exhibit 3 Airline American America West Continental Delta JetBlue Northwest Southwest United US Airways Domestic Costs and Revenues per Available Seat Mile Data Cost/ASM 3rd Qtr 2004 10. 93 8. 46 11. 02 13. 94 6. 13 13. 91 7. 60 12. 25 16. 13 Rev/ASM 3rd Qtr 2004 10. 11 8. 07 10. 30 12. 33 6. 61 14. 14 8. 58 11. 38 14. 12 Source: U. S.

Dept of Transportation. Exhibit 4 Southwest 34-Year Comparison 1971 4 195 108,554 3 6,051 2,133,000 -3,753,000 1999 306 29,005 52,600,000 55 602,578 4. 2 billion 433,400,000 2004 417 31,000 70,900,000 59 **1,022,000 6,5 billion 313,000,000 Size of Fleet Number of Employees Number of passengers carried Number of cities served Number of trips flown Total Operating Revenues Net Income (Losses) Sources: K. Freiberg and J. Freiberg, Nuts: Southwest Airlines’ Crazy Recipe for Business and Personal Success, Austin, TX: Bard Press, 1996, p. 326; Hoovers Southwest Airlines Fact Sheet, www. southwest. com/about_swa/press/factsheet. html. 16 A07-05-0006

Exhibit 5 2000 $5,467,965 $4,562,616 $3,963,781 $3,639,193 $3,269,238 $2,760,756 110,742 102,990 98,500 94,758 80,005 65,825 70,853 69,981 101,699 82,870 56,927 46,170 5,649,560 4,735,587 4,163,980 3,816,821 3,406,170 2,872,751 4,628,415 3,954,011 3,480,369 3,292,585 3,055,335 2,559,220 1,021,145 781,576 683,611 524,236 350,835 313,531 3,781 7,965 -21,501 7,280 9,473 8,391 1,017,364 773,611 705,112 516,956 341,362 305,140 392,140 299,233 271,681 199,184 134,025 122,514 $625,2249 $474,378 $433,431 $317,772 $207,337 $182,626 $. 849 $0. 63 $0. 58 $0. 43 $0. 28 $0. 25 $. 799 $0. 59 $0. 55 $0. 41 $0. 27 $0. 24 $0. 01 $0. 01 $0. 01 $0. 01 $0. 01 $0. 1 $6,669,572 $5,652,113 $4,715,996 $4,246,160 $3,723,479 $3,256,122 $760,992 $871,717 $623,309 $628,106 $650,226 $661,010 $3,451,320 $2,835,788 $2,397,918 $2,009,018 $1,648,312 $1,427,318 10. 1%9 19. 9%9 9. 20% 18. 10% 9. 70% 19. 70% 8. 00% 17. 40% 5. 90% 13. 50% 6. 00% 13. 70% 6. 60% 15. 60% $2,497,765 54,419 39,749 2,591,933 2,275,224 316,709 17,186 299,523 120,192 $179,331 $0. 25 $0. 24 $0. 01 $2,823,071 $583,071 $1,238,706 1999 1998 1997 1996 1995 1994 1993 Southwest Airlines Ten-Year Financial Summary 1992 A07-05-0006 $2,216,342 $1,623,828 42,897 33,088 37,434 146,063 2,296,673 1,802,979 2,004,700 1,609,175 291,973 193,804 32,336 36,361 259,637 157,443 105,353 60,058 $154,2844 $97,385 (5) $. 214 $. 14(5) $. 214 $. 13(5) $0. 01 $0. 01 $2,576,037 $2,368,856 $639,136 $735,754 $1,054,019 $879,536 6. 2%(4) 16. 0%(4) 4. 6% (5) 12. % (5) 63,678,261 57,500,213 52,586,400 50,399,960 49,621,504 44,785,573 42,742,602(6) 36,955,221(6) 27,839,284 42,215,162 36,479,322 31,419,110 28,355,169 27,083,483 23,327,804 21,611,266 18,827,288 13,787,005 59,909,965 52,855,467 47,543,515 44,487,496 40,727,495 36,180,001 32,123,974 27,511,000 21,366,642 70. 50% 69. 00% 66. 10% 63. 70% 66. 50% 64. 50% 67. 30% 68. 40% 64. 50% 663 634 597 563 546 521 506 509 495 903,754 846,823 806,822 786,288 748,634 685,524 624,476 546,297 438,184 $85. 87 $79. 35 $76. 26 $72. 81 $66. 20 $61. 80 $58. 44 $59. 97 $58. 33 12. 95? $12. 51 12. 76? 12. 94? 12. 13? 11. 86? 11. 56? 11. 77? 11. 78? 9. 43? 8. 96? 8. 76? 8. 58? 8. 36? 7. 94? 8. 07? 8. 35? 7. 89? 7. 73? 7. 48? 7. 32? 7. 40? 7. 50? 7. 07? 7. 08? 7. 25? (7) 7. 03? 78. 69? 52. 71? 45. 67? 62. 46? 65. 47? 55. 22? 53. 92? 59. 15? 60. 82? 9,274 27,274 25,844 23,974 22,944 19,933 16,818 15,175 11,397 344 312 280 261 243 224 199 178 141 2003 2002 2001 Operating revenues: $6,280 $5,741 $5,341 $5,378,702 Passenger8 Freight 117 94 85 91,270 133 102 96 85,202 Other8 Total operating revenues 6530 5,937 5,522 5,555,174 Operating expenses 5976 5,454 5,105 4,924,052 Operating income 554 483 417 631,122 Other expenses (income), net 65 -225 24 -196,537 Income before income taxes 489 708 393 827,659 176 266 152 316,512 Provision for income taxes3 $313 $442 $241 $511,147 Net income3 Net income per share, basic3 $0. 40 $0. 56 $0. 31 $0. 67 Net income per share, diluted3 $0. 38 $0. 54 $0. 30 $0. 63 Cash dividends per common share $0. 02 $0. 02 $0. 02 $0. 2 Total assets $11,337 $9,878 $8,954 $8,997,141 Long-term debt $1,700 $1,332 $1,553 $1,327,158 Stockholders’ equity $5,524 $5,052 $4,422 $4,014,053 Consolidated Financial Ratios1 Return on average total assets 2. 85% 4. 70% 2. 70% 6. 50% Return on average stockholders’ equity 5. 90% 9. 30% 5. 70% 13. 70% Consolidated Operating Statistics2 Revenue passengers carried 70,902,773 65,673,945 63,045,988 64,446,773 RPMs (000s) 54,418,343 47,943,066 45,391,903 44,493,916 ASMs (000s) 76,861,296 71,790,425 68,886,546 65,295,290 Passenger load factor 69. 50% 66. 80% 65. 90% 68. 10% Average length of passenger haul 753 730 720 690 Trips flown 981,591 949,882 947,331 940,426 $88. 7 $87. 42 $84. 72 $83. 46 Average passenger fare8 11. 76? 11. 97? 11. 77? 12. 09? Passenger revenue yield per RPM8 Operating revenue yield per ASM 8. 50? 8. 27? 8. 02? 8. 51? Operating expenses per ASM 7. 77? 7. 60? 7. 41? 7. 54? Fuel cost per gallon (average) 6. 47? 6. 44? 6. 30? 70. 86? Number of Employees at year-end 82. 8? 72. 3? 68. 0? 31,580 Size of fleet at year-end 31,011 32,847 33,705 355 417 388 375 Selected Consolidated Financial Data1 (In thousands except per share amounts) 2004 1 2 3 The Selected Consolidated Financial Data and Consolidated Financial Ratios for 1992 have been restated to include the financial results of Morris Air

Corporation (Morris) Prior to 1993, Morris operated as a charter carrier; therefore, no Morris statistics are included for 1992 Pro forma for 1992 assuming Morris, an S-Corporation prior to 1993, was taxed at statutory rates 4 Excludes cumulative effect of accounting changes of $15. 3 million ($. 02 per share) 5 Excludes cumulative effect of accounting changes of $12. 5 million ($. 02 per share) 6 Includes certain estimates for Morris 7 Excludes merger expenses of $10. 8 million 8 Includes effect of reclassification of revenue reported in 1999 through 1995 related to the sale of flight segment credits from Other to Passenger due to the accounting c000 9 Excludes cumulative effect of accounting change of $22. 1 million ($. 03 per share) 17