BY SUSAN WARREN THE WALL STREET JOURNAL

Posted on Sunday, December 4, 2005

DENVER — Southwest Airlines has prospered by targeting new cities where the competition is weak and the costs are low. But when it starts flying out of Denver in January, success won’t be so easy.

Southwest will be going up against two entrenched carriers : Frontier Airlines Inc., a rival low-cost carrier based in Denver ; and a newly streamlined United Airlines, which controls nearly 60 percent of the Denver market and is set to emerge from bankruptcy early next year.

While Denver International Airport has dramatically reduced airline fees in recent years, the city will be one of the most expensive that Southwest serves. Southwest estimates its Denver airport fees will run between $ 8 and $ 9 per passenger, compared with a systemwide average of $ 5. That’s high for an airline that’s begun offering tickets for Denver flights at introductory fares as low as $ 59 each way.

Southwest is weathering the industry’s financial crisis better than most other U. S. carriers and is determined to use that advantage to strengthen its market position before the rest of the industry recovers. It has posted an unbroken string of profitable quarters even as other airlines racked up hundreds of millions of dollars in losses. It is the leading carrier at Little Rock National Airport, Adams Field, and with Denver it will be entering its third new city in eight months, its fastest expansion pace since 1999. But Southwest’s days as an industry upstart may be drawing to a close. When it began flying in 1971, it terrorized established carriers with rockbottom fares made possible by no-frills service and shrewd use of secondary airports. But hard times are driving big changes in the industry. With other airlines slashing costs inside and outside of bankruptcy court, Southwest is losing its industry lock on low fares.

STAYING AHEAD To cope with higher costs and leaner rivals, Southwest is adjusting its distinctive formula. Moving into Denver is one of the bigger risks the airline is taking as it tries to grow before other airlines catch up. “The low-hanging fruit is gone,” said Stuart Klaskin, an industry consultant based in Coral Gables, Fla. “There are only so many markets that are underserved and overpriced, and those markets shrink every day because somebody else is coming to serve them.” One of Southwest’s main cost advantages over other airlines is likely to melt away in the next few years. When oil prices were low, Southwest executed extensive fuel hedges to lock in low prices. For the past 18 months, the benefits have been huge, but they will shrink steadily in the next five years. If oil prices remain high, Southwest won’t be able to negotiate new hedges at attractive prices, moving its fuel costs more in line with other airlines.

“We’ve bought ourselves time,” Southwest Chief Executive Gary Kelly said in a recent interview. “The advantages we have are immense, and shame on us if we squander them.”

Kelly plays down the difficulties in Denver. He notes that Southwest already competes effectively against other discount carriers in cities such as Phoenix and it flies out of big airports with lots of competition, such as Los Angeles International.

“This is not extraordinary for us,” he said. “We’re a growing airline, and we’re very disciplined. It’s just what we do.”

Frontier and United already have matched the low fares Southwest announced for its flights between Denver and Phoenix, Las Vegas and Chicago, which are scheduled to begin Jan. 3. With comparable fares, passengers will choose between no-frills Southwest and two airlines that, unlike Southwest, offer assigned seating and premium features such as first-class sections, more legroom and inflight entertainment.

For some Denver travelers, that’s reason enough to stick with the airlines they’ve grown used to flying.

“My premium status, more leg space — I wouldn’t easily give that up just to save a few bucks,” said veteran flier Ellen Cervarich, who was waiting to board a United flight to Chicago in Denver recently.

Frontier and United both will see their financial results squeezed by a fare war with Southwest, airline analysts say. Kelly argues that his airline’s low cost base gives it more “staying power” in a low-fare environment. In other words, Southwest hopes to outlast competitors who may not be able to sustain the rock-bottom fares. Southwest’s operating cost, as measured by each seat flown one mile, is a low 7. 85 cents. That compares with 8. 68 cents per seat mile for Frontier and 10. 43 cents for United, in the most recent quarter. But if fuel prices go down, that advantage could shrink. Excluding fuel, Southwest’s cost is 6. 31 cents per seat mile, compared with Frontier’s 5. 86 cents and United’s 7. 11 cents.

ROAD TO DENVER Denver, which opened a new airport in 1995, had been courting Southwest for decades. When a casually dressed fourperson Southwest team visited July 11, Denver officials were at first deflated. “I don’t think anybody was over 35” years old, said Thomas Clark, head of economic development for Denver. “I thought, ‘ OK. They’ve sent the junior team. ’” Clark changed his mind when the Southwest team began pelting Denver officials with detailed questions about economic growth and plans for development in the region. What are the demographics for winter skiers ? What kind of conventions do you have planned for the next five years ? “These are questions we’ve just never been asked by an airline before,” Clark said. The Southwest representatives told Denver officials that they loved the city but there were no promises. The next month, Hurricane Katrina demolished the airline’s careful planning. Southwest had been running 57 flights a day to New Orleans. The storm knocked out most air service to the city, leaving Southwest with 15 jets sitting on the tarmac, unable to generate revenue.

One possible solution was to quickly launch a new city to take up the slack. Ordinarily, Southwest needs six to nine months between announcing service to a new city and beginning flights. To further complicate matters, a strike at Boeing Co. threatened to delay the delivery of new airplanes Southwest had ordered for 2006. If Southwest didn’t get those planes, the idled New Orleans fleet might not be available to use in a new city.

On Sept. 29, the month-long Boeing strike was resolved. Bob Montgomery, Southwest’s vice president of properties, was dispatched immediately on a two-week tour of the top five airports on Southwest’s secret expansion shortlist. Montgomery arrived in Denver on Oct. 7 and found most of what Southwest needed — terminal space, gates, baggage handling — was already in place.

Southwest’s planning team crunched numbers and concluded the airline could keep costs in Denver to less than $ 9 a passenger. Although that was considerably higher than the $ 5 systemwide average, it was less than the $ 10 Southwest was paying in Seattle. The airline figured that despite the presence in Denver of low-cost Frontier, it could set fares 30 percent to 50 percent lower than rivals for certain routes, and still make money.

Frontier Chief Executive Jeffery Potter says he knew that other airlines, including Alaska Airlines, had successfully competed against Southwest in some cities, and felt reassured that Frontier compared favorably to those airlines.

MEASURING UP Southwest has a near-mythic reputation in the industry as an airline that usually can’t be beat. Airlines far bigger than Frontier, such as US Airways Group, had decided to cut back service to cities that Southwest entered. Potter composed a letter to rally his employees. “We are not about to cower or back away,” he wrote, assuring them that “not everything you have heard about Southwest is necessarily true.” In an interview, Potter said fliers will prefer Frontier’s extras, such as more legroom in its seats and personal television screens that offer programs and onboard movies for a fee. He maintained that fliers are turned off by Southwest’s firstcome-first-serve seating, which sometimes results in long lines of passengers waiting to board. “Pricing is Southwest’s big advantage,” notes Frontier spokesman Joseph Hodas. “Take that away, and what do they have ?” Frontier immediately matched Southwest’s introductory Denver fares, and Potter maintains that the airline can make money at the lower prices. Kelly contends that Southwest’s battle-tested approach will continue to work in Denver, even if there is no difference in fares. Southwest’s core advantage is its performance, he argues. Southwest has a long record of superiority in categories such as on-time flights, baggage handling, frequency of complaints and canceled flights.

In recent years, though, lowcost rivals have been beating Southwest in some categories. Frontier, for example, had a better on-time record in the third quarter than the much larger Southwest, according to Department of Transportation data.

Kelly says Southwest won’t be resting on its laurels and is willing to make changes to stay competitive.

United executives also are working out a response. Like other traditional airlines, UAL Corp. ’s United has slashed costs and reduced domestic service to concentrate on expanding overseas. It posted its biggest loss ever in the third quarter, but that was because of $ 1. 84 billion in restructuring costs as it prepares to exit bankruptcy in the spring. Now, United is expecting to turn profitable by the end of 2006.

Sean Donohue, a United vice president in charge of its Ted Airlines discount operations, contends that Denver customers of both Ted and United will remain loyal, partly because of United’s frequent-flier program. Accumulating mileage on United allows passengers to fly all over the world, while on Southwest, “you can go to Lubbock or Amarillo,” Donohue said. Actually, Southwest now flies to 61 cities nationwide.

Southwest still has the lowest costs of any major airline. But Donohue notes that other airlines have been lowering costs, reducing Southwest’s advantage.

“I’m not trying to be arrogant here in saying Southwest is not a fierce competitor, because they are,” Donohue said. “But things are changing. And things are changing pretty significantly.”