Gary Kelly remembers the early days of hot pants and peanuts, when the masters of the corporate sneer turned their noses skyward while discussing Southwest Airlines. By the time Kelly arrived as a controller in 1986, the hot pants had been stowed, but the airline with the gimmicks was still looked upon as a bit too gimmicky.

Nobody’s laughing anymore. And nobody wonders if a numbers guy from finance has the skills to soar as an industry innovator. Kelly is reluctant to refer to himself as a maverick, but his aggressive, imaginative style has drawn the praises of corporate Dallas yet again.

For the second straight year, local business leaders have named Southwest’s president, chairman of the board, and chief executive officer Dallas-Fort Worth’s CEO of the Year. Voting by the area’s top executives was conducted by SMU’s Cox School of Business.

Kelly says he’s “overwhelmed” to be recognized again, especially because it’s by his peers.

The philosophies so ingrained into Southwest’s daily mindset by co-founder Herb Kelleher have remained intact since Kelly became CEO in 2004. If anything, the 55-year-old Kelly has caught competitors flat-footed by vaulting Southwest into a leadership position in an industry that for two decades has been stalked by dark clouds. Like other sectors, the airline industry can be a copycat world. One airline does something brash and gets away with it; others soon follow in lockstep.

Not Southwest. After the airline weathered the recession of 2008 and 2009, Kelly and his executive team conducted a careful review of its fleet, destinations, customer experience, and reservations systems. Southwest committed to expand into more U.S. cities, and also to fly internationally—but only when it was ready to do so. The airline is upgrading its frequent flyer program and refreshing its five-year plan. It’s also preparing for greater battles­—battles welcomed by Kelly and his aggressive executive board.

“We recognize that we’re operating in an environment where the air travel market is not growing,” Kelly says in his office at Southwest’s corporate headquarters at Dallas Love Field. “In fact, there are fewer people traveling today than there were traveling 10 years ago. In some markets it’s even less than it was 20 years ago. So it’s just a recognition that for growth at Southwest [to occur], we might need to look more forcefully at taking customers away from competitors.”

Southwest positioned itself well for that with two blockbuster moves in 2010. First the airline said it would add the larger Boeing 737-800 aircraft to its fleet. Then, in October, in the most significant deal in its 40-year history, Southwest snapped up rival AirTran Holdings Inc., the eighth-largest U.S. carrier by traffic, in a $1.4 billion cash and stock deal.

First International Flights

The AirTran merger gives Southwest access to an additional 38 airports. Of the 107 airports that Southwest and AirTran fly to combined, only 32 overlap. The real stunner is Atlanta, the only major U.S. city that Southwest did not fly into. There, Southwest will war head-to-head with Delta Air Lines on its home turf.

And, with AirTran’s existing service into Cancun, Mexico, and the Caribbean, the deal gives Southwest its first international flights. U.S. regulators currently are reviewing the merger, but Kelly anticipates confirmation by next summer.

“It definitely caught people flat-footed,” Kelly says of the AirTran transaction. “And we love that. It’s undeniable that the major market [in the merger] is Atlanta, and there’s no reason to pretend otherwise. ... AirTran has spent 17 years developing that market, so we’re stepping into their shoes,” he continues. “Today they have 200 flights a day in Atlanta, which rivals our largest cities. And so, from the Southwest view of the world, we’ll be starting at 35,000 feet going into Atlanta, and that’s very exciting to us.”

The decision to add the larger Boeings became even more appropriate following the AirTran deal. Southwest currently flies 547 Boeing 737-700s, and all but 25 have a 137-seat configuration requiring three flight attendants. The Boeing 737-800 has 175 seats (“with little more cost,” Kelly says) and necessitates a fourth flight attendant. But Kelly says the -800 is a better long-haul aircraft than the 737-700—so long as customer demand fills those additional 38 seats.

“We feel like we have the opportunity within the domestic U.S. route map that we operate to deploy somewhere around 70 737-800s,” Kelly says. “The purpose ... is to operate those flights more effectively and therefore more profitably.”

Besides Mexico and the Caribbean, Southwest also plans to expand to Hawaii, when the economics are right. “The -800 becomes not really an alternative aircraft, it almost becomes mandatory in those markets,” Kelly says. “The 737-700 is just not competitive enough, in my opinion, for those markets.”

Kelly believes Southwest can add destinations and lower fares, stimulate the market, and grow the airline. These are confident, hopeful words for a CEO who desperately struggled to keep his company profitable in 2009. Only last autumn Kelly had forewarned, “The worst is ahead of us from an earnings perspective.” Instead, 2010 will make the 38th consecutive year that Southwest Airlines has recorded a profit. No employees have ever been furloughed or laid off. In fact, Kelly says everyone got raises last year.

“We struggled with record high energy prices and a terrible recession,” he says. “We faced the threat of an annual loss for the first time since 1972. ... [But], we avoided disaster.”

How? “I’ve been here 25 years, and my memory is that we’ve never had a year where the fourth quarter was the best quarter of the year,” Kelly says. “It was last year. We’ve made dramatic schedule adjustments, eliminating poor performing flights. Last year, in the midst of the recession, we opened up four new cities [Minneapolis, New York City, Boston, Milwaukee]. That’s a very bold move in a tough economy.”

Now, Southwest is looking for bluer skies and even smoother landings. “By this time last year we were definitely seeing signs of life in our business,” Kelly says. “But even in October of last year, we weren’t sure where we were going to end up for the year. This year we’re seeing the culmination of some efforts that we’ve had under way for five years, and our momentum is very good.”

No Charge for Bags

Kelly says Southwest has found other ways to set it apart from competitors. “The industry has moved to à la carte pricing and nickel-and-diming customers, and we have avoided all of that. We have been able to differentiate ourselves, especially since 2008, most notably with our Bags Fly Free [program] and our Bags Fly Free advertising campaign, which has been absolutely superb.”

According to Kelly, Southwest has enjoyed a 1 percent share shift since other airlines began charging bag fees. It brought an additional $1 billion to Southwest when bag fees were the only significant change in the industry, he says.

“We are convinced that not charging for bags wins us more customers, and therefore more revenue and more profits, as compared to doing what everybody else does, which customers universally hate,” Kelly says. “Charging for bags goes against everything we stand for.”

What it does stand for might seem superficial to some, but Southwest is famous for its laid-back work place. For example, you may find an executive in flip-flops interviewing a pilot candidate in a suit. Employees often say they can pick out visitors at the airline not just by their white ID badges but because they’re usually the only ones who are formally dressed. At Southwest, every day is casual Friday.

The legendary Kelleher—who shares Kelly’s birthday, March 12—must have seen more than a numbers cruncher when he elevated Kelly from executive vice president to CEO, not just to bolster revenue but to maintain Southwest’s trademark corporate culture. Kelly agreed to take the position—so long as Kelleher didn’t spend his days looking over Kelly’s shoulder.

“My request of him was, ‘I’m happy to work for you Herb, as CEO, but if you want me to be CEO, this is what I think that means,’” Kelly recalls. “And he readily agreed. I’ve been a student of his for 25 years. We all just have to put ourselves in the shoes of the founder who has been so dramatically successful, and understand that he was turning over his baby to some guy. ... Lucky for me that I had such a great mentor.”

Meantime, Kelly is understandably sanguine about Southwest as he reviews its history. “We’ve carried the population of the United States four times over, without a single fatality. So there’s a real professionalism to the operation that is renowned around the world,” he says. “But in the early days, in the ’80’s, we weren’t highly regarded by competitors. I think we had customers who were fans, no doubt, but we were a niche airline. When I started out, we were a fraction the size of our legacy competitors.

“In the 1990’s when we were making money and they were all losing money after the first Gulf War, that’s when people, and Wall Street, really started taking notice again. That allowed us to grow at a rapid rate very successfully through the ‘90’s,” Kelly continues. “And while this decade has been a very difficult decade, our capacity has grown by about 60 to 70 percent while the legacy airlines as a group have shrunk 25 to 30 percent. So although this decade has been tough, we’ve added a dozen cities and we’ve become the largest airline in the United States, based on the number of customers served.

“All along the way, our mantra is, we want to be better this year than we were last year,” Kelly says. “That’s not happening with many of our competitors.”

cover photography by Dan Seller