(FORTUNE Magazine) – If there's one thing Herb Kelleher is famous for, it's telling stories. He has loads and loads of them: There was the time he pretended to be his own evil twin brother; the time he did a soft-shoe dance with Speaker of the House Jim Wright; there were many Wild Turkey-drenched parties, perhaps remembered better by others. But Kelleher's most remarkable story of all, without a doubt, is how he built Southwest Airlines from a doodle scratched on a cocktail napkin into the most successful airline in history.

A San Antonio lawyer, Kelleher founded Southwest with one of his clients, Rollin King (now a board member), over drinks at a local bar in 1966. He ponied up $10,000 of his own money to get it started (his stake in Southwest is now worth more than $200 million). At the time, the idea was revolutionary: a cut-rate airline that would fly between Dallas, San Antonio, and Houston. And no one--not even Kelleher--was sure it would work. Indeed, its competitors were determined to make certain it didn't. From the minute the company was created, they fought to keep Southwest grounded. For the first ten years of the company's life, Kelleher, then a board member and the airline's lawyer, spent the better part of his days in court defending Southwest against lawsuits from the likes of Texas International and Braniff Airlines.

Although he became chairman in 1978, Kelleher didn't actually become CEO until early 1982. At that point, the airline had just 27 planes, $270 million in revenues, and 2,100 employees, and flew to 14 cities. Since then Kelleher has built the company into a $5.7 billion business. Based in Dallas, Southwest now has more than 30,000 employees and flies to 57 cities--from Baltimore to Nashville to Los Angeles. At $14 billion, Southwest's market capitalization is bigger than American's, United's, and Continental's combined. And it still offers some of the cheapest fares in the industry: A one-way ticket from Nashville to New Orleans costs $56.

But what is most stunning of all about Southwest is that since 1973, when it first turned a profit, the company hasn't lost a penny. In an industry plagued by fare wars, recessions, oil crises, and other disasters, this is an astounding feat. No other airline has ever come close to it. Even during the Persian Gulf war, when every other major carrier gushed red ink, Southwest made money. In just this past quarter, because of rising jet-fuel prices, five of the largest air carriers--including Delta, United, and American--lost money. Southwest made $121 million in net profits--up 65% from a year ago.

Now Kelleher is getting ready to step down as CEO and president. On June 19 he will hand over the controls to Jim Parker, the company's longtime general counsel, and executive vice president Colleen Barrett. Although Kelleher will remain chairman, this moment marks the end of a remarkable career as one of the most successful and colorful CEOs of our time. On the eve of his retirement, FORTUNE asked Kelleher, the New Jersey-born son of Campbell Soup's general manager, to recount, in his own words, the story of his remarkable 35-year run in the airline business. (Reporter Alynda Wheat also asked friends, competitors, and colleagues for their tales of Herb--you'll find three of the most colorful in the pages that follow.) Over three days in May and at least ten packs of cigarettes, Kelleher regaled us with tales of adventures and exploits, crises and struggles, and, of course, the fun he had building Southwest. With no further ado, we give you the chairman of the board, Herb Kelleher:

I love battles. I think it's part of the Irish in me. It's like what Patton said, "War is hell, and I love it so." That's how I feel. I've never gotten tired of fighting. For the past 35 years my job has been helping Southwest Airlines get through one battle after another. We've been like the French Foreign Legion--they had a firefight just about every two days. That's like us. Even before our first airplane got off the ground, we were fighting.

Southwest got started in a bar. It was at the St. Anthony's Club in San Antonio, as I remember it. Rollin [King] came to me with the idea of starting a low-fare airline in Texas, and I said, "Well, that sounds kind of nutty to me." There were already several big carriers in Texas. But then I really looked into it and realized it was feasible. Of course I also realized it was going to mean Armageddon. I knew the incumbent carriers--Braniff, Texas International, Continental--were going to fight us tooth and nail. It proved to be even more ferocious than I had anticipated.

As soon as the Texas Aeronautics Commission authorized us to fly, the other carriers immediately went to court to stop us. It was continual litigation from then on. It literally went on for 3 1/2 years. It was like all of the hounds of the Baskervilles were simultaneously ripping and nipping at us. One of the papers at the time said, "Don't bother spending your money on a movie or going to see a play or attending a concert. Just come over and watch Herb Kelleher and the lawyers for Braniff and Texas International cut each other into little bits and pieces."

One time, during the course of the trial, one of the attorneys for our competitors was sitting in the juror box and he became so angered by a remark that I made that he jumped out of the jury box and tried to take a swing at me. But he got his foot caught in the railing and collapsed on the floor at the foot of the judge. I didn't help him, but I can tell you I watched him pick himself up off the floor with great interest.

I pulled so many all nighters in those days. Once I stayed up all that night trying to prepare the case before the Texas Supreme Court. I wrote my brief and then got a motel room to try to catch a few hours of sleep before going to court. The motel was beside a highway and so noisy that I finally went into the bathroom for some quiet and lay down on the floor. I woke up several hours later and I was completely covered with marks from the tile--you know, I had little squares all over my face. I went into court that way. But then, something extraordinary happened. Right after the arguments, the lawyers on the other side came up to me and said, "We're calling our clients and telling them you've won." And sure enough, we had.

But that wasn't the end of it. Our competitors went to the U.S. Supreme Court to try to stop us. The court rejected their petition, and we set the date to start service: June 18, 1971. They tried to stop us again, two days before our first scheduled flight. They got an Austin trial judge to enjoin us again from commencing service. I was very angry. The constant proceedings had gradually come to enrage me. There was no merit to our competitors' legal assertions. They were simply trying to use their superior economic power to squeeze us dry so we would collapse before we ever got into business. I was bound and determined to show that Southwest Airlines was going to survive and was going into operation. If it didn't, then something was very wrong about our whole system, about our whole society.

So I headed back to the Texas Supreme Court in Austin to get the injunction lifted. Before I left Dallas, I told Lamar Muse--who was CEO of Southwest Airlines at the time--to go ahead with our scheduled flight no matter what. Lamar said, "Gee, Herb, what do I do? Suppose the sheriff shows up and tries to prevent the flight?" So I said, "Leave tire tracks on his shirt. We're going, come hell or high water."

And we did. We went into service the next day as scheduled. That's how the first Southwest airplane got off the ground.

That old warrior spirit

Getting Southwest up and running was just the beginning of another saga: the fare wars with Braniff Airlines. At one point Braniff cut the price of its one-way fare from Houston to Dallas from $26 to $13. Lamar Muse came up with the brilliant way to match them. We'd offer customers a choice: They could pay $13--or they could pay $26 and we'd throw in a free bottle of whiskey. That made us the largest liquor distributor in Texas for a couple of months. One evening I came home and I guess I looked kind of beat because Ruth, my younger daughter--who was about 12 at the time--said, "Dad, what's the matter? You really look down." I said, "Well, it's just fare war after fare war in the airline industry." She told me, "Well, Dad, don't whine to me. You started it!"

The fare war turned into a real war. I mean a physical war. We were the barroom brawlers of the American airline industry. One time some Braniff people went up to the roof of the terminal in Houston and hung a sign over the edge to advertise their service to Dallas. Our station manager went up there and tried to cut it down with a knife. He ended up getting into a tussle with their people right there on the top of the terminal. Another time Braniff didn't have enough room to move one of its planes away from the terminal and they asked us to move our airplane. We said no. So they tried to power it out using all their engines and blew out two of them. That was a great day. Finally the FAA told us, "Guys, unless you two quit this, we're going to throw you both out of here. Still, those early battles were the basis of Southwest's warrior spirit. They bred a consciousness that life can be very short--even in business--and very precarious. And that's how we learned to endure and to survive.

I quit...for two days

Very few people know about this. I've just never talked about it. It was March of '78. Lamar and Rollin were having a tussle. They didn't get along real well almost from the beginning. I kept trying to patch things up. Just as I'd think that things were resolved, the fighting would break out again. It got to the point where the squabbles were dominating things. Finally they had another fracas, and I got so mad that I said, "You know, I'm just not going to do this anymore." So I sent everybody on the board of directors a telegram saying that I was resigning. I said I wasn't going to spend the rest of my life as a go-between, and I went down to Houston to work on a case for my law firm. At the same time--and I was unaware of this when I sent my telegram--Lamar sent a memo to the board members where he, in effect, made it a choice between Rollin and him. Well, the board ignored my telegram. Two days later they called me and said, "We have a real emergency--you'd better get up here right away." So I flew back to Dallas that afternoon to go to a meeting of the board. The first thing someone said was, "Well, I guess the first order of business is to accept Mr. Muse's resignation." Lamar was sitting in the room, so I said, "Whoa--I think we've got a little conflict here." And we asked Lamar to step out of the room while we discussed the issue. I didn't want Lamar to be fired. I didn't want Lamar's resignation to be accepted in that way. I argued against it because I felt he had done a terrific job. So I persuaded the board to let me talk to Lamar about trying to resolve his issues. I left the board meeting to go talk to him and found that he had left the building. When I went back to tell the board that Lamar had departed the premises, they said, "Okay, Herb, forget it." And Lamar was out. Everyone voted for it--except me. I didn't vote.

Then the board turned to me and they said, "You have to be the chairman and the CEO." And, you know, I looked over my shoulder because I wasn't sure who they were talking about. I thought there must be someone standing behind me. Even though I was a co-founder, I hadn't had any previous business experience as such. I was primarily working for Southwest on the outside--in the courts. I hadn't worked much on its internal operations. But, of course, I had invested many years and a whole heck of a lot of my time helping get Southwest started. I didn't want it to disappear. I said to myself, "Holy mackerel, my beloved is in a real emergency. I have to step in and do what I can." So I agreed to be chairman but not CEO. Frankly, I enjoyed practicing law, and I wanted to continue practicing it. So I asked the board to bring in someone else to be CEO. And we hired Howard Putnam from United to be Southwest's CEO.

My mother's disciple

I sort of served a three-year apprenticeship with Howard. He was new to Southwest and he asked me to handle many of the internal things. I started to become involved day-to-day in the operations. I got to know people a lot better and in a personal way. And that was a very enjoyable period for me. You'd go over to maintenance and talk over how the planes were running. You'd talk to the flight attendants and get involved in such discussions as what their uniforms ought to be.

At the time, they wore hot pants. Now, understand, back in the '70s, when we first started flying, hot pants weren't so out of line. You had matrons in San Antonio walking down the main street in hot pants. It was fashionable then. But, of course, society's attitudes changed, and the flight attendant leadership told me they wanted to get rid of the hot pants as their uniform. I didn't see any reason why we should continue to make the flight attendants wear them if they felt uncomfortable. But then a funny thing happened: I got a petition from the customer service agents arguing to keep the hot pants. So we came up with a compromise: the wraparound skirt. The flight attendants could tie it over their hot pants if they wanted to.

You have to treat your employees like your customers. When you treat them right, then they will treat your outside customers right. That has been a powerful competitive weapon for us. You've got to take the time to listen to people's ideas. If you just tell somebody no, that's an act of power and, in my opinion, an abuse of power. You don't want to constrain people in their thinking.

My mother taught me that. She was an extraordinary person. When I was very young--11 or 12--she used to sit up talking to me till three, four in the morning. She talked a lot about how you should treat people with respect. She said that positions and titles signify absolutely nothing. They're just adornments; they don't represent the substance of anybody. I was kind of her disciple. I learned firsthand that what she was telling me was correct, because there was a very dignified gentleman in our neighborhood, the president of a local savings and loan, who used to stroll along in a very regal way up until he was indicted and convicted of embezzlement. She taught me that every person and every job is worth as much as any other person and any other job.

The thing that would disturb me most to see after I'm no longer CEO is layoffs at Southwest. Nothing kills your company's culture like layoffs. Nobody has ever been furloughed here, and that is unprecedented in the airline industry. It's been a huge strength of ours. It's certainly helped us negotiate our union contracts. One of the union leaders--a Teamsters leader--came in to negotiate one time and he said, "We know we don't need to talk with you about job security." We could have furloughed at various times and been more profitable, but I always thought that was shortsighted. You want to show your people that you value them and you're not going to hurt them just to get a little more money in the short term. Not furloughing people breeds loyalty. It breeds a sense of security. It breeds a sense of trust. So in bad times you take care of them, and in good times they're thinking, perhaps, "We've never lost our jobs. That's a pretty good reason to stick around."

I learn to play the game

In my first year as CEO in 1982, I had to learn how to run a company--in a big hurry. Wow, that was some year: Twelve thousand air-traffic controllers were on strike--they had all walked out on the same day. It was a huge crisis. Whether or not you got the right to fly your new airplanes was determined by a lottery in Washington. We were actually picking Ping-Pong balls--like a bingo game--out of a big container. We had new airplanes coming in, and airplanes don't do very well if you just put them against the fence and plant geraniums in them. I came back from Washington and thought, "Man, this is an emergency. We've got to do something fast."

So we learned how to play the slot game. We had this subsidiary called Midway Southwest Airlines. Even though it wasn't operating, it was regarded as a new airline. New airlines got first preference on drawing for slots. So we had Midway Southwest start drawing in a preferred position. It would get the slots and then transfer them to Southwest Airlines. It wasn't against the rules, but people started getting very angry about it. The FAA summoned me to Washington, and they said what we were doing was not what was intended. I said, "Well, I don't care what was intended. The rules permit you to do it." They said, "Well, you have to be an operating carrier in order to participate in the slot lottery." So I sold Midway Southwest to a guy who operated one Lear jet and that made it into an operating carrier. He would get the slots and then transfer them to us. After we started doing that, I got summoned to Washington by Lynn Helms, the administrator of the FAA. When I walked into his office, he said, "Close the door." So I closed the door. He said, "Herb, I think this is the funniest thing I've ever seen. You've completely taken advantage of the rules!" And he started laughing. He thought the whole thing was funny as hell. But he told me the general counsel's office was really peeved and he was supposed to be telling me off. "When you walk out of here, I want you to look like I've really given you a good hiding, that I have just cleaned your clock," he told me. So I left his office, walking along with my shoulders slumped like I'd just gotten caned.

My big mistake

Several years after leaving Southwest, our old CEO, Lamar Muse, set up another airline, Muse Air, to compete directly with us. It was called Revenge Air in the financial community, and I suppose one of its purposes was to take Southwest Airlines down. By 1985 it was on the verge of collapse. We wound up buying it, renamed it TranStar, and operated it as an independent airline. But I made one miscalculation: Frank Lorenzo [the notorious CEO of Texas Air]. He was operating out of Intercontinental Airport in Houston, and we were operating out of Hobby Airport, also in Houston. He took out after TranStar like you wouldn't believe. It turned into probably the most severe fare battle in the history of the airline industry. People talk about the fare wars that have raged in the industry, and I've seen plenty of them. I've seen carriers offering green stamps, Polaroid cameras--all sorts of things--if you flew on them. But this got to the point where Frank was offering free roundtrips to Polynesia. When we put in service between New Orleans and San Diego and had a flight that was, say, at 8:15, then Frank would put in one that was at 7:45 and one at 8:30. I said, "Well, that's it--we're not putting in any more money to fight this war." So we wound up selling the company's assets to Frank Lorenzo.

In CEO years I was kind of young then--but one thing I knew was that when something turns into a financial mistake, just stop it. You have to look at things the way a scientist would: This experiment didn't work out; it's over. You can't get emotional about it. That's the key as far as I'm concerned: There's no ego involved. You can't keep something on life support for years and years because you've let your self-esteem get tied up in things.

The little things add up

The years between 1990 and 1994--that was a horrible time for our industry. The worst that I'd seen. The country may have been in a recession, but the airline industry was in a depression. It lost $13 billion during those years. It started with Desert Shield, which turned into Desert Storm. You had a war in the Middle East, which caused fuel prices to go up just precipitously. I mean, overnight. It was just humongous sums of money. At the same time, you had a downturn in the economy. On top of that you also had a lot of people who were afraid to fly for fear of terrorists. All of those combined was absolutely devastating.

How did we stay profitable then? I've always said--I think people are getting bored of hearing it--manage in good times so that you're ready for bad times. Most people think of us as this flamboyant airline, but we're really very conservative from the fiscal standpoint. We have the best balance sheet in the industry. We've always made sure that we never overreached ourselves. We never got dangerously in debt and never let costs get out of hand. And that gave us a real edge during that time.

It's the same today. Now we've got another crisis. Jet-fuel prices are skyrocketing, and our industry is suffering. But we were prepared. In the middle of 1999, I started to think we were all deluding ourselves about cheap fuel prices. Fuel prices were so low--it got down to $10 a barrel, you know. And because they were so low, I realized we were getting lax about other costs. People tend to get a little careless when one of your cost elements is so cheap. So I had an internal cost study done, and it showed that our nonfuel costs had increased 22% faster than those of the other airlines over the last couple of years. At that point I knew we had to do something or we'd be in trouble somewhere down the line. We did two things. First, we asked our people to cut our nonfuel costs. I wrote a letter asking each of them to save $5 a day. It sounds like nothing, but, believe me, the little things can really add up. By each saving $5 a day, our people at Southwest helped cut our costs last year by 5.6%--which is extraordinary in one year. Then we also hedged 80% of our fuel costs--at $22 a barrel. Jet-fuel prices spiked precipitously shortly thereafter [fuel cost at press time was $28 a barrel]. When the crisis hit, we were ready.

I'll never be a recluse

People often ask me if getting diagnosed with prostate cancer two years ago is why I'm stepping down. For me, the cancer was never an issue. It was just something I had to get through, and I tried to keep my sense of humor about it. Actually my doctors had wonderful senses of humor. And I tested all of them. One day I walked into the exam room with a lighted cigarette. I just wanted to see what would happen. They went berserk. They said, "You can't do that! Put that out!" And I said, "I don't have anywhere to put it out. If you want smokers to put out cigarettes, you ought to have ashtrays. You want me to put it out on the floor?" And they laughed and said, "Get out of here!"

I had an agreement with the board that when I got to be 70, we ought to do something about succession. I guess the board just thought it might be embarrassing to have a chairman and president and CEO who was 70. You should never become infatuated with power. If you have any common sense, you know the time will come when you have to let go.

I thought about who would be my successor very seriously for quite some time. My biggest concern was that I wanted someone who would be respectful of Southwest's culture and would be the sort of person who was altruistic in nature. I think Jim [Parker] and Colleen [Barrett] fit that. Someone asked Jim, "How are you going to handle succeeding Herb?" And he said, "Well, Colleen's going to handle the smoking, and I'm going to handle the drinking." At least they've got that divided up.

I've seen people retire from Southwest Airlines and become reclusive when they left. But I don't think I'd ever become a recluse. As chairman, I'm going to continue to be responsible for some of the things I love doing, such as fighting for Southwest in Washington. When I start to have more time, I have thought that I might write a few things. I might write about science. I might write about astronomy. I might write about Southwest. It would be a fascinating story. When I look back on all my years at Southwest--all the fights, the fare wars, the political battles--I just think to myself, "That was a hell of a lot of fun." And I wouldn't change a thing.

REPORTER ASSOCIATE Alynda Wheat

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