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Southwest Airlines (NYSE:LUV)

Q4 2008 Earnings Call

January 22, 2009 11:30 am ET

Executives

Gary Kelly – Chairman, President, and CEO

Laura Wright – Senior Vice President of Finance and CFO

Analysts

Gary Chase- Lehman Brothers

William Greene- Morgan Stanley & Company, Inc.

Duane Pfennigwerth – Raymond James

James Parker – Raymond James

Helane Becker – Jesup & Lamont

Operator

Good day everyone, and welcome to the Southwest Airlines fourth quarter 2008 earnings conference call. Today’s call is being recorded. We have on the call today Gary Kelly, Southwest’s Chairman, President, and Chief Executive Officer, and Laura Wright, the company’s Senior Vice President of Finance, and Chief Financial Officer.

Before we get started, please be advised that this call will include forward looking statements, because these statements are based on the company’s current intent, expectations and projections, they are not guarantees of future performance and a variety of factors could cause actual results to differ materially.

This call will also include references to non-GAAP results, therefore please see our earnings press release in the investor relations section of our website at Southwest.com for further information regarding our forward looking statements and for our reconciliation of our non-GAAP results to our GAAP results.

At this time I’d like to turn the call over to Gary Kelly for opening remarks, please go ahead sir.

Gary Kelly

Thank you Steve, thank you everyone for joining us this morning and happy new year everyone. We are pleased, once again, to report a quarterly profit, and a full year profit. The fourth quarter 2008 represents our 71st consecutive profit, excluding special items, 2008 the full year represents our 36th consecutive year of profitability, and in a year like we had in 2008 that is no small accomplishment so I want to thank all of our employees at the outset, it is a phenomenal job in what was a roller coaster year.

Obviously we have a deep recession, and despite a deepening recession our people produced very strong revenue results. I’d like to make a comment about that first.

I am very proud of them, I am very proud of the industry leading operational excellence that they produce everyday, and also the industry leading customer service.

We had another very strong year of on time performance, we have near the top, a few as customer complaints, and we have very few flight cancellations for the year, all of those very important metrix. Once again, our people have us right up at the top in the industry. Virtually every survey that we conduct internally, or see externally reveals Southwest Airlines to be a top brand in our industry, and getting better and I’m very proud of that and I’m very proud of our people for that.

We continue to out-perform our competitors on revenue growth as evidenced once again in the fourth quarter, clearly evidence that our no hidden fees campaign is working.

Last year we made great progress in enhancing our customer experience, things like our new boarding process, our extreme gate makeover, the ability now to offer Business Select to customers who want that product, our cashless cabin, and we are continuing to invest in our customers this year as well.

We hope to bring internet in-cabin soon; we have continuing development underway of the next generation Southwest.com rapid rewards revenue management, and also expanding our code-share capabilities.

There is a lot of work underway, there is a lot that we are investing in for the future, and I’m very proud of the progress that our folks are making.

It is probably easy for me to say, and everyone understands, that the economic environment has never been more uncertain, certainly in Southwest Airlines history, and accordingly, we have to adjust.

We have adjusted, we will continue to adjust as necessary, and given this very dramatic environment, our immediate goals will be to protect, we want to protect our financial health, and we want to protect our profitability, and our adjustments will be guided by those two over-arching goals.

As to what we have done to adjust, I think just in the nick of time we have cut our fleet growth, and as we are reporting today our fleet growth plans are suspended indefinitely. I definitely want Southwest Airlines to grow, I believe we will be able to grow, but that is certainly a secondary objective in this kind of an economic environment.

Coincident with that, we slashed our capital spending for 2009 and 2010, and Laura is going to report on that in a few minutes. We have also boosted our liquidity.

In a world where credit is simply unavailable, no company can afford to sit by and not seek access to the capital markets, and I am absolutely delighted that we were able to do that and in very, very short order despite a very difficult environment, I think despite a lot of cynics who said that we would not be able to raise money in that environment, so I’m very proud of our finance department, for what they have accomplished there.

Energy prices have been all over the map in 2008, they have collapsed, and we have had to adjust and adjust aggressively. We have managed our fuel hedge position quite well, we’ve managed it for a bear market, and we will be prepared for a bull market when that turn comes, and surely it will, certainly for the time being we foresee very soft energy prices.

We are going to continue to optimize each flight schedule, and by that we mean we will continue to prune unproductive flights, an this is a technique that is unprecedented for Southwest Airlines, so I am very proud of our schedule planning department, number one, to have the foresight to get that capability in place, and number two to deploy it so effectively.

Even with that, we are delighted that we will be able to at least for this year continue to expand out route map, so while we will not be increasing our flight activity, we will be reallocating some of our flights to some new opportunities that we think are quite exciting, Minneapolis/St. Paul is coming in March, and hopefully we can close on our transaction to ultimately acquire slots for New York’s LaGuardia airport. I would expect that at earliest, we would close on that transaction in March, and then would have a schedule announcement for LaGuardia after that.

Having said all of that, all the while what we want to do here at Southwest Airlines is take care of our people, protect our employees, preserve the culture because that is so important to what we do, and our whole customer service experience. I am very pleased that we have been able to do that.

I want to thank our people one more time for a very solid 2008, and as despite some extraordinary challenges, and I for one am very glad that 2008 is over, and I would say that Southwest Airlines more than just survived it, we are very, very well prepared for some really tough times, and that is when our low-fare brand and our people have historically really excelled.

Finally, I would like to turn it over to Laura Wright, our Chief Financial Officer, to go through the earnings report.

Laura Wright

Thank you Gary and good morning everyone, including our webcast listeners.

Our fourth quarter GAAP results included special non cash charges, totally a net $117 million relating to mark-to-market, and other items associated with SFAS 133.

Excluding these special charges and other special items, our fourth quarter net income was $61 million, or $0.08 per diluted share. These results exceeded Wall Street’s mean estimate of $0.05 per diluted share.

Since we fielded just a few (inaudible) hedge questions recently, I am going to begin with a discussion regarding our fuel costs and our hedging.

We recently announced a significant reduction in our net fuel hedge portfolio to approximately 10% in each year, from 2009 to 2013. The net 10% fuel hedge in each year represents our aggregate hedge portfolio combining our original hedge positions that still exist today with the offsetting hedge positions we layered on during the fourth quarter.

The result is a remaining 10% net hedge in each year from 2009 to 2013. Based on current market prices, we are estimating our 2009 fuel cost per gallon, including fuel taxes to be less than $1.90, but to exceed the current market price by about $0.17 per gallon.

Although this is higher than market, it is significantly less than our economic jet fuel cost per gallon, including fuel taxes, of $2.32 in 2008, and it is almost $1.00 less than what we were forecasting for our 2009 fuel costs back in July, when prices peaked, representing approximately 1.5 billion in annual 2009 savings.

In fact, even with this significant hedge portfolio we have in place, we have participated in about 85% of the decline in the market since last summer, resulting in accumulative $10 billion reduction in our projected fuel and oil expense for 2009 to 2013 in total based on the current forward curve.

As of two days ago, the total net liability of our entire fuel hedge portfolio is approximately $1 billion.

To provide you with some sensitivity with respect to the impact of the remaining net 10% hedge, our 2009 economic fuel price at $25 a barrel is estimated at $1.14 per gallon including taxes, which is a $0.24 increase above the un-hedged market price at that level

At $100 a barrel, that estimate increases to around $3.25 per gallon including taxes, which is a $0.09 increase above the un-hedged market price.

Again, using the current 2009 forward curve as it exists today, we are estimating approximately $0.17 per gallon increase over un-hedged fuel prices for 2009, so clearly we benefit from our remaining 10% hedge, which begins to provide some price protection as you move up the cure for 2009.

However, since the remaining hedge volume is only 10%, the hedge does not generate enough gain to completely offset some locked in losses until crude reaches approximately $140 a barrel on average for the year.

For 2010, using a flat curve, at the $25 and $100 crude levels I just walked through for 2009, we estimate a similar amount of spread between our 2010 economic fuel price per gallon and the un-hedged market prices.

Again, all of these sensitivities assume there are no changes to our existing hedge portfolio.

The existing fuel hedge liability could potentially by offset if we can successfully layer in additional hedges in advance of a rising fuel environment. We certainly do not wish for fuel prices to rise, but we will not abandon our philosophy of protecting our costs through hedging.

With respect to our fuel hedging strategy, we have not changed our fundamental philosophy that we must protect our cost structure from market volatility and catastrophic increases. However, in the current environment, with a very weak economic outlook, significant deterioration in demand, surplus inventory, and a paralyzed credit market, we do not believe it is the time to be long on energy. It is a bear market with a very contango, which means that the back end of the curve is significantly higher than the (inaudible).

As opportunities unfold that allow us to put in protection in a cost effective manner, we are well posed to react.

Turning now to our fourth quarter cost performance, excluding fuel, our unit cost excluding special items increased 10.9%, largely due to the significant increase in our fuel costs.

Even though we realized 32 million in favorable cash settlements from our fourth quarter fuel hedge contracts, our economic fuel cost per gallon increased 24% to $2.27 per gallon versus fourth quarter of ’07.

Our fourth quarter economic fuel prices include approximately 39 million in fuel sales and excised taxes. During the quarter, we reclassified our fuel sales and excise taxes from other operating expenses to fuel and oil expenses for both the current and all prior periods.

Excluding these taxes, our fourth quarter economic fuel cost was 2.17 per gallon, which was slightly better than expected, due to the rapid decline in energy prices throughout the quarter.

Based on our current net fuel hedge position and market prices, we expect our first quarter 2009 economic fuel prices including taxes to be in the $1.80 range, including taxes versus $2.10 at which we recorded in the first quarter of 2008, which we have restated to include fuel taxes.

This$1.80 range estimate for the first quarter includes a $0.17 per gallon fuel penalty versus un-hedged prices.

Because of the instruments we chose to use to reduce our net fuel hedge to 10% in each year for 2013, we did not incur any additional premium costs on these transactions.

However, we still incurred the premium costs associated with the original contracts, which were approximately 22 million in the fourth quarter. We estimate our first quarter 2009 premium costs will be in the $32 million range.

Our fourth quarter unit costs excluding fuel and related taxes increased 6.9% to $6.86, which was in line with expectations.

As expected, increased airport and maintenance costs contributed to our fourth quarter ex-fuel unit cost increase, although there was about a 1% cost penalty associated with minimal fourth quarter capacity growth, RASM increase from our capacity changes more than offset this chasm penalty.

We expect our maintenance, airport, and additional cost pressures associated with further reductions in our capacity to continue into the first quarter of 2009.

As a result of these trends, we currently expect our first quarter 2009 unit cost excluding fuel and related taxes to exceed first quarter 2008’s 6.86 cents.

We anticipate an additional 2% chasm penalty in the first quarter attributable to the 4.4% capacity reduction. However, the rise in increases associated with our January capacity reductions well exceeds this cost penalty.

A 20% year over year increase in our maintenance unit costs were primarily driven by increased airframe maintenance costs. We also experienced increased engine maintenance costs, and we anticipate our first quarter maintenance cost spend to be similar to our fourth quarter 2008 spend.

Our landing fees and other rentals unit costs increased 18% to $0.65, primarily due to airport rate increases and fewer favorable airport audit adjustments this year. Although our airports are generally trying to respond appropriately to the recessionary reductions in industry capacity due to continued rate inflation at various airports, and the expectation that we will not receive a similar amount of favorable adjustments in the first quarter of ’09, we expect our first quarter airport unit costs to be exceed fourth quarter 2008’s $0.65, and we are currently estimating first quarter’s to be in the low $0.70 range.

Our salaries, wages, and benefits increased to 3.23 cents over the same period last year, primarily driven by increased health care costs, accruals associated with our ongoing labor negotiations, and weather related costs.

Our stock option expense for the fourth quarter was 5 million, versus 7 million last year. Our profit sharing expense was 18 million, our 401K contribution was 37 million, and based on our current cost and capacity trends, we expect our first quarter 2009 salaries, wages, and benefits unit costs to increase from fourth quarter 2008’s 3.32 cents, but to not exceed 3.40 cents.

Our aircraft rents for ASM were flat year over year at $0.15. Due to our recent sale-lease back transactions, we currently expect our first quarter 2009 aircraft rent for ASM to be around $0.18.

Our other operating unit costs, excluding fuel tax increased 2.3% to 1.35 cents, primarily due to revenue related costs. We currently expect our first quarter other operating unit costs to be under 1.50.

Interest expense increased during the fourth quarter 3%, due to prior year and 2008 financing transactions we expect our first quarter 2009 interest expense to be under $50 million.

With respect to guidance on our tax rate, we currently expect our first quarter tax rate to be in the 38% range.

Moving to revenues, we were very pleased with our record fourth quarter performance. Despite a very troubled economy, our operating revenues were up almost 10%, with a 0.8% capacity increase to $2.7 billion, which was an 8.8% unit revenue, or a RASM increase.

Our passenger revenues increased 9.8%, at 2.62 billion. Our traffic declined 1.4%, resulting in a fourth quarter load factor of 67.8%, which was 1.5 points lower than last year’s strong first quarter performance of 69.3%.

Although our load factor declined, our yield was up 11.4% year over year to 15.19 cents, and our average passenger fare increased 14.9%, to $126.12. We are very proud of these results and the progress that we have made to grow revenues.

In addition to fare increases, we have enhanced our revenue management capabilities significantly over the past year, both of which contributed to our yield and fare increases.

Our schedule planning, revenue management, and marketing teams are doing a terrific job optimizing our schedule, and maximizing our revenue opportunities in this challenging economic environment.

The revenue impact of our capacity changes represented 2 to 3% of our year over year RASM increase during the fourth quarter.

We have enhanced the customer experience and created more value for our customers with our new boarding process, and our new Business Select product.

Business Select revenues was 19 million in the fourth quarter, and almost 75 million for full year of 2009. On a unit revenue basis our resin year over year trends for October and the holiday periods were strong.

October’s resin was up 14% on a year over year basis and resin was up year over year at approximately 7% for November and December combined. Based on bookings and revenue trends so far January is also tracking to be up around 7% year over year.

Post-January we are seeing notable [softness] in our booking trends. It’s tough to measure the impact since our booking curve is so short. We did see more close-in bookings in December and in January then we have been experiencing, however, we also saw our [hot air trans] exceed non-holiday periods. So we do remain cautious.

Based on current trends, and taking into account the eastern mismatch, eastern was on-April 12th, this year; it was on March 23rd last year- we do not expect that January’s strong [inaudible] will continue into February and March.

Again, with the shortness of our booking curve, it’s difficult to draw any meaningful conclusions regarding trends. However, our outlook must be cautious given the recessionary environment.

Our 4th quarter revenues increased 5.7% to $37 million at the result of higher rates. Based on current trends, we expect similar year over year growth in the first quarter of ’09 at no guarantee in this weak economy.

Our other revenues increased at 8.7% for $75 million primarily due to increase business partner income and increase military charter revenue. In the first quarter of 2009, we’re expecting other revenues to move more in line with our year over year capacity changes.

Turning to the balance sheet, we ended the year with core unrestricted cash and short term investments at $1.8 billion. Considering the difficult credit markets we were pleased to complete several transactions during the fourth quarter, the [singular liquidity] of $1.1 billion, we drew down $400 million of our $600 million revolving credit facility.

We raised $400 million through a secured [term one]. We raised $173 million from the first five aircraft [tranche] of our sale-lease back transaction and we monetized $91 million of our offshore rates securities under a new line of credit. Subsequent to year end, we have also closed on the second five year [tetrads] for another $173 million.

Taking into consideration all of these recent financing transactions, our leverage, including the aircraft leases, including those that we closed in January, is approximately 45%. The value of our unencumbered aircraft at year end is around $8 to $9 billion and we still have $200 million available under our $600 million unsecured revolving credit line. And we remain the only U.S. airline with an investment [grade] rating recently affirmed by all three credit agencies.

Our year end quart-half balance of $1.8 billion was subsequent the posting of $240 million in cash collateral to our fuel hedge counter parties. As of January 20th, we have posted $300 million in cash collateral and have used approximately $50 million of our $400 million aircraft fuel hedge collateral.

We are not required to post any collateral of the remaining portion of our hedge portfolio. We previously announced an agreement with one of our counterparties that significantly limits potential cash collateral requirements with that counterparty. Under the new agreement our cash collateral obligation is limited to $300 million as long as our market-to-market exposure with that company is less than $700 million. Any potential exposure between $300 million and $700 million has been collateralized with Boeing 737 and 700 aircraft.

This is the only counterparty that currently has any cash collateral obligations given our investment grade credit rating. Our required cash collateral post would have been approximately $500 million and higher at January 20th had we not substantially modified our fuel hedge portfolio during the fourth quarter and completed the collateral agreement with one of our counterparties.

We currently have hedging agreements with eight counterparties that currently have major contracts with only three of them. Although not all of our counterparties require cash collateral, based on our investment grade credit rating, we will continue to explore any and all avenues to minimize our exposure to any potential liquidity risks.

Our full year 2008 capital expenditures were $923 million and for 2009 we current expect our cap spending to be in the $150 million range which is about $250 million less than we reported at last quarter’s conference call due to the decrease in Boeing progress payments related to the revised 2010 and 2011 delivery schedules as well as cuts that we have made in our non-aircraft spending.

For 2010, we currently expect our capital expenditures to be in the $800 to $900 million range. And I’ll close today with some comments regarding fleet and capacity plans. We did not take deliveries of any new aircraft during the fourth quarter but we returned one lease 300.

The three remaining Boeing… 700s that were scheduled for the fourth quarter of ’08 were delayed as expected into 2009 due to the Boeing machinists’ strike. So for 2008 in total, we added 26 aircrafts and we returned 9-300 to [inaudible] to end the year with a fleet with 537 aircraft, two more than previously expected due to the delay of [] 300 lease returns planned for the fourth quarter but delayed into the first quarter of ’09.

Our fourth quarter available [seat…] capacity increased 0.8% and our full year 2008 AMS increased 3.6% year over year. For 2009, we expect to take delivery at 13 new Boeing aircraft which includes the three originally scheduled for delivery in ’08.

We also plan to return or retire 15 aircraft to end 2009 with a fleet count of 535. Today we announced our revised Boeing 737-700 delivery schedule. We worked with Boeing on adjustments to the delivery schedule to reflect impact from the machinist strike and our own desired growth in light of the current economic environment.

We reduced our 2010 aircraft deliveries to from orders and we reduced our 2011 aircraft deliveries to ten to firm orders and ten options. We also exercised five options for firm delivery in 2016. Additional adjustments have been made to the schedule in 2011, however our total firm orders, options and purchase rights remain at 2020 and we’ve included the revised delivery schedule in the accompanying tables to the press release for your convenience.

For the first quarter of 2009, we are currently expecting our available seat miles to decrease 4.4% year over year. We remain cautious about our 2009 growth and current expect to reduce our available seat miles by approximately 4% for the year.

We continue optimizing each published flight schedule and since August of 2007 we have eliminated approximately 10% of daily flights from our schedule. This continual pruning of unproductive capacity allows us to increase the potential efficiency and profitability of our network and provide flexibility to pursue compelling market opportunities.

And Steve, with that Gary and I are ready to take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Thank you. If you would like to ask a question, press start one on your touchtone telephone. Please make sure your mute function is turned off to allow your signal to reach our equipment. Again, press start one for questions and we’ll go first to Gary Chase [Bar Place] Capital.

Gary Chase- Lehman Brothers

Hi, good morning, everybody.

Laura Wright

Hey, Gary.

Gary Kelly

Hey, Gary.

Gary Chase- Lehman Brothers

Guys, I wonder if you could just very quickly, could you just give us a conceptual explanation of what you did with the hedge book and how you’re thinking about those losses. In other words, if you were to look at it on a market-to-market basis, today if I read the release, there’s a billion dollars market-to-market loss.

You’re spreading that over your gallon consumption between here and I think I saw disclosure as far out as two 2013. Is that the right way to think about it and I know it’s placed a little bit differently in the years. You’re in essence locking in a loss and spreading it over those periods or am I not getting that right?

Gary Kelly

Well, I think that’s the right way to think about it although it’s a bit of an oversimplification. But we have a hedge position all the way through 2013 so you understand that correctly. The market-to-market is now largely contained around a billion dollars because we have substantially reduced the hedge portfolio. So there’s not a great risk, in other words, that it goes a lot higher than that.

I want to let Laura speak to this too but I think the way to view it is that we have built our hedge insurance policy with options and those options are mostly collars. I know you’re familiar with all of this, Gary. We have not sold those instruments; we still have them. So to net the hedge down to a net of 10% we’ve sold two ops against it.

So I think the way to visualize it is we’ve got a pool that’s long and we’ve got an offsetting pool that’s short. The losses on the long part exceed the one billion dollars but gains on the short part offset that so we can- depending on our view of fuel prices in the future we have a long way to go before I think we’re ready to concede that we have “locked in losses” for the next five years.

I think the way that we’re viewing it is that we’ve caped our losses at this point so that there’ll be roughly no more than about a billion dollars. And it’s all with the understanding that we still have a small hedge out there at 10%.

Gary Chase- Lehman Brothers

I guess, Gary, just trying to, again, get my arms around it conceptually; what did you have to sacrifice to cap that loss? Because there was no premium paid.

Gary Kelly

We just did swaps, Gary. So they were straight up sale of swaps. They were short swaps in essence and if we want to unwind that we simply buy the swap back and it reactivates the hedge.

Gary Chase- Lehman Brothers

Ok, now I understand what you’re saying. That you for that. Laura, could you also give us- when you read the press release you talk about notable softness in bookings.

I know you don’t want to give an exact number but is there any way to quantify what that means? Can you tell us what book load factors are doing and just give us a little bit of help on how we might think about what it means to be notably soft?

Gary Kelly

Well, let me answer that first. First of all, the bookings are less for at least March, April then they were a year ago. February, I think, is building. And I don’t think we’re ready to predict as an example that our February load factor will be less than last year. We just don’t know yet.

So the best answer we can give you is you know what’s happened in the fourth quarter, you know what we reported thus far in January. We’ve said that bookings are soft in the future. They were for December and January also and December-January so far turned out to be pretty good.

So, I don’t think any of us are comfortable in predicting one way or the other. I think that that’s the watch word right now for the outlook for 2009 and is a tremendous amount of uncertainty. But we’re not trying to guide you one way or the other we’re just trying to tell you exactly what it is.

And I’ll let Laura tell you what the exact bookings are and I’ll just caution you once more. It would be dangerous to draw any real meaningful conclusion from such few bookings that are out there for particularly the March-April time period.

Gary Chase- Lehman Brothers

I think that’s what I was driving at, is I certainly agree with you on the uncertainty part but I was driving at bookings have been soft for the last several months when RASM has been good, so, this isn’t necessarily new. It’s just no one knows.

Gary Kelly

I think that the bottom line is bookings can’t be anything that we can hang our hat on to support a continued outlook consistent with what we’ve seen in December-January. We’re going to have to build a lot of bookings between here and there to be able to continue that run rate and we don’t know whether we can do that or not. That’s certainty the objective. We just don’t know.

Gary Chase- Lehman Brothers

Thank you very much.

Gary Kelly

I think Laura wants to-

Gary Chase- Lehman Brothers

Oh, sorry, sorry.

Laura Wright

Let’s give it some color, Gary. If you look at February, our booked revenue’s down about 12% at year over year but you have to think about where we are for February. At the beginning of January, we only usually have about 20% of our bookings in place and that builds during the month. So again, we saw a lot more late bookings in December. We see more in January, so it’s hard to tell but the bookings are down year over year.

Gary Chase- Lehman Brothers

Ok and set capacity’s going to be down?

Laura Wright

February, yes. For the 4.4%.

Gary Chase- Lehman Brothers

So down 12 revenue on down four and a half capacity?

Gary Kelly

Adjusting for the leap year in February.

Gary Chase- Lehman Brothers

Ok, thank you.

Operator

We’ll go next to William Greene with Morgan Stanley.

William Greene- Morgan Stanley & Company, Inc.

Good morning. I’m wondering if we can talk a little bit about the Tafax numbers. As you take delivery of the new aircraft in your selling holder craft, obviously you’re still making a pretty sizable net investment in the fleet. And we’ve struggled a little bit here in the returns and we’re in a period of weakness. So, why wouldn’t you be selling some of the new aircraft to reduce the capital spending to essentially maintenance levels until the returns just [pay] further investment in it?

Laura Wright

Bill, we have really reduced our cap spending by reducing the number of new airplanes for taking. If you look at our cap spending for new aircraft versus the guidance we gave you in third quarter row seven, we’re down about $700 million in aircraft spending for 2009.

As you know, it is a pretty ugly credit market out there and as a result there aren’t a lot of people that are able to get financing to buy the new airplanes. We also have a lot of our older airplanes that are nearing their retirement age. You know, they’re 25 years old.

So we think we’ve reached about [] with returning a modest number of our older airplanes, which have higher operating costs and reducing our cap exposure by significantly reducing our new aircraft spend.

Gary Kelly

Bill, if we can do that, we will. I don’t think we disagree with the objective that you described. We’ve been marketing airplanes for months and have not been able to close the transactions. So, I just don’t know that that is a realistic alternative for us at this point.

William Greene- Morgan Stanley & Company, Inc.

Ok, that makes sense.

So when you talked about the growth assumptions, and you talked about being sort of indefinitely suspended, so how should we think about your long-term growth assumptions, then? And how do you adjust a company that’s had decades of growth to a period of, could be years, of no growth, I suppose, depending on the economy?

Gary Kelly

Well, I think that’s one reason that we have to lay out at least an intermediate term vision that’s says we’re not going to grow. And we are going to have to- it’s a growth factory, as you know. So those elements of our company that are geared towards hiring and training and deploying, etc. we’re going to have to scale back and redeploy those activities.

The more certainty we have with that kind of direction, you know, the more efficient we can be in doing all that. So for this year, we’ve consistently been saying that, at least for the last several quarters that we don’t want to grow the fleet for ’09.

The report today is that we’re extending that thought through 2010 and what we do at ’11, I don’t think we’re real worried about right now. Laura’s done a good job with working with Boeing to give us even more flexibility with our fleet. We will have some retirement options coming up in 2010, 2011, 2012.

So, we’ve got a lot of flexibility on that front. If that’s the way things pan out. Now as I said at the outset of my comments, while the immediate objective is to make sure that we protect our financial health and our profitability, we still want to grow. So that’s a desire. And I think we want to continue to do the best we can to build the means to do that profitably. Keep our costs low, keep our service levels high and in face we’re investing to improve our customer experience.

So, I thin it remains to be seen exactly how successful we are with the investments that we’re making. We’re all very confident that our revenue plan is going to work. But, just to bring it back to a more pragmatic approach, we still need a sizable contribution from co-sharing, from the next generation Southwest.com, the next generation of Rapid Rewards, and that will help answer the question about whether it would be prudent again to begin growing a fleet again.

But, my hope is that we’re actually growing the fleet sooner than later. But that gives us at least a 12 to 24 month time horizon to be thinking that we won’t be growing the airline. In fact, we’re going to be aggressively pruning out those flights we don’t think are productive. So that’s the priority right now.

William Greene- Morgan Stanley & Company, Inc.

It sounds like what you’re also suggesting is that it’s got to be a revenue driven story to some extent because when you have no growth it’s going to be a challenge to keep those costs flat at best, I would think.

Gary Kelly

I would concede that, Bill. Although life just doesn’t stop, it’s never one-dimensional, one-focus so part of our DNA is to be low-cost. Part of our brand is to be the low-cost producer and offer low fares. So, right now, yes, we’ve got a very intense focus to transform the airline that you’re very familiar with.

That does not mean that we’re going to take our eye off the ball in managing our costs and in fact we may have to double down our efforts over the next two to three years to rein this cost growth in. So, we can’t take our eye off of that ball either.

If I look at our cost performance over the last five years, [notwithstanding] but I think we’re undertaking the next three years from a very strong position. But as we’re optimizing the flight schedule, it may be optimized from a marketing perspective but it’s not optimized from a cost perspective.

So there are some future opportunities across the spectrum here at Southwest Airlines as we continue to get more and more efficient.

William Greene- Morgan Stanley & Company, Inc.

Ok, thanks. That’s helpful. Just one last question: Leverage ratio, where do you want it to or where are you comfortable letting it go to?

Gary Kelly

Well, these are tough times, you know, so I’m glad that it’s strong where we are. So, I think we definitely want to keep our leverage ratios modest. Something less than 50% has been our long-term target and we’ve shared that often and over many years.

As long as we can boost our profits this year we [will have] a substantial improvement in our outlook for two reasons: the industry capacity is down dramatically and fuel prices have collapsed. So this year alone we’re going to save $1.3 billion compared to what we thought we were going to spend.

So, I don’t see any immediate danger of us having our leverage get out of control. But that assumes the economy supports a reasonable revenue outlook. If that proves to be untrue, well then, we’ll be scrambling like everybody else. But I don’t think that that’s the most likely scenario.

William Greene- Morgan Stanley & Company, Inc.

Thanks for your help.

Operator

We’ll go next to Mike Linenberg of Merrill Lynch.

Mike Linenberg

Hey, good morning, all. Two questions here; I guess first, on fare sales. You know, Gary, I know late 2008 there wasn’t a lot of activity and I know, I think for the most part we saw very few, if any, sales from Southwest. And more recently, we’ve seen some targeted fare sales. What are you seeing in your markets- you know, anything that can give us a sense of the trends?

Gary Kelly

Well, thanks, Mike. 2008 was for the most part about ten months of intense actions to boost our average fares. So we had a series of fare increases. We had some very purposeful management revenue techniques to boost our yields. We had a new business select product coming online. And we just, again, had the absence of sale activity.

And it worked. It worked very well all the way through October. And then with the markets collapsing in September-October, that just suspended a lot of consumer spending and certainly affected future bookings for air travel.

We changed that tactic in November. And have been aggressively promoting our low fares and offering sales and promotions consistently since then. In that kind of an environment, obviously we do very well comparatively during recessionary times and I think the fourth quarter is good evidence of that.

I thought our revenue management marketing [inaudible] did a spectacular job in recovering very quickly in shifting gears from trying to drive fares up in a higher energy cost environment to, oh wow, now we’ve got a very serious recession and very weak demand and produced a heck of a December and January.

Mark Linenberg

Gary, I realize on the next part of this question you may have to go back to the last downturn but you did indicate that you were promoting the low fares and the promotions being aggressive.

But if you could think back to the ’01 timeframe, because of the cuts to capacity in the system because of the fact that you have a much better tool box- you’re revenue management system is much more sophisticated.

Would you say that maybe you are being aggressive but not the kind of discounting we saw eight, nine years ago? Is it more controlled? Anything you could provide on that would be great.

Gary Kelly

Great question, Mike and I’ll just try to bifurcate the answer here. I think from what we’ve seen so far, starting with November, December, January, that you’re point is accurate. In other words, because the industry has reduced capacity aggressively, we’re absorbing the reduction in demand without destroying unit revenues completely.

And the fourth quarter is evidence of that. And what we’ve reported to you all about January thus far is evidence of that. Those are decent unit revenue gains in any environment, much less a recessionary environment.

I think the $64,000 question is will that continue? We all know that the airline industry is a lagging economic indicator. Will demand hold up or will it worsen from here? And I don’t think any of us know. And we’re not prepared to predict that and we’re going to do everything we can to prevent that.

But clearly what we’ve seen so far is far better than- you lived through 1991- it’s a lot better than that. Actually, I can remember ’91 better than I can remember ’01 but we definitely saw some unit revenue slow-downs. I don’t remember if it turned negative for Southwest Airlines or not but it did in 1991 and it was very, very difficult.

We’re far from that right now. I hope we don’t get there. And because the capacity reductions have been so sharp perhaps that will pay big dividends and make a big difference.

Mike Linenberg

Ok, good. My second is [respecting] on the cost side. For Southwest to start [shrinking], you indicated that it’s a phenomenon, that it’s a new era for the company. Should we assume that as you plan your business for 2009 and maybe even 2010- it’s a slow growth or no growth environment- will we see structural changes like increased aircraft utilization, or to do you resort to increasing the stage length again? Is that something we should anticipate?

Gary Kelly

Well, I think that you and our investor community know what our plans are. I would admit that, as I was trying to point out in my earlier remark, we’re going to have to continue to adjust in order to protect our financial health and protect our profitability if things get worse from here.

I don’t want to reveal the kinds of things that we are exploring but clearly we’re looking for opportunities to improve the productivity of our equipment and our people in a no-growth environment.

From where we are there are more radical changes and more difficult to undertake. It seems like everything we want to do is different than the Southwest Airlines play of the first three decades requires a fairly significant technological investment.

So if we’re talking about a different scheduling technique for the airline then, yeah, that might be possible but it might take some time to implement. I’m very confident with the tools that have been developed this decade in schedule planning the airplanes; n revenue management, as well as operating the rest of the company on a department by department basis.

We’re very well prepared for this environment. But right now we’re going to run the play that we described. And we’re going to trim our capacity this year. It’s already paying handsome dividends with the flights that we’ve eliminated this quarter. I’m sort of guardedly optimistic that that will serve us well this year and we’ll have a very good year and be very well prepared to take advantage at opportunities that some of our competitors falter.

Mark Linenberg

Ok, very well, thank you.

Operator

We go next to Duane Pfennigwerth of Raymond James.

Duane Pfennigwerth – Raymond James

Just to expand on Mike’s question- it looks like your PRASM growth in the fourth quarter was roughly double the industry despite the fact that your capacity was up 1% and the industry down double digits.

So as you sort of attribute that to items, I mean things that you’re doing, capacity reduction on the part of your competitors- how do you rank those and how do you explain that dynamic?

Gary Kelly

Outstanding leadership, Dwain, but in addition to that, we all know that’s a joke. I do think that we have been building to this point over the last several years and it’s beginning to pay some nice dividends.

I think the Southwest brand is stronger than it ever has been, I think the customer response that we have had to the changes and the no hidden fees approach I think is working. In addition to that, we had made some good scheduling adjustments that were reflected in the fourth quarter results, there are even better ones that were done in January.

I think what we are seeing is a trend change, from the September October time period, where we know that we are benefiting the airline revenue production by making these schedule changes. You are not going to see them where we are thinking because there is this recessionary effect that is at least showing up somewhat on yields. The net effect of that is obviously better than it would have been without our schedule changes.

I am very proud of our people, I think they have done a tremendous job. It is classic Southwest Airlines to face down adversity and certainly our low fare brand stands up very well in this kind of an economic environment. You put all of that together and, obviously, we are going to challenge our people to continue to outperform the industry.

Duane Pfennigwerth – Raymond James

That is helpful, I have one more question and then Jim has one. Can you tell us where the price is on your ’09 hedge, or asked differently, where would oil need to go, or jet need to go, to trigger additional collateral from here?

Laura Wright

The remaining 10% hedge, the best way to quantify that is with some of the sensitivities that I walked through during the call. When you look at the way that we offset those hedge positions there is not an exact match, you look at the lever you put it on and the level you took it off. What we wanted to provide you with was, with current market prices for ’09, it is about a $0.17 penalty, and then we walked through if prices decreased what the change would be and if they go up where we start getting benefits.

Again, if we move up to about $100 a barrel that $0.17 penalty declines to around $0.14. That is really the sensitivity that you need to be thinking about in terms of where that remaining 10% hedge provides protection. You had a second question as well.

Duane Pfennigwerth – Raymond James

On the collateral, does oil need to go to zero for you to get more than 700 million?

Laura Wright

We would have to have a flat curve all the way to 2013 of about $25 a barrel for us to exceed the 700 million collateral with that counter-party that requires cash, so we are in pretty good shape there.

Duane Pfennigwerth – Raymond James

Thank you for that detail, Jim?

James Parker – Raymond James

Jim Parker, just quickly regarding competing capacity and the impact on your RASM, it appears that in the first and second quarters of this year, competing capacity is going to be down 15%, but is a more relevant figure, does that include Southwest capacity? When you do that total seats look like they would be down 8% in the March quarter, and maybe 9% in the June quarter, which is more relevant?

Gary Kelly

Great question Jim, you are right on point. I think everything Jim said is factually correct, I know that our competitors are down about 15% on a seat, and then we know that we are down about 4% and the combination of 8, Laura?

Laura Wright

I have 7 to 8% total capacity reductions in our market.

Gary Kelly

Jim, to your point, so everyone can realize this, we typically go into markets and with our low fares and great service put a lot of flights in there, so we tend to have the majority of the flights and seats in the markets that we serve. Looking at it on a combined basis is the appropriate way to think about it.

Some of our markets, in other words, our competitors could be reducing their seats by 15%, but if we have 75% of the seats in the market it does not have that big of an impact on the market, so clearly I think you want to include us because we are so large in the markets that we serve.

James Parker – Raymond James

Thank you.

Gary Kelly

Steve, we have time for one more question.

Operator

We will take that from Helane Becker of Jesup & Lamont

Helane Becker – Jesup & Lamont

Thank you very much Gary for taking my question. Can you discuss the progress you have made at Love Field with the scheduling changes and how much that has added to revenue?

Gary Kelly

One of our successes that we are proud of this decade is the Setting LUV Free campaign, and it will be 2014 before the restrictions at left field are completely lifted, in fact there is a nice article in the Dallas Morning News this morning outlining our plans for Love Field and remaking that airport. We currently have 137 daily departures at Love Field, I want to say that is up, compared to 110 daily departures when the compromise was first reached in 2006, and Laura and Tami can confirm that for you later, but we have been able to boost our flight activity there. We have been able to hold onto that increased flight activity, the load factors and the traffic are up significantly, as compared to the pre-Wright Amendment Compromise, the quarterly revenue boost was, Laura?

Laura Wright

42 million, and that is up from 31 million last year Helane. Year to date our Love Field revenue is 170 million, up from 113 million last year.

Gary Kelly

I think those are benchmarks relative to were we were in Dallas before the Wright Amendment repealed, so admittedly we are going back several years to make that comparison, but the point is while we have benefited from increased traffic from customers and revenues, the fares have come down and we have been able to follow through with our promise, to boost traffic and in and out of north Texas. It has been a really good thing, and Love Field as an airport is in dire need of an upgrade, and that work is agreed to and underway. It is a very good news story and one that we are very proud of. Our folks have done a phenomenal job working with the city of Dallas and Love Field to get it to this point.

Helane Becker – Jesup & Lamont

On the work at Love Field, is that work that you have to pay for, how does that work?

Gary Kelly

Ultimately, the costs are passed through to the airlines, so the easiest answer is yes, although we will work with the city as to how that is funded, and Laura may want to speak to that, but it is a hundreds of millions of dollars project over the next five years or so, and it is in essence remaking the airport, Laura?

Laura Wright

Helane, the estimated cost is just over $500 million and it is expected that about 150 million of that is going to be financed through PFCs, AIP, and NTSA, contributions, and the remaining 350-plus million will be through bonds that are basically backed by Southwest Airlines lease obligations.

Helane Becker – Jesup & Lamont

Thank you very much.

Gary Kelly

Thank you, Helane. Thank you everyone, I believe that is the end of our investment call.

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Source: Southwest Airlines Q4 2008 Earnings Call Transcript
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