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Southwest Airlines Co (NYSE:LUV)

F1Q09 Earnings Call

April 16, 2009 11:30 am ET

Executives

Gary C. Kelly - Chairman of the Board, President and Chief Executive Officer

Laura H. Wright - Senior Vice President Finance and Chief Financial Officer

Analysts

Jamie Baker - J. P. Morgan

Bill Greene - Morgan Stanley

Michael Linenberg - Bank of America/Merrill Lynch

Hunter Keay - Stifel Nicolaus

Duane Pfennigwerth - Raymond James & Associates

James Parker - Raymond James & Associates

Helane Becker - Jesup & Lamont

Kevin Crissey - UBS

Bob McAdoo - Avondale Partners, LLC

Operator

Good morning and welcome to the Southwest Airlines First Quarter 2009 Conference Call. (Operator Instructions) 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 and the Investor Relations section of our website at southwest.com for further information regarding our forward-looking statements and for a reconciliation of our non-GAAP results to our GAAP results.

At this time I would like to turn the call over to Gary Kelly for opening remarks. Please go ahead sir.

Gary Kelly

Thanks Steve and thanks everyone for joining us this morning. Excluding special items our first quarter 2009 results were a loss of $20 million or $0.03 a share and of course while the recession and weak air travel demand aren’t surprises, a loss is always disappointing. Although we did have an operating profit, x items and strong operating cash flow, this represents the first quarterly loss, again x items, since the first quarter of 1991. It was also marked by a mild recession and high energy costs during the first go forward.

I want to thank all of our employees for what I consider to be valiant efforts. Without these efforts our first quarter results would have been much worse and while there is much good to talk about in our first quarter, we need to focus on the prime challenges at hand which is surviving this difficult recession, difficult revenue environment and of course sustaining our profitability, cash flow, and financial health.

We benefited significantly in the first quarter from lower fuel costs. Including our hedging losses, year-over-year our spending was down over $170 million. X items, again, our unit costs were flat with first quarter of 2008. Since January though, we have lowered our 2009 revenue projection dramatically. First of all, going back to our January earnings release for the fourth quarter we reported at that time that bookings for February and March were soft. In fact, when we got into February, and as we reported all quarter long, we began to see a significant softening in our close-end full-fare business travelers. Now, so far that seems to have bottomed out March, but of course with the Easter benefit in April this year confusing our year-over-year trends I am certainly not ready to call the bottom just yet: May should tell us a lot. Again, in May we’ll be watching for those close-end full-fare bookings and at this point in time there is no way to predict what we might see there yet.

I would like to recap what we’ve done so far and what we’re going to do to adjust to this reality. Of course last year we had already decided to slow our fleet growth to zero. I want to reiterate that we have no commitment to grow our fleet and that is indefinite. Certainly we won’t grow our fleet unless our profit outlook supports that. Beginning in late 2007 we began pruning our flight schedule, taking out f

In January of this year, for the first time, we reduced our flying on a net basis; so if you compare our November 2008 schedule to January 2009 we reduced our daily departures by about 190, which is about 5.5% of our November flying. Of course, the result of that was you see that our available seat miles for first quarter ’09 were down about 4.1%. The outlook for the year is in that range, probably down about 5%. The effect of that change was a positive for our operating profit. We boosted our RAS and we think about 3.5 points. We also, of course, penalized our unit costs somewhat; we think about two percentage points. Net that together we feel like we boosted our first quarter operating profit about $40 million.

All of this pruning is continuing. Our August schedule, that we just published this week, will have 72 fewer daily departures than what we published back in January and of course on a gross basis many more flights have been cut and then redeployed to places like Minneapolis-St Paul and I would just mention to you all at the outset here it is off to a fabulous start. It is an instant success. It is an immediate contributor and of course we are hoping for the same result when we start up New York LaGuardia in late June and Boston Logan in August.

Next, we have been aggressively promoting our Low Fare brand that, of course, is underscored by our No Hidden Fees campaign. When you add all of these things together, our schedule adjustments, slowing the fleet growth, and our aggressive promotions, it is working. We had a record load factoring first quarter. At this point in time it appears we will continue to have strong loads into the second quarter and again, all told, I think that certainly helps explain why we are outperforming most, if not all, of our competitors on the revenue front.

Of course, supporting this relatively strong performance is our people. Our brand continues to score extremely well. Our customer service metrics remain at the top of the industry. Our customer experience continues to improve and our operations are just superb. So, there are a lot of good things to talk about and certainly a lot of the reason that we are, again, outperforming our competitors on the revenue front.

As you all know, a significant commitment has been made by Southwest to new technology and the follow on new revenue streams. These initiatives will continue to completion this year and next. Our goal remains $1.5 billion in incremental revenue as compared to 2007 baseline.

On the cost side there a lot of positives. Our fuel burn continues to decline. That is based on a number of ongoing initiatives within the Company. We cut our capital spending. In addition, today we are affirming a freeze on our overall headcount. We are also affirming a pay freeze for senior management. In addition, we are offering something new today. We are offering a voluntary early-out program available for virtually all of our employees, except for our senior management, and that is with the express intent to reduce our headcount. Of course, as we have reduced our flying this year we need to right size our staffing. If you look at our headcount year-over-year we were up about 2%, but our available seat miles are down 4%. So, we need to get that in sync, because certainly the first quarter results suggest that we’re not going to be increasing our flying anytime soon.

Finally, we have adjusted our hedging and boosted our cash reserves with a series of excellent financing transactions. The lady who deserves all of the credit for that is to our right; our Chief Financial Officer is going to take us through our first quarter results. Laura?

Laura Wright

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

Our first quarter GAAP loss included special non-cash charges totaling a net $71 million relating to mark-to-market and of $20 million, or -3 pennies per share, and these results did fall below the Wall Street mean estimate of a $0.01 loss. As a result of the challenging revenue environment, our first quarter of 2009 unit revenues were down 2.9% on a 4.1% decline in available seat miles, with total revenues down $173 million from last year.

We had a decent January, but February was way off trend. March somewhat stabilized, but with the Easter shift we were still down approximately 10% on a unit revenue basis.

Business travel slowed considerably which drove a 2.8% decline in our [yelp]. Our full fare mix for the quarter was 20% which was down four points from the fourth quarter and down almost six points from the first quarter of 2008. Even with this slow down in our business travel, the demand for our business select product held up very well. Our business select revenue was $18 million in the first quarter and that was up from almost $15 million in the first quarter of last year, with 9% more passengers than a year ago.

Our revenue also continues to grow resulting in approximately $38 million in the first quarter versus $34 million one year ago. In response to the weak demand we increased our fare sales and our discounting. This resulted in a record first quarter load factor despite the impact that we had in March from the timing of the Easter holiday.

The Easter shift represented about 1% of our first quarter revenue decline and because of this our April comparisons should be easier.

Month-to-date our passenger RASM is estimated to have increased about 1% on a year-over-year basis due to the Easter benefit in April. However, for the full month of April we expect our unit revenues to be more in line with last year. As Gary pointed out, we’re going to have to see how May and June play out. Our comparisons will become more difficult beginning in May and even more so in June as a result of our 2008 fare increases.

As a result of the increased sell activity and discounting our second quarter booked load factors thus far are ahead of last year, but at lower yields.

While we are hopeful that our revenue trends are stabilizing, without any certainty in the trends following Easter our outlook remains cautious. Thus, based on current revenue trends and the bookings in place for the remainder of the quarter, we are expecting another year-over-year decline in RASM for the second quarter. We remain intensely focused on our revenue initiatives and we are making great progress on our technology improvement.

Despite our overall decline in unit revenues for the quarter, as Gary pointed out, our continued schedule optimization efforts and the overall reductions in competitive domestic capacities had a positive contribution to our unit revenues in the first quarter. We are estimating that the present benefit from the schedule reductions in the first quarter represented about a 3.5% year-over-year increase.

As announced earlier this week, we opened our schedule from August out through the end of October with another optimized schedule. Including this most recent schedule we now have two full years of aggressively optimizing our network and since August of 2007 we have eliminated over 500 flights from our schedule, which is 15% of our daily departures from August 2007. We have redeployed about 300 of those flights, or 10% to our new and developing markets, which are San Francisco, Denver, Minneapolis, New York, and Boston and the remaining is the 5% reduction. And, we will continue to optimize our schedule to eliminate unprofitable flying.

Moving to costs, our first quarter 2009 unit costs, excluding special items, decreased slightly primarily due to the benefit of lower fuel costs versus the first quarter of last year. Our economic fuel costs declined 16.2% to $1.76 per gallon and our cash costs for fuel, after hedging, decreased by $172 million. Again, the spectacular effort of our employees to conserve fuel continues to pay off handsomely. Our fuel burn for ASM was down 2.7% versus one year ago.

As noted in our press release this morning, we have begun to rebuild our fuel hedge portfolio. Lower market prices have presented an opportunity to economically layer back in some protection. We have used only purchased call options for the contracts that we’ve added for 2009 and 2010 to retain the ability to continue benefiting if market prices stay low, yet provide the necessary protection in the event of a significant surge in market prices.

We now have derivative contracts in place for about 50% of our estimated second quarter fuel consumption, halved at a weighted average crude equivalent of about $66.00 a barrel. Our current second quarter 2009 derivatives will result in an estimated $37 million in premium costs which are recorded as non-operating expenses in our Other Gains and Losses. Based on this second quarter position and market prices as of two days ago we currently expect that our second quarter economic fuel price, including taxes, will be in the $1.75 range.

For the second half of 2009 we currently have derivative contracts for approximately 40% of our estimated fuel consumption and they are capped at a weighted average crude equivalent of about $71.00 a barrel. Based on these contracts in place, and the market prices as of April 14, we are currently estimating our full year 2009 economic fuel prices, including taxes, to be in the $1.80 to $1.90 per gallon range. Based on the current 2009 forward curve this represents approximately a $0.16 per gallon increase over unhedged prices for 2009.

As of two days ago the total net liability of our entire fuel hedge portfolio was approximately $950 million liability.

Our first quarter unit costs, excluding fuel, increased 8.4%, which was in line with our expectations, but nonetheless not an acceptable cost performance especially in this economic environment. As Gary mentioned in his opening remarks, we are taking a number of immediate and necessary steps to reign in our operating costs. However, based on our current cost trends and our continued reduction in capacity, we expect our second quarter unit, excluding fuel, to be in line with first quarters 7.07 cents.

Our labor costs increased more than anticipated due to increased healthcare costs and slightly higher costs associated with our labor negotiations. Under utilization of our flight crews with higher reserve guarantee pay, normal step increases, which are not averaged down by new employee wages, the impact from the new labor agreement, and higher benefits all contributed to his quarters 9% year-over-year increase.

Based on the current cost trends, and taking into consideration our ongoing labor negotiations, we do expect some relief in our year-over-year trends in the second quarter for total salaries, wages, and benefits unit costs. Also, we currently expect that our second quarter salaries, wages, and benefit unit costs will decline from first quarter 2009 not to exceed 3.40 cents.

Our maintenance unit costs were $0.76, which was slightly better than expected primarily due to timing of events, but it was still 33% above our first quarter of last year and the increase was primarily due to increased engine maintenance costs. We anticipate our second quarter maintenance unit costs to increase slightly from the first quarter spend due to slightly more airframe maintenance events.

Our lending fees and other rentals for ASM increased 1.5%, which was better than expected, as a result of various audit settlement charges received from airports in the first quarter of 2009. These true ups are really difficult to forecast and they can go either way, but they are generally small as our airports typically do a reasonably good job forecasting their rates. Adjusting for these settlements, we currently expect that our second quarter 2009 lending fees and other rentals for ASM will be in the low $0.70 range.

Our first quarter 2009 effective tax rate of 15% was impacted by our current 2009 financial projections for the year and the related impact that permanent tax differences have on those projections. Since the tax rate is based on anticipated full year GAAP results, which are very fluid, it is very difficult to provide guidance for our full year ’09 rate.

Turning now to the balance sheet, we ended the quarter with core unrestricted cash and short-term investments of $2.1 billion. We maintain our goal of preserving our financial strength in this environment with a core cash target of at least $2 billion. In today’s uncertain financial markets being the only US airline with an investment grade credit rating enables us to access liquidity in an otherwise very tight credit market.

Over the past six months, through the end of the first quarter, we’ve seized the arguably unique opportunity to boost our liquidity by approximately $1.3 billion. Subsequent to quarter end we have executed and closed on the first of an expected two-tranche sell and lease back for six of our Boeing aircraft. The first three of our tranche closed at the beginning of April and with proceeds of approximately $105 million. The second set of three is expected to close in May for a like amount.

Our fuel-hedging program is intended to provide insurance against rising energy costs that prevent inner price risk, but they must also be structured to manage our liquidity exposure. With that in mind, the new fuel hedge positions that we added during the first quarter present no additional exposure to cash collateral requirements.

It is our desire to structure agreements that allow us to use collateral other than cash to the maximum extent possible and we desire to limit our cash collateral exposure to less than $500 million. As such, we have modified our agreements with two of our five fuel-hedge counter parties.

As we have previously disclosed back in December, we completed a revised agreement with a counter party that limited our potential obligation to post cash for collateral for that counter party up to $300 million and in excess of $700 million. Any potential exposure between $300 million and $700 million was secured by 20 of our Boeing aircraft. As of April 14 we had posted $300 million in cash to that counter party and used approximately $50 million of the $400 million aircraft collateral pool.

In addition to that agreement, we recently completed a new agreement with another one of our major counter parties and in this agreement it limits our potential obligation to post cash for collateral to that counter party up to $125 million. Any potential exposure between $125 million and $625 million is secured with 29 of our Boeing aircraft and for amounts above $625 million we have to post either cash or letters of credit.

Under the previous agreement we had with this counter party if we had become obligated to post collateral all such collateral would have been required in cash or letters of credit. So, as of April 14 with this counter party we have now posted $125 million in cash and we have used approximately $300 million of the $500 million aircraft pool.

In total, as of April 14, and based on our investment grade credit rating, our total collateral obligations with all counter parties required that we post $425 million in cash and use $350 million of our $900 million aircraft collateral pool.

Even at a non-investment grade rating, our additional cash collateral requirement is now less than $200 million and of that approximately ½ of that would burn off during 2009.

Including all of our financing transactions, including the aircraft leases, our leverage remains under 50%. We continue to have a tremendous value in our unencumbered aircraft estimated to be in the $8 billion range as of today and we still have $200 million available under our $600 million unsecured revolving credit line.

Now moving to capital spending, our first quarter CapEx was $85 million. For the full year we continue to expect our capital expenditures to be in the $750 million range.

For 2010 the estimate is in the $800 to $900 million range and overall we’ve reduced our planned CapEx for both 2009 and 2010, which combined equals about a $1.4 billion reduction since our original projections at the beginning of last year.

We will continue to closely monitor both our aircraft and non-aircraft capital spending, but at this point we have not suspended the investment in our strategic initiatives.

Let me finish up with Fleet. We ended the quarter with $539 aircraft. We acquired three 700s from Boeing during the quarter and returned one Classic that’s 300 to the [left floor]. Thus far in April we have received one new delivery and we plan to take seven more this quarter with the final two in the third quarter. That nets to 13 total new deliveries for the year. It is still our intention to retire 15 aircraft during the year and end the year with 535. In addition to the one lease return that we already executed in the first quarter we have four more planned for the remainder of the year. That leaves us 10 more aircraft to be retired, sold, or returned by year-end.

Our Boeing delivery schedule through 2017 is disclosed in the tables in the press release for your reference.

On the capacity side our first quarter available seat miles decreased 4.1% year-over-year and our second quarter capacity is expected to decrease approximately 3% year-over-year. We continue to remain cautious about our growth and currently expect to reduce our capacity for the full year by approximately 5%.

With that Steve, Gary and I are ready to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Jamie Baker with J. P. Morgan.

Jamie Baker - J. P. Morgan

Gary, I was a little surprised to see that the pilot CA does appear to have some minimum fleet requirements included in it. Is there some flexibility on management’s behalf or forced major that would allow the fleet to be smaller than 568 units by the end of 2012?

Gary Kelly

Well Jamie, thank you for that question, because I know that some of the coverage has said that. It hasn’t implied it, it’s said that and that is not correct. We, of course, cannot commit Southwest Airlines to a fleet schedule. We may find ourselves if the economy gets worse from here that we have to reduce our fleet. I’m not predicting that, but I’m just pointing out that this company, like all companies, needs maximum flexibility with regards to that.

Now, with regards to our pilot needs and desires and our tentative agreement, we do have targets to grow the fleet, but they are not commitments. So, our pilots, like me and like all Southwest employees, would love to consider to grow Southwest Airlines. We do think that we will have opportunities to do that in the future.

The remedy if we don’t hit those targets is we simply have more restrictions about how large our code share can be. If my memory serves me right, it is in the Mexican, Canadian, Caribbean and maybe Hawaiian markets. Our pilots want us to grow and they don’t want us to code share in lieu of growing the fleet. So, I felt like that was the best way for us to demonstrate to our pilots that in fact, yes, we do want to grow the fleet too, and we will put some fences around how large we’ll make the code share to prove that to you. I think that gives the Company added flexibility to boost profits and revenues via code share and also provides a nice balance to protect our pilots.

Again, the bottom line answer is what I told you at the outset which is absolutely we are not committed contractually to grow the fleet. We cannot do that and of course we wouldn’t do that.

Jamie Baker - J. P. Morgan

Okay, well I appreciate that very important clarification.

I have a second follow up question on the contract. It does look like there are some protections for the pilots in the event of a merger. I realize that is not as hot a topic these days as perhaps a year ago, but I am also less familiar with the prior contract. My question is whether this TA makes any difference in how you personally view the potential for consolidation under certain circumstances with another US airline.

Gary Kelly

This contract has been under negotiation since the fall of ’06, so I will have to admit that I don’t recall in detail exactly those discussions. I remember the discussions very well; I just don’t remember the details. So, I am going to beg off on giving you a real insightful answer other than to say I don’t think it reflects any view that I have, or that leadership here has, about what might happen in the industry any more than it has been. It was something that our pilots were interested in, because they want the company to grow. They want us to increase our pilot hiring and that obviously provides growth opportunities for them personally.

Jamie, we will have to get back with you on that, but I don’t remember anything that was all that dramatic that was different in this TA versus our prior contract.

Jamie Baker - J. P. Morgan

Okay, well that’s very helpful. Thanks a lot Gary.

Operator

Your next question comes from William Greene with Morgan Stanley.

Bill Greene - Morgan Stanley

I am wondering, Gary, if we can talk a little bit about the ancillary opportunities. You sort of talked about the non-fare opportunities. If you look at the loss this quarter, I could be wrong, but I would guess that if you had had bag fees in place you could have actually gotten to a profit, because it wouldn’t have been that big of a jump. Given what the other airlines have experienced, bag fees certainly contributed to the revenue line. So, what is the thinking: why not put those in place given that most of the airlines now have that bag fee in place?

Gary Kelly

Well again, a very fair question. I think from the top down I would argue that our revenue results would demonstrate that we are somehow doing something different than our peers, because the revenue results are better. Number one, you have to either agree or reject that argument, but we would argue to you that our load factors and our revenue production is superior to what we’re seeing and especially compared to the legacy carriers. Then, of course, it becomes a question of answering well why?

I think we would acknowledge that there are a number of things that we’re doing that will contribute to the revenue performance and arguably a superior revenue performance. But, the bottom line assessment that we’re making today is based on all of the research that we’re doing. We believe that we’re having a meaningful impact in creating awareness among customers that we are virtually alone in not charging the bag fee. That is translating to higher demand for Southwest Airline.

This is an environment, as you well know, where of your two basic pools of passengers, business and leisure, we are more dependent upon people on personal business than ever and they’re the most price sensitive and, of course, the bag fees hit the most price sensitive people the most. It doesn’t take too many additional customers to pay for the bag fee charges. In other words, if you lose one customer that is sort of the equivalent of, however you want to add it up Bill, but it is certainly a handful with not 10 or 12 bag fees.

It is just our view that customers are becoming actually more price sensitive than ever. Southwest Airlines is a very well known, value brand, if not a low fare brand, and we are getting all kinds of recognition on that point today.

Finally, it is at least my personal view that if we were to begin charging bag fees, than I am not at all convinced that it would be revenue positive and it would certainly be disruptive to all of the things that we’re trying to do to build the brand. Again, in this environment where you are more dependant than ever on personal travel, you just really risk losing customers to competitors. It is a very, very competitive environment out there. We know that for a fact and we just need to make sure that customers are giving us credit for the fact that we don’t charge the bag fee. Again, the bottom line argument is we think that we’re getting that credit.

Bill Greene - Morgan Stanley

If you wanted to turn it on tomorrow, could you or do you need to put technology in place to get the bag fee in if you wanted?

Gary Kelly

We would need to do something, Bill. It is certainly not on our technology agenda to implement that. In fairness to your question, I will admit to you that we don’t have it in the work plan and we’re not constructing it. So, off the top of my head I’m not sure that I have a thorough list here. We certainly have the ability to charge for fees at the airport. But, just think about the number of customers that we carry on a daily basis. To have everybody have to whip out their credit card as they are checking their bags at the airport, I just don’t know that that would be the right customer experience. It would actually work against us in everything that we’re trying to do for the airport experience.

Bill Greene - Morgan Stanley

All right and Gary let me just do one quick follow up on Jamie’s question on the contracts. If I understood him, I think you have put in place some wage increases, but given the environment economically how do you think about that? I mean, I think your unions have shown some leadership in this regard in the past that they have been willing to help the Company by, sort of, foregoing some wages increases and certain contracts in the past. Yet, if I understand it correctly you are giving some now and I don’t understand why that makes sense given the losses in the economic environment.

Gary Kelly

Another very fair question, but I have just one quick comment. Laura poked me when you were asking your question. We will have a technology enabled soon that will make it easier for us to entertain charging a bag fee, by the way. I don’t want you to think that it’s something that we can’t do, at least in a reasonable amount of time. I will admit to you it is not on our agenda.

On the pay increases, you know, the timing is awkward and I will fully admit that. Of course, what we are trying to do is we are trying to be equitable with as many of our employees as possible; so all contracts don’t get negotiated at the same time or on the same terms. In any event, the view that we had this year has changed dramatically since January. If we were beginning to discuss pay today I would have a very different view on what made sense in this environment.

Basically, the answer to your question is as negotiations were evolving we had offers on the table and we chose not to pull them and to see these through; even though during the period of time that the offers were outstanding the world was changing dramatically. Right or wrong, that is what we’ve done. If you will allow me this, I owe it to our union leaders and our employees to have any kind of discussion with respect to relief with them and not do this in a public forum.

Certainly, your view of our employees, I think, is very accurate, which is our employee’s are very engaged. They love Southwest Airlines. Everybody wants their pay to increase. They do a phenomenal job; they are the best in the business. We are just trying to put all of those things together in a way that makes sense. But, I feel very confident that if we get to a point where we do need relief that we can have a conversation with our employees about that.

The question then becomes at what point do you do that? It has to be negotiated not matter what. Whether you are discussing this in January of ’09 or whether you are discussing this in January of ’10, but we are certainly banking on the fact that we are all in this together. We are doing a lot of things right and if we need relief we will seek that. That is not where I am today. I don’t see that there is any reason for us to panic based on our first quarter results. We had a modest operating profit for that matter, but we can’t let this continue to decline and that is why you’ve seen the actions announced as you have today. It is something we will have to keep a very close watch on.

Bill Greene - Morgan Stanley

All right, thanks for the time.

Operator

Your next question comes from Mike Linenberg with Bank of America/Merrill Lynch.

Michael Linenberg with Bank of America/ Merrill Lynch

I have two questions and I just want to make sure that I heard Laura correctly. Laura, when you were talking about the salary and wage expense maybe not being up as much in the second quarter versus the first quarter is that because the increases tied to the contract hit in the March quarter? I know that, I think, for at least one of the labor agreements there were some retroactive payments, or is that something that you have accrued over the last couple years? Can you just run through the dynamic on that and how that is going to hit the P&L if it hasn’t hit already?

Laura Wright

Yes. We weren’t way off with our accruals, but we did have some additional accruals in the first quarter, which was why our first quarter labor CapEx guidance that we gave you in January was a little bit lower than where we ended up. However, as you know some of those contracts are a couple of years old and so we have the effects of as we put the new rates in we’ve got some compounding effect. That hits a little bit more in the first quarter then you are going to see later in the year. We also got hit by higher benefits in the first quarter that we don’t think are going to continue at that same pace year-over-year in the second quarter. I think it is a combination of several items, but the good news is the year-over-year increase won’t be as high and the actual absolute chasm should be lower the second quarter than the first quarter.

Gary Kelly

I think the productivity is a little better too. I think we’ll have a little bit better absorption of our salary costs, because you will have a few more ASMs and last year was a leap year. It is just one day, but one day does make a little difference, probably a point. There are a couple of things going on there.

I think Laura and I are both counting on us continuing to improve our productivity through reducing our headcount, at least through natural attrition, so we have a hard freeze on our headcount and in some areas we have a hard freeze on hiring. So, we’ve got very strict controls on even replacement hiring.

Michael Linenberg with Bank of America/ Merrill Lynch

My second question, Gary, goes back to the baggage fees and also the revenue performance. I know you made the point that you definitely out performed the industry and you do see it, at least, in the year-over-year declines. I’m not sure if you were comping just domestic versus domestic or you think about the major carriers they carry a lot more business in first class travel, they have cargo. There are other things in there that are going to drive down the results, but kind of moving beyond that, if we look purely at profitability. If we look at EBIT, the fact is you did have a small operating profit.

What is interesting is that what we may see in this quarter is at least some of the major carriers are not going to be that far away from where you were on an operating profit basis. If I go back and I look at the last time that you guys lost money, which was in March of ’91, you lost money, but the majors lost a lot of money and their margins were significantly worse. In some cases their EBIT margins were double digit. This time around some of them may be in the -1 to 3% category, so you have definitely seen some convergence here.

I know you indicated that you are not thinking about the baggage fees, but if everybody else is doing it and at the end of the day this is a game about being outperforming on a profitability basis and then being able to use that as additional flexibility and leverage to stay ahead of the pack, how do you think about it?

Gary Kelly

Mike, I don’t know that I’m tracking the facts that you’re arguing. At least with the airlines that have reported so far they are much worse than what we’re talking about. So, we probably need a little bit more time to understand what your arguments are.

Again, I think that the bottom line assessment that we have is that you have a unique brand in Southwest Airlines. You have a very strong awareness of our low fare commitment. We are arguing to you that the No Hidden Fees is an extension or an underscoring of our Low Fare brand, which I would argue to you is not different than not charging $400 one way from Minneapolis, St Paul to Chicago. We also “walk away” from that kind of pricing technique. It is not unique to our Low Fare strategy and in fact it supports our Low Fare strategy.

The other thing that I would just emphasize is that we almost stand alone with this approach, which gives us a somewhat remarkable position and the brand awareness with our customers. At least, in my view, it makes it a more credible argument that we will be able to get more customers with this approach as compared to simply becoming another airline who nickels and dimes customers that they hate. You can’t find customers to tell you that they like these fees. They don’t like the fees.

The bottom line is that we don’t believe that it would be revenue positive to us anymore than we would argue to you that we can push through a $10.00 fare increase right now, because at the end of the day people are only going to pay so much in a recessionary environment to take a trip. Whether you want to gauge them with a baggage fee or whether you want to try to push through a $15.00 or $25.00 fare increase there is just so much that can be done there. Of course that is why our traffic is down overall.

Michael Linenberg with Bank of America/ Merrill Lynch

Thanks. I understand that philosophy. We can talk about the profitability gap offline.

Gary Kelly

Well we certainly would agree that this company needs to be profitable. It needs to be profitable at prosperous levels and we think that the strategy we have is the right one.

Michael Linenberg with Bank of America/ Merrill Lynch

All right thank you.

Operator

Your next question comes from Hunter Keay with Stifel Nicolaus.

Hunter Keay - Stifel Nicolaus

I am a little bit confused, so I would like a little bit of clarification on the cash collateral position. If I am not mistaken, I think you had mentioned that at year-end last year you had posted about $240 million in cash collateral and now you have posted $425 million, but crude, as I see it, is about maybe $10.00 to $12.00 a barrel higher. How should we think about this collateral moving around going forward? Is it not necessarily a function of the underlying spot price, or is it some sort of timing issue on the contracts themselves?

Laura Wright

Hunter, all it had to do with was totally renegotiating the agreements and how the collateral provisions worked. The agreement that we talked about in December with one counter party had us posting up to $300 million. At the end of December 31 it was $240. In early January, with some of the lag, it was at $300 million. I believe we disclosed that on the call last time. So, there is no change in that. With that agreement, with that counter party, anything from $300 to $700 million is secured by aircraft. We have only used $50 of that, so we have got a lot of room there. We don’t really see any cash call coming that way particularly since all of our new hedging is pure call options.

What we did new is one of our significant counter parties we entered into a new collateral agreement with them. We totally threw away the old one. The old one was just based on credit ratings. It improved our position with respect to that counter party, with respect to when we’re in a net owed position. But, what it did was eliminate any potential risks that we might have in the event of any ratings downgrades that there could be a cash call. As part of that we’ve posted $125 million and we put up aircraft collateral for the next $500 million of exposure. From this point we don’t see any real calls on cash collateral in the near term.

Hunter Keay - Stifel Nicolaus

Okay, great, that’s helpful. Thanks. I have one quick follow up. I am wondering if you could maybe give us a sense of the volume of inventory that you guys have released for sale over the, as you look at a booking group, that is going to be six to eight weeks. If we think about these buckets, and you guys added a lot of inventory buckets last year, I assume at this point in time a lot of those seats you’ve released a far greater number of seats for sale over the summer months, maybe even in the fall months, than you had at this point last year. Is that reflected in the book load factor number?

So, if you say book load factors are earning slightly up did that effectively include the same denominator? Is that based on the total seats available for sale ultimately or the number of seats that you have released for sale? Does that make any sense?

Laura Wright

We have released all of the seats for sale. I think what you’re asking about is do we have higher amounts of inventory available at lower fares and discounts? I would say the answer to that is yes. Certainly the fact that we’ve done a lot more sales is why the book load factor is up year-over-year.

Hunter Keay - Stifel Nicolaus

Okay so effectively you have pretty much just released everything for sale at this point? There are very few, if any, buckets left?

Gary Kelly

I don’t know that I would make it so literal, but we were certainly on sale this year and we’re not last year. Yes, we have adjusted to the environment which means we definitely need to get out there and sell as many seats as we can.

Laura Wright

Every seat is for sale. So many seats are on sale. The denominator is the same, it is just that the number of discounts [interposing].

Gary Kelly

Don’t worry. We won’t sell 100% of our seats on sale, of that I can assure you.

Hunter Keay - Stifel Nicolaus

All right, good stuff. Thanks for the color guys.

Operator

Your next question comes from Duane Pfennigwerth with Raymond James & Associates.

Duane Pfennigwerth - Raymond James & Associates

Laura, I wonder if you could help us with the decline in RASM expected in the Q2. Just given 1Q did include, I think, a +6 in January and most likely May would be better, I would expect, than what you’ve seen in March, but can you help us at all directionally with sort of down three in 1Q how that might shake out in 2Q?

Laura Wright

Well Duane, I wish we could. I think what we’ve given you is where we are month-to-date for April. We certainly know that April has an easier comp than March did because of the Easter mismatch. Beyond that, I think, because of not knowing how the near end bookings are going to materialize really the best we can tell you is that we do expect our year-over-year RASM to be down in the second quarter. We are just going to have to see what May looks like as we get a little further out.

Duane Pfennigwerth - Raymond James & Associates

Okay that’s helpful. Then just in terms of yields, typically when you’ve had this Easter shift sequentially you would have yields increasing. You did have that last year despite the fact that the Easter shift was going in the other direction, but you were fighting higher fuel prices. So, how should we think about yields on a sequential basis and specifically that comparison year-to-year?

Gary Kelly

Sequentially, just quarter-to-quarter in other words?

Duane Pfennigwerth - Raymond James & Associates

Correct.

Laura Wright

Well if you look back at the first quarter, Duane, I think we told you we were up about 6, that was really kind of up in the 5% to 6% range in January and February was down kind of close to 1, low 1 to 2 and March was on a RASM basis down about 10. So we saw the quarter get worse on a…

Gary Kelly

Another thing, well Laura is thinking, I will just fill the gap here for a second. I think that ’08 is a little bit of an anomaly, because we were so aggressively trying to increase fares throughout the year. One thing that you might look at is whether that is a normal sequential annual trend, from your records, and we can certainly help you with that. But, ’08 was a somewhat unique year in that regard.

Laura Wright

And, I think I pointed out in the comments that our comparisons are going to get more difficult for that reason in May and June, because we were, as you remember, we were really aggressive and really successful inducing fares with four fare increases just in the second quarter of last year. I don’t think last years trends, with the current economic environment, are going to be the best to assume for this year.

Gary Kelly

In other words the rule of thumb that, I think, we would typically use, Laura, is that as load factors go up, which they would from first to second quarter, that means that yields are going to go in the opposite direction. What’s implied is that you’ve got a higher mix of personal travel at a discounted fare. So, the RASM is better sequentially, but the yield is not necessarily. I think last year was somewhat unique in that regard, but you would have to look back and we would have to look back with you to see if that’s true.

Duane Pfennigwerth - Raymond James & Associates

Thank you. I think Jim has a question.

James Parker - Raymond James & Associates

This week I was at LaGuardia on Tuesday sitting there on the taxiway for an hour and 15 minutes. Usually it is at least an hour. And, I thought, well pretty soon Southwest is going to be doing this and burning fuel and paying some pretty good rates for labor. This is greatly different than the model many years ago on Southwest, get in cheap airports, and get out quick. I am just wondering if there is some larger grand plan about the likes of LaGuardia. I can understand Minneapolis, maybe Logan, but is there something beyond this?

I know that you could say our customers want us to do it. Well, your customers would love for you to fly them around for free. So, my question is how do you justify that?

Gary Kelly

Yes those customers can be real pests, Jim, so we have to be careful what we do on that front. I think it is clearly one that we are willing, at this point, to only expose ourselves to modestly. Although we have 16 trips, eight out and eight back in out of 3.200 or so, they will need to be very, very careful about that.

We have real evidence based on our ATA code share about what New York LaGuardia will do for Southwest Airlines. We are very confident that with that number of flights it will be a positive contributor. So, we don’t want the utilization to infect the rest of our system. Clearly with 16 trips we think the risk of that is modest.

We have a very clear view of what we should be able to expect and if we’re talking to Chicago customers the fact that we’re adding Minneapolis, Boston, and La Guardia will be, we think, an enormous boost to our Chicago business based on our results so far of Minneapolis, which is very, very encouraging and we think it’s going to work.

James Parker - Raymond James & Associates

Okay thank you.

Operator

Your next question comes from Helane Becker with Jesup & Lamont.

Helane Becker - Jesup & Lamont

What has the response of Delta Northwest been to your Minneapolis incursion as it were?

Gary Kelly

Well, again, we have a small presence there. We have eight flights currently; we will be adding three in May to non-stop to Denver. I would say that we have had a response and we have seen more flights and fares competing with us aggressively, certainly on a non-stop basis. Less aggressively with us on a connecting basis, but, as one would expect, we’ve certainly seen a response.

Helane Becker - Jesup & Lamont

Is it consistent with what you thought they would do, or is it better, worse?

Gary Kelly

I would say it’s consistent.

Helane Becker - Jesup & Lamont

Okay, thank you. That was really it. Everything else has been asked and answered.

Operator

Your next question comes from Kevin Crissey with UBS.

Kevin Crissey - UBS

I just want to go back to the bag thing. No, I’m just kidding, I really don’t.

Gary Kelly

Well we’re ready to talk about it, so…

Kevin Crissey - UBS

Distribution, can you talk about kind of, you have to be looking for revenue, as you talked about. Can you talk about, you are in what, two GDSs’ now. Can you talk about your thoughts on the performance there, whether there might be others in place? Any thoughts on participating in the OTAs’ and maybe any thoughts on package bundling initiatives that you maybe have on the horizon?

Gary Kelly

Well, yes, I think we can speak to all that rather quickly. We have been pleased with the performance so far of the GDSs’ that we’ve joined. It is part of a larger strategy to make Southwest Airlines more broadly appealing to business customers and large corporate customers. That strategy is not fully implemented yet. We have got a frequent flyer plan enhancement that is coming, as well as enhancements to southwest.com, just to name a couple. The fact that we are adding more destinations to our route network, back to this whole notion in Chicago, trying to appeal to the corporate Chicago customer if you don’t take them to LaGuardia sometimes it is hard to get them. I think you have to look at all of these things combined.

The distribution in and of itself, by itself, I don’t think is a huge contributor, but it certainly is a component of a number of tools that we’re trying to package together. We think it is the right thing.

We have definitely seen our business go up. The actual number escapes me. I will defer to Laura if she wants to disclose that, if she knows it off the top of her head, but we have definitely seen our travel agency business through GDSs’ go up.

With respect to the retail online travel agencies, I don’t think we have anything to report to you there at this point. We’re not ready to tell you that we’re going to do anything different in that space.

Kevin Crissey - UBS

Okay and I think, Laura, when we met a while back you were saying more initiatives on the website. Maybe there are hotel packages, car sales. Is that still a priority here and how you are doing in that regard?

Laura Wright

Yes. We have a lot of releases that will be coming on southwest.com. We have released our first recently and hopefully you have had a chance to see it. We have huge opportunities to capitalize on that distribution system in place and it certainly includes being able to sell more hotels and cars and travel related products. Those will come out over time in several different releases.

Kevin Crissey - UBS

Do you source all that yourself from the hotel inventory, or do you use the back end from the OTAs’ the Expedia’s or whatever for the hotel and other inventory?

Laura Wright

We’re using a back end.

Kevin Crissey - UBS

Thank you very much.

Operator

Your last question comes from Bob McAdoo with Avondale Partners.

Bob McAdoo - Avondale Partners, LLC

Gary, you made a comment early on, something that said in March you thought your close-end full-fare traffic had bottomed out. What does bottomed out mean? Can you kind of put a little color around that?

Gary Kelly

Sure, Bob. I will try at least. We saw a detectible, a remarkable change in our traffic in February. We saw some signs of that back in January, but it was real by the time we got to February and continued to get worse on a weekly basis. When Laura and I were at the J.P. Morgan conference in early March we reported that, that we were seeing a continuing decline in our week of travel full-fare alleged to be a business travel, which by your experience you would know that is very typical of a recessionary environment.

The point I am making is that in my earlier remarks that we have not seen that decline continuing throughout March and then now into April the 16th. Simply recognizing that the comps are confusing because of the movement of Easter over the last, I think, it is three to four weeks that have all been impacted on a year-over-year comparison basis.

I am a little reluctant to draw any conclusions yet, but back to the question that Laura got earlier about where do you see RASM heading from here, I don’t think we have any empirical evidence that tells us it’s going to be any worse than the first quarter. Although, you can sort of pick apart what was January like and what do you expect April to be? I don’t think we’re expecting April to be up 6%, which is what we had in January. We don’t have great expectations for April, so I have a hard time believing that the second quarter will be better than the first quarter comparison. In fact I think it is more logical that it could end up being worse, but we don’t have any [interposing].

Bob McAdoo - Avondale Partners, LLC

When you say worse you mean like if you’re down 2% or 3% in the RASM in the first quarter that you would call 3% or 4% down worse that is what you mean by the comparison you are talking about?

Gary Kelly

Yes, so to be specific, we were down 2.9 in 1Q year-over-year. I have a hard time believing that the second quarter will be down year-over-year less than 2.9. I wouldn’t be shocked at all to see that it’s down more than 2.9, but on April the 16th we don’t have an empirical way to say that based on what we see for May and June that we know that it is going to go this direction. There is just no way, because I think we are primarily dependant upon that walk up travel to pay us full fare which we’ve seen weakened since February. Assuming that that continues in May and June then yes you are going to have down RASM of at least 2.9%.

Bob McAdoo - Avondale Partners, LLC

And you said that full-fare traffic is running what about 30 or, what is the percentage you said?

Laura Wright

It was 20%.

Bob McAdoo - Avondale Partners, LLC

20% so when you say it bottomed out that means, gee at one point maybe it had been 25% and it had dropped down to 20%, but it’s now kind of been holding at 20%, is that what you mean by bottoming out?

Laura Wright

We had a period where it was getting worse each week and so we haven’t seen it, again, we don’t have a long period to say it’s a trend, but we haven’t seen it continue to erode. Again, we had Easter and we have all this other confusion in there, so you can’t really go with it. You know, Bob, I think we told you in the prepared remarks that we think April probably will be flat with last year, because we have this Easter benefit. But, May and June are going to be more difficult comparisons, because we were really increasing fares last year.

Bob McAdoo - Avondale Partners, LLC

Let me change the subject right quick for one last thing. You’ve got this early-out program. I have a couple of questions related to that. What kind of targets do you have in terms of how many folks you would like to have accept it? Also, should we be expecting some kind of a one time hit to expenses in the second quarter as you get everybody signed up by June?

Laura Wright

We don’t have a set target. Honestly, we don’t know how many people will take this offer in this environment. We think whatever number takes it is good and will help us with our staffing issue and our cost issue. We will have a charge. The timing and the amount of that charge is going to depend on the number of people and in what positions they’re in. What we will do is the charge is basically accrued from the time they accept the offer to their last day of work; so there is going to be some service requirements. I would anticipate we will probably have some charge in the second quarter, but at this point I would assume the third quarter charge is going to be where the bulk of it hits. We will have to give more guidance when we know more.

Bob McAdoo - Avondale Partners, LLC

So it may be a third quarter piece, but it is like if somebody leaves and you give them something, I assume they get some passes? They get maybe some healthcare and stuff going forward and some kind of so many dollars for every so many years they worked or something.

Gary Kelly

Precisely.

Bob McAdoo - Avondale Partners, LLC

Yes and that will all be accrued as of the last day there, physically on the payroll, obviously, but with the healthcare being dragged on as the healthcare is actually paid for. Is that kind of the way it would be booked?

Laura Wright

No. We will actually estimate the cost of that healthcare for the period it is going to be offered and the cash and etc… and we will spread that cost over the period from when they accept the offer to the last day, so, it won’t be [interposing].

Bob McAdoo - Avondale Partners, LLC

But, from the acceptance of the offer to the last day, that could be like what a week, ten days, two weeks or something?

Gary Kelly

No, because we are going phase out the exit over nearly a year. First of all you put out a broad net like this and you just don’t know what response you are going to get by a work group and we’ve got to keep the wheels on between now and then.

Bob McAdoo - Avondale Partners, LLC

You want everybody in Buffalo to quit in the winter huh?

Gary Kelly

You got it. But, there is no set target for the program, but I think we would both say that we do have a desire to reduce our headcount and continue to have productivity improvements that would be measurable to you and everyone sort of on a headcount per aircraft basis. I am sure we will get to those productivity targets through a combination of things. It may be asking people to move around the company and take on new positions. It may be attrition. This will just be one component of that.

Bob McAdoo - Avondale Partners, LLC

Got it, okay. That is very helpful. Thanks a lot.

Laura Wright

Thank you everybody for listening in. If you have any questions please feel free to call our Investor Relations department. Thank you.

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Source: Southwest Airlines Co. F1Q09 Earnings Call Transcript
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