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Executives

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

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

Analysts

Duane Pfennigwerth - Raymond James

Hunter Keay - Stifel Nicolaus

William Greene - Morgan Stanley

Daniel McKenzie - Next Generation Equity Research

Kevin Crissey - UBS

Jamie Baker - J.P. Morgan

Helane Becker - Jesup & Lamont Securities Corporation

Gary Chase - Barclays Capital

Southwest Airlines (LUV) Q3 2009 Earnings Call October 15, 2009 11:30 PM ET

Operator

Good day and welcome to Southwest Airlines third quarter 2009 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 a reconciliation of our non-GAAP results to our GAAP results.

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

Gary C. Kelly

Thank you, Ben and thank you all for joining us this morning. After many adjustments to this most challenging of revenue environments, I am obviously very happy to report a profit for the third quarter. Excluding special items, we reported a modest profit of $23 million which was $0.03 a share but like a lot of hard-fought gains, that number doesn’t tell the story.

But regardless a profit is a profit and in this terrible environment, we’ll certainly take it. I am very proud of our people. They have managed through a dramatic amount of change. The construction and implementation efforts have been huge. We’ve had three large scale technology projects implemented over the last 12 months that is supporting a variety of current and future revenue initiatives. Every single Southwest employee has been involved with what have turned out to be aggressive changes to our flight schedule. We trimmed away unprofitable flights. We redeployed successfully aircraft time to new markets including Boston Logan, New York La Guardia, Minneapolis St. Paul, and of course we’ve increased our Denver service dramatically over the last year.

For November 1st, we have yet another new market, which will be Milwaukee, Wisconsin and we are excited about that.

And then finally, we have a host of new initiatives that have been introduced over the last year, including our early bird product, an upgraded southwest.com, and revenue management enhancements. I think the results speak for themselves. We are leading the industry in customer satisfaction according to many sources and not the least of which is the U.S. Department of Transportation.

Our on-timer performance is running at the best levels in years, almost three points better than a year ago, and again among the industry leaders. Our load factors have been consistently running at record levels and in some cases beating some longstanding previous records. And then finally, our unit revenue performance has consistently outperformed the industry this year. That’s compared to 2008 and 2007, and then finally we’ve really surged ahead even further in September and so far in October we seem to be sustaining that momentum.

I think it’s true that the economy is stabilizing. There are many that believe that. That does not account for the Southwest revenue performance. That credit goes to our people. I am very proud of them and I am very grateful for their enormous efforts.

This is a very difficult environment to operate in. Cost pressures continue and particularly rising energy prices. I don’t believe the worst is behind us, if for no other reason because of higher energy costs, and there’s no reason to believe that business travel will return anytime soon to help bail us out. But we are going to continue to work vigorously on implementing more new revenue initiatives and of course as always do all we can to control our cost and look no further than the improvement in our productivity in the third quarter yet again.

So with that very brief overview, I would like to turn it over to Laura Wright to take us through the quarter.

Laura H. Wright

Thank you, Gary and good morning, everyone. First of all, I would like to echo Gary and thank the great employees of Southwest Airlines for a great quarter. They worked very hard.

Our third quarter GAAP results included a $27 million charge net of profit sharing and taxes related to our early retirement program. In addition to this special item, the third quarter GAAP results included a net loss of $12 million relating to non-cash, mark-to-market and other items associated with SFAS-133.

Excluding the special items, our third quarter net income was $23 million, or $0.03 per diluted share. These results exceeded Wall Street’s mean estimate of $0.02 per diluted share.

Our unit revenues declined 2.2% year over year, which was far better than we expected just 90 days ago, again thanks to the actions we have taken to grow our revenues.

As Gary mentioned, we believe we are gaining a substantial amount of customers and revenues by differentiating ourselves in a meaningful way from other carries with no first or second back seat.

We have record load factors in July, August, and September, ending the quarter with an all-time quarterly record of almost 80%.

Our traffic or revenue passes or miles were actually up 6.3% in the quarter despite a 5.8% reduction in our available seed miles.

Our third quarter passenger unit revenues were better than our historical sequential trends and on a year-over-year basis, our September PRASM was up about 3%.

For October, our month-to-date PRASM is running up about 1% compared to the same period a year ago. Trends for the remainder of the quarter are more difficult to precisely predict for a number of reasons, including a difficult year-over-year comparison in the month of December.

Despite the improvements that we saw in the quarter, our full fare demand remains weak. Our full fare mix was 17% for the third quarter versus 24% in the third quarter of last year.

Still our revenue trends continued to significantly outperform the industry, which is strong evidence that our revenue initiatives are working. We introduced early bird check-in in September and thus far we’re on track with our revenue target and hopeful that it has revenue potential similar to business select.

Our early bird revenues are included in other revenues and were about $2 million for the month of September. So far, we have not seen a negative impact to our business select product.

Our business select revenues for the third quarter were about $18 million, which is included in passenger revenues.

We generated about $10 million in revenues during the quarter on our new pet fare, our unaccompanied minor service charges, and our excess bag and heavy fees combined.

We’ve also benefited tremendously from our network optimization efforts, which provided well over $100 million of benefit to our third quarter unit revenue performance. We are excited about our new and improved southwest.com, which through recent upgrades provides the foundation for future revenue generating features, and we are already achieving higher booking rates from shoppers and producing higher fares.

Late in the third quarter, we made some further enhancements to our revenue management structure and techniques. Specifically, we’ve restructured our fares to allow for an array of low fare options to better respond to the impact the recession has had on demand. We believe this fare restructure has the potential to provide substantial incremental revenue and early indications are that the returns could be as significant as early bird or business select.

I should also probably mention that we increased fares modestly this week.

With respect to our freight and other revenues, our freight revenues were off significantly due to the weak economy and we expect that weakness to continue into the fourth quarter. Our other revenues were up slightly from last year, supported by the increase in our ancillary revenues, such as our pet, unaccompanied minors, and early bird. These increases were offset by less charter revenue and business partner income. We expect positive trends in our other revenues to improve in the fourth quarter.

Turning to our cost performance, excluding the charges associated with the early out program and the related profit sharing impact, our third quarter unit costs decreased 1.9%, largely due to the significant year-over-year decrease in fuel costs. Our economic fuel costs decreased 17.4% to $2.13 per gallon. However, the year-over-year fuel cost decline is relative when you consider how extraordinarily high the energy market was this time last year. In fact, fuel prices remain very volatile and significantly above historical levels, currently around $75 a barrel.

We continue to believe it’s necessary to have fuel hedge protection against catastrophic energy prices and we currently have derivative contracts in place for over 45% of our fourth quarter estimated fuel consumption, effectively in the low $70 per barrel range. Based on this position, and yesterday’s closing market prices, we expect our fourth quarter economic fuel price to be in the $2.25 per gallon range, including taxes, which is approximately $0.13 above the market jet fuel prices.

Based on our current fourth quarter derivative contracts, our fourth quarter fuel costs per gallon would begin to fall below market once the market exceeds the mid- to high-$80 per barrel range.

In regards to our premium costs for the fourth quarter, we currently expect about $45 million in non-operating expense related to our fourth quarter derivative contracts.

For 2010, we currently have derivative contracts for over 65% of our estimated fuel consumption. The volatility that we are seeing in the market makes it quite difficult to provide precise guidance for 2010; however, our best touch point to provide at this juncture is somewhere in the $2.40 per gallon range, again based on yesterday’s market closes.

Looking forward to 2011, we have approximately 40% of our estimated fuel consumption hedged and we have modest positions in 2012 and 2013.

The total net liability of our current fuel hedge portfolio is currently around $526 million, which is significantly less than the $805 million we reported to you last quarter. The total collateral associated with this value was $551 million, supported by $340 million in cash and 211 in aircraft collateral.

Excluding fuel and special items, our operating expenses increased slightly but on a unit basis were up 6.6%, largely due to our reduction in capacity.

Our airport costs remain under tremendous pressure as the industry continues to cut capacity; therefore we anticipate airport cost inflation to continue into the fourth quarter.

We also experienced a significant increase in our aircraft [inaudible] expense per ASM primarily due to our sale leaseback transaction since the third quarter of last year.

Based on our current cost trends and our fourth quarter capacity plans, we currently estimate our fourth quarter 2009 unit costs excluding fuel to be in the $0.075 range. While we have taken steps to contain our costs, we will continue our intense focus to preserve our low-cost advantage and protect our low-fare brands.

Now I will turn to the balance sheet and cash flow. Over the past year we’ve been diligent in shoring up our liquidity and as a result, we remain prepared with a strong investment grade balance sheet. As of yesterday, our core unrestricted cash and short-term investments was $2.4 billion. We announced last week that we replaced our revolving credit facility that was scheduled to expire in August of 2010 with a new three-year, $600 million credit facility that expires in October of 2012. The full $600 million is un-drawn and fully available today.

Our leverage, including our aircraft leases, is under 50% and for the first nine months of 2009, our cash flow from operations was $493 million, which is net of $185 million increase in our collateral deposit.

For the full year 2009, we expect our capital spending to be in the $600 million to $700 million range. This is a [inaudible] than previously expected as we have continued to cut spending more prudent.

For full year 2010, we have also lowered our capital spending target to the $700 million range.

With respect to our fleet plans, we have taken delivery of all 13 of our Boeing 737-700 firm aircraft orders planned for this year and thus far we have returned three 737-300 leased aircraft and retired two of our 737-300 owned aircraft.

Our full-year 2009 capacity is expected to decrease approximately 5% compared to 2008.

For 2010, we are currently planning to keep our capacity in fleet roughly flat with 2009. We have firm orders with Boeing for 10 new 737-700 aircraft in 2010 and we have a like amount of leased aircraft with expiring leases next year, which allows for anywhere from 0 to 10 aircraft retirements next year. Flexibility with our retirement schedule and other alternatives provides the ability to adjust our 2010 plans, if needed.

And Ben, with that, Gary and I are now ready to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) We’ll take our first question from Duane Pfennigwerth with Raymond James.

Duane Pfennigwerth - Raymond James

Good morning. Just in terms of the revenue comparisons in the fourth quarter, at least on the numbers that we have, it seems like October was a pretty difficult comparison and they get far easier, so how should we interpret that 1% relative to easier comparisons in November and December?

Laura H. Wright

Yeah, you’re right -- last October we were actually up 14% on a unit revenue basis. November was up 1% and December was up 12%. There’s some weird things going on with the holidays, as you are probably aware. Last year Thanksgiving was very late in the month of November with a lot of the return travel in December, so when you look at November and December this year, I think the December comp will be more difficult just because of the holiday mismatch.

The other things to keep in mind are our own capacity reductions, which are more weighted to early in the quarter. So for October, we’re going to be down about 10% on capacity; November down about 8%, and December down about 6%, so that’s going to fit into those comps. And then the third thing to think about is from a competitive basis, the capacity reductions of our competitors in the fourth quarter were greater last year than what we are going to see. They are going to be pretty modest in the fourth quarter this year.

So I think December is going to be a more difficult comparison and certainly October is a tougher one because of the great results we had a year ago.

Duane Pfennigwerth - Raymond James

Okay. That’s helpful, I appreciate that. Just in terms of your capacity, you know, initial guidance of flat next year, how should we think about ex-fuel unit cost growth or decline, assuming flat capacity?

Laura H. Wright

You know, we’re still working on our 2010 plan and have not finalized our business plan for 2010, so we’ll give more guidance on our 2010 call at a later time.

Duane Pfennigwerth - Raymond James

Okay, and then just lastly, Laura, in terms of your fuel guidance, can you give us any help with what you are assuming behind that beyond the futures curve? So what sort of premium to market and what sort of new hedges versus old hedges are you baking in there?

Laura H. Wright

You’re talking about 2010?

Duane Pfennigwerth - Raymond James

Yes.

Laura H. Wright

Yeah, so for 2010, I’ll just look at my notes here -- we’ve got at current market that would suggest about a $0.07 penalty, carry-forward penalty on our hedges for 2010. And that’s based on yesterday’s 2010 market prices, which are in the high 70s -- $79.

Duane Pfennigwerth - Raymond James

And does that assume any positive contribution from the new hedges? So in other words, the 65% that you are hedged?

Laura H. Wright

It does. If you take that $0.07 penalty, think of that as a combination of the penalty we started the year with offset by the improvements that we’ve had with the new hedge positions that we have put on subsequent to the end of last year.

Duane Pfennigwerth - Raymond James

So starting from $0.15 and working to $0.07?

Laura H. Wright

That seems right.

Duane Pfennigwerth - Raymond James

Okay. Thanks so much.

Operator

We will take our next question from Hunter Keay with Stifel Nicolaus.

Hunter Keay - Stifel Nicolaus

So you guys mentioned that you matched a modest fare hike last night and I know it was very modest, the nominal increase was very modest but does that mean -- can we interpret this as you guys getting maybe potentially a little more comfortable with visibility or is visibility still very challenged?

Laura H. Wright

In terms of?

Hunter Keay - Stifel Nicolaus

In terms of how the booking curve kind of looks and how it is shaping up over the next say six to eight weeks.

Laura H. Wright

I think there’s no change in the visibility to the booking curve. Even in a great economic environment, we don’t have a long visibility to our booking curve. But certainly the high load factors and the success that we’ve had with demand gives us a lot more confidence in pushing through some very modest fair increases.

Gary C. Kelly

I think the good thing is, Hunter, that we’ve created some momentum here from a combination of the things that have been outlined by Laura and what was covered in our press release, and they are all contributing but I think the low fare brand in particular is a very, very strong based on not only the numerical result that you see but also based on all the constant surveying that we are doing with our customers. So the bookings that are in place right now for our October, as an example, again imply, as we’ve said, they imply a strong record and the first time that we would have established a record in 13 years for the month of October.

So it’s leisure driven, the demand is definitely -- the majority of the demand is in the discount category. As I mentioned in my remarks, there’s no evidence of any significant change in business travel demand, i.e. full fare demand, so again when you use the word visibility, you know, we are looking at advanced bookings that are discount oriented and being driven by our low fare brand and a pretty big push with our advertising campaign too. And the good news is that that play is working for us and it appears that it will continue for the foreseeable future but certainly there is no visibility much beyond December that you can count on. But right now the bookings for October/November/December, at least what we have in place, are quite good and again, no doubt at lower fares than a year ago.

Hunter Keay - Stifel Nicolaus

Sure. Okay, great. My second question, on the September loads, and again we’re talking about strong load factors across the board, not just September and as you mentioned, Gary, obviously into October too. Do you have any kind of empirical evidence or any kind of actual statistics that can show hard and fast that it is in fact because of a lack of bag fees or even change fees for that matter? Any kind of -- I mean, do you have any kind of data that you can sort of put to the no-hidden fees campaign working outside of just maybe what people are concluding based on what load factors are doing?

Gary C. Kelly

I think in terms of what you are looking for, the answer is not yet and we’ll continue -- you know, as time goes by, we collect more empirical information but I think the hardest fact that we have in addition to just the change in our revenue production versus our competitors is the awareness among our customers and non-customers that we don’t charge for the first two bags is huge and so we know that we are getting credit for the fact that we are not charging bags and that is unchanged from what we reported to you back in July. I think we shared that with you after our second quarter results.

Our own experience, as you know, we’ve argued this analytically, we know that if we increase fares we are going to see a drop-off in traffic. I don’t think it’s a reach at all to suggest that we are getting two or three percent of our customers because we are not charging for bags and a little number of a big number is a big number, so -- but no, we can't put a number to that yet. We have done surveys that would suggest that if we start charging bags that a fair percentage of our customers would change their behavior. That is all theoretical, of course, but it’s well beyond 2% or 3% that say they would react differently if we were to start charging for the first bag.

Hunter Keay - Stifel Nicolaus

Great. Thanks for that color, appreciate it.

Operator

We will take our next question from William Greene with Morgan Stanley.

William Greene - Morgan Stanley

Gary, maybe I can just follow-up on your comments there. I think in one of the media outlets, I’m not sure which magazine it was now, you kind of talked about that bag fees could add as much as 5% revenue but your comments here suggest that net net, you are not sure the passenger line would keep up if you did that. So as we think about the ancillary opportunity you guys have talked about, why wouldn’t we just assume that net net, there really isn’t going to be much increase in the revenue trend because you will have a change in the passenger behavior to just adjust for any kind of extra fee you put in place, so really the ancillary revenue opportunity is not real except perhaps temporary.

Gary C. Kelly

Well, yeah but the $500 million that you are referring to, Bill, was in this context that we are discussing. In other words, we all know that if we charged a bag fee that we would get money for the bag fee. What we don’t know is how many people would change their behavior and so it’s been our view that we are at worst neutral by not charging the bag fee and that when we believe that we are ahead of the game by getting more customers by not charging the bag fee. So I think I am simply repeating what you are saying but the short of it is that we have no plans to charge for the first or second bag.

William Greene - Morgan Stanley

Sorry, maybe what I’m -- basically if I think back to two years ago, you guys talked about an ancillary opportunity that exceeded $1 billion. But it sounds like net net, there really isn’t an ancillary opportunity because of the change in behavior that ultimately occurs.

Gary C. Kelly

Well, I think that that’s -- you know, two years ago we had -- there was no thought of charging for bags beyond the third bag and to be clear on that, we do charge for heavy bags. We charge for the third and other bags, and additional bags. And that’s going to generate somewhere on the order of $40 million plus or minus a year and we’ve recently increased that so that the -- Laura was referring to the increase in bag revenue earlier but there are substantial ancillary revenue opportunities besides bag fees that we are continuing to pursues and admittedly, the one that we have earmarked, that we are most enthused about is the move to the next generation of frequent flyer program, [inaudible]. So we have very substantial ancillary revenue opportunity associated with that.

Laura H. Wright

Bill, the only distinction I want to make is the target was on incremental revenues. I know there’s a clarification of what’s ancillary and what’s incremental, so it was -- we wanted to grow our total revenues over our 2007 base and that does include items that are in passenger revenue, like schedule op innovation and some of the other things we’ve done. So not just pure ancillary add-ons.

William Greene - Morgan Stanley

Okay. Just as a follow-up on a different point then, unit cost pressures, they are obviously something that you are watching closely. As you think about 2010 or even beyond, how much do you have to take into account the need to start to grow again to offset these unit costs because when I think about Southwest, there’s probably not a lot left that you are going to be able to do to cut out a lot of cost from here aside from I guess looking at labor but that is obviously something that’s a challenge to do, so -- do you think you will end up sort of erring on the side of growing more and sooner than you should to offset these pressures? Or how can you -- how do you think about that?

Gary C. Kelly

I’ll take that one -- obviously and Bill, we’ve talked about this many times. We see ourselves as a growth company. Now is not the time to grow, of course. Hopefully the economy will in fact improve, travel demand will strengthen. We’ll be a low fare, low cost carrier that’s preeminent in the U.S. and we’ll have ample opportunities to grow our route map, not only in the U.S. but also in the near international markets and -- so we are thinking about our future along those lines.

You make an excellent point that everyone knows, that growth will help dilute our cost structure so that makes it easier to contemplate the next unit of growth but it’s not the reason to grow, if that makes sense to you. So it’s just an acknowledgement that our incremental costs associated with a unit of growth is less than our average and it just makes it -- you know, that’s just part of building the business case.

We’re not in the position where we are thinking about growing at all. We’re looking for opportunities to grow our route map but at the same time keep our overall capacity relatively flat.

William Greene - Morgan Stanley

All right. Thanks for the time.

Operator

We will take our next question from Daniel McKenzie with Next Generation Equity Research.

Daniel McKenzie - Next Generation Equity Research

I am wondering if a change in the airport strategy suggests a need for a change in the fleet strategy. And what I am really getting at is with respect to the airport strategy, is airports like say La Guardia or Boston, which are newer, the newer, denser, more intensively competitive airports for you folks, and with respect to the fleet, it looks like Southwest has the option with Boeing to substitute larger 800s for the current 700s, which of course would be a way to potentially lower unit costs.

So I guess is this potentially a good opportunity or a bad opportunity to lower unit costs and would Southwest need to renegotiate with the pilots for the larger aircraft type?

Gary C. Kelly

Well, I’ll just take the last point first -- yeah, if we introduce an 800 into the fleet, we would need to talk to our employees about that, and including the pilots. I think that that is a decent idea and something that we have focused on off and on for the last five years. We’ve never concluded that it was the right thing for us to do. I think we would be better served if we had a compelling market opportunity that would drive a fair number of 800s, and that’s possible.

It’s really not La Guardia and Boston -- it’s really just La Guardia in my opinion. Boston Logan is a very efficient operation for us, so -- but we would need more, Dan, than La Guardia to justify the difference in the fleet type because in particular, the 800 would drive a fourth flight attendant for us.

Daniel McKenzie - Next Generation Equity Research

Okay, thanks. That’s helpful. And I guess my second question relates to Southwest's network optimization strategy which if I understood correctly was worth about $100 million this quarter. So based at a look at the schedules data, the strategy has resulted in some pretty heft cuts at major cities and it looks like at least in some markets, and I think Salt Lake City as an example, legacy carriers are beginning to backfill so I guess I am wondering how you thinking about this and does it suggest that Southwest might need to reconsider this revenue strategy?

Laura H. Wright

I don’t have the Salt Lake example off the top of my mind but honestly, Dan, if you look at kind of the capacity cuts that we’ve done and you look at the capacity cuts in our markets, the competitors have been reducing more seats than we have, so -- if you go look at the third quarter, their seats were down I think in the 3% to 4% range in our markets and they have been trending above that. So that one might be an anomaly but I can't think of any markets where we’ve seen a significant share shift negative in our favor as a result of our cuts.

Daniel McKenzie - Next Generation Equity Research

Okay, great.

Gary C. Kelly

Dan, the only other thing I would say, and not trying to parse words but really we’ve simply adjusted our schedule tactically and we’ve had obvious opportunities to go in and trim out unprofitable, unpopular flights. That’s helped boost our overall load factor, so in other words we haven’t -- we have purposefully not made scheduling changes that I would call strategic where we are exiting markets that we feel like their under development towards success. And we are -- the main thing we’ve been able to do is trim out flights at the beginning and the ends of the day that aren’t heavily utilized and also go into the meat of the day where we have plenty of frequencies and we can trim out one here and there.

So that’s a tactic we’ve been using, it’s been working very well. We’ve been for the most part been able to keep those customers we were serving before and just spread them over fewer flights and with little negative customer reaction. We have found some cases where we’ve cut a little bit too deep and there are customers that have said golly, Southwest, we need that five o’clock flight and we are certainly reacting to that. But I would say that that’s more a tactical adjustment than a strategic change in our schedule.

Laura H. Wright

Dan, the only thing that I will add is if you look at our share of domestic RPMs and our share of domestic passengers, they are big and growing year over year. So we -- despite the fact that we’ve cut capacity, we are still seeing a shift in our favor in terms of market share just because the cuts have been greater from the rest of the industry.

Daniel McKenzie - Next Generation Equity Research

Understood. That’s great clarification. Thanks a lot, appreciate that.

Operator

We will take our next question from Kevin Crissey with UBS.

Kevin Crissey - UBS

Can you talk about regional weakness and strength, where you -- kind of how things lay out regionally from -- maybe more on a forward-looking basis, if you can in terms of kind of forward bookings?

Gary C. Kelly

I think we might have discussed this earlier this year, so I may be giving you I hope the exact same answer. That’s what I intend to but I don’t think that it is so much regional as it is more heavily oriented towards business markets where we consistently see remarkable consistency and weakness, so it’s more of the short-haul markets, whether it’s California, Texas, Florida, you name it but I think that we are pretty consistently seeing weakness there. If you group our markets according to stage length, the revenue performance is much better in our long haul markets comparatively than it is in the short-haul markets, so I would -- that’s my reaction to that.

Laura H. Wright

That’s right. I think it is more -- you are exactly right. The long haul markets have been strong in every region and it is certainly the markets where we have the highest business mix that have seen the more difficult year-over-year comp.

Kevin Crissey - UBS

Okay, thanks and one other, I guess, and maybe this is for you, Laura -- the other non-operating line as we look forward into 2010, running the last couple of quarters like 41, $40 million. How should we think about that on a go-forward basis?

Laura H. Wright

I think we haven’t -- but I think the guidance that we’ve given you for the fourth quarter, you should kind of assume that it will kind of continue at those trends as we move into 2010.

Kevin Crissey - UBS

Okay. Thank you very much.

Operator

We will take our next question from Jamie Baker with J.P. Morgan.

Jamie Baker - J.P. Morgan

Gary, you know, we haven’t heard about the 15% return target in quite some time. Obviously we are in a downturn here but I am wondering if there has been any sort of shift in how you view that longer term decision as to whether or not you want to deploy capital when returns are so weak.

Gary C. Kelly

No, there’s no change in our view that we need to have 15% as our return target and the fundamental change this decade, of course, is higher operating costs and that leaves us with two strategic questions -- do we go about boosting revenues, do we go about cutting costs? And I do think that, as you’ve heard me say many times, I think we have a substantial opportunity to generate more revenues with the assets that we’ve deployed, so that’s focus. At the same time, we are working hard to control our costs -- that’s primarily through productivity and I’m just very proud of our people. They are working extremely hard and the productivity gets better every single quarter, every single year so -- but the main driver going forward to achieve that 15% return is going to be transforming our revenue capabilities, recognizing that this is the worst recession that we’ve had in decades, so -- but no, we haven’t lost sight of our long-term goal and these bad times will pass and we’ll be very well prepared to be prosperous in the future.

Jamie Baker - J.P. Morgan

And just to challenge you a bit, or I should say for clarification on the productivity issue, what sort of internal metric do you use for that? You know, when we look at the number of employees per trip or the number of aircraft trips per day, I mean, it seems to point to a deterioration in efficiency.

Gary C. Kelly

It is the primary -- the gross metric that we use is employees per aircraft and you are completely accurate in saying that our trips per aircraft per day are less now, so there is absolutely no argument there. But it is still a matter of finding ways to improve the staffing. As you know, there’s no direct correlation necessarily in an aircraft day with numbers of trips and numbers of employees. It comes more in steps so there is still much work that has been accomplished to improve the productivity and we look at hours paid per trip in many of our departments and those statistics are quite strong, especially in our airport operations.

Jamie Baker - J.P. Morgan

All right, that helps. And a quick question -- I’m sorry, did I cut you off, Laura?

Laura H. Wright

I was just going to say, Jamie, if you look at our employees per aircraft, at the end of the third quarter it was 64 versus 66 a year ago, so we have not this year added on that metric.

Jamie Baker - J.P. Morgan

Okay, that’s helpful and while I have you, Laura, just anymore detail on the new term loan agreement? I assume it’s purely incremental liquidity but you know, Mark and I were a little surprised to see that you were funding on a secured basis, you know, considering that your unsecured borrowing costs have likely improved as of late. Should we be modeling for additional borrowings on a secured or unsecured basis going forward?

Laura H. Wright

Jamie, I assume you are talking about the European financing that we did in early July -- is that the one you are talking about?

Jamie Baker - J.P. Morgan

Actually I was referring to the $124 million new term loan agreement, so yeah, I guess that was July, third quarter.

Laura H. Wright

That was like the first couple of days of July and certainly the unsecured market is very different today than it was even in June or July and so I would agree with you that in today’s market, an unsecured is certainly a no-brainer. That wasn’t the credit market environment at that time and the terms of that financing, as you know, were very attractive.

Jamie Baker - J.P. Morgan

And it does represent --

Laura H. Wright

In terms of modeling for additional financing, our cap spending requirements are pretty modest. We told you today that they are in the $700 million range, so down from where we were. We are in a situation where we don’t need to do additional financing. We’ve got the cash we need on-hand and we’ve got the revolver fully available. On an opportunistic basis, we may consider a financing but I don’t think you should assume that we have any financing requirements that you need to model.

Jamie Baker - J.P. Morgan

Got it, but the $124 million was incremental liquidity that you raised?

Laura H. Wright

In July, yes.

Jamie Baker - J.P. Morgan

Okay, got it. All right. Thanks again, Laura, appreciate it.

Operator

We will take our next question from Helane Becker with Jesup & Lamont.

Helane Becker - Jesup & Lamont Securities Corporation

Thank you very much, Operator. Thanks for taking my questions. Good morning. So just a couple of things -- is there any way you can break out how much Wow added in September to your -- I mean, I know the load factor is up 11 points but can you say what the core would have been?

Gary C. Kelly

Well, we’ve got a number that we’ve assigned to it. I’m not sure how scientific it is but I think it was probably worth $10 million-ish in the month of September, so it’s certainly nothing to sneeze at but I think what was most encouraging to us is that when we launched the sale in July over -- as I recall it was a 48-hour sale and it was really -- that doesn’t really tell the story either. Most of the bookings as I recall came in in the second 24-hour period, so it was really, really hot and set all-time record bookings for a 24/48 hour period, let’s say. So the booking numbers for September spiked very sharply at that point. We are showing very large year-over-year booking comparisons. What was remarkable is that we sustained that year-over-year comparison for many, many weeks and so our marketing folks concluded from that, and I agree with them, that it was largely incremental bookings as opposed to accelerating bookings that would have otherwise taken place.

So it wasn’t the difference between winning and losing September but it sure got us off to a good start and it’s carried on. You know, we’ve had substantial bookings put in place for October and November and I would certainly give credit to the Wow sale for getting October off to a very strong start and as I mentioned earlier, if things continue we’ll have a record October load factor, just like we’ve had for the last gosh, four or five months.

Helane Becker - Jesup & Lamont Securities Corporation

Great, gotcha. And then can you say at all -- I know you sort of talked about California and Florida being underperforming markets but can you say how La Guardia has rolled out in the past couple of months since you started here?

Gary C. Kelly

Well, I didn’t say that California and Florida were under-performing -- I said what has been hit the most are the short-haul markets in places like California, Texas, Florida -- but it’s not just those areas. It’s across the country, just using those as examples.

La Guardia is the second of our big three cities that we’ve added this year. We are running well above average load factors, just with two non-stop destinations. It’s a very nice contributor to the third quarter results. The delays that we have suffered there are painful when they happen. That’s going to happen. We knew that going in and that’s why I am glad we only have eight round trips there. But the on-time performance has held up, so we’ve been able to manage the schedule to not allow the rest of our operation to be infected by long delays there, but all the way around I think we’ve been delighted with all three cities. I have to say that the combination of Boston, Manchester, and Providence has been the strongest and we’ve had very strong traffic numbers out of the Boston region, but including Providence and Manchester.

Helane Becker - Jesup & Lamont Securities Corporation

Okay, and then my last question is about new cities for next year, have you thought about that and -- or ruled that out? I mean, you talked about 10 plus or minus planes.

Gary C. Kelly

We’ve thought about that a great deal. We are going to continue to fine-tune the flight schedule by eliminating trips that we don’t like, that they are not profitable, they are not popular, et cetera. And I think we are getting closer to the end of that process but I do see that we’ve got opportunities to consider some new cities next year, so stay tuned on that one.

Helane Becker - Jesup & Lamont Securities Corporation

Great. Okay, thanks, guys.

Operator

We now have time for one more question. We will be taking our last question from Gary Chase with Barclays Capital.

Gary Chase - Barclays Capital

A couple of clean-up ones and then I wanted to ask a broader one -- you know, Laura, I thought you said somewhere in your prepared remarks or in the Q&A that the fuel hedging impact next year was $0.07 a gallon, and that would imply that you are modeling like 225 spot jet? Could you just clarify what’s in your 240? Could you kind of build it up from spot to realized hedging losses for us?

Laura H. Wright

Yeah, well, let me find my notes here -- 2010, if you look at yesterday’s close, was about $79 a barrel and so if you kind of take the forward crude and the forward crack, taxes, we are modeling un-hedged physical price next year of about $2.32 a gallon, including taxes. And that’s based on yesterday’s close.

Gary Chase - Barclays Capital

Okay.

Laura H. Wright

So the $2.40-ish implies about a $0.07 per gallon carry-forward penalty from the de-hedging of last year.

Gary C. Kelly

Gary, if I could just chime in right quick, Laura had to -- she had to set me straight this morning because prices have moved really big just over the last couple of days, so that number surprised me as well that it was so high and it just reflects the most up to date view of the market as of yesterday.

Laura H. Wright

As of yesterday’s closes, so --

Gary Chase - Barclays Capital

Have you guys added like more taxes or differentials in the last year or so? Because that just seems way off the curve we looked at.

Gary C. Kelly

Well, as I say, we can talk to you about all of that offline but the big move, and at least from what I was looking at in a days time, it’s moved at least $0.20, $0.15.

Laura H. Wright

Probably but Gary, as you know, we’ve had really low crack spreads in 2009. The forward curve doesn’t have the same crack spread that we’ve enjoyed this year. And [jet divs] have been -- are extremely low, so again you’ve got to take all those things into account. In the end, we all know we don’t know what they are going to be next year because they are going to change every day but if we just take market numbers for all those pieces, as of yesterday, that’s the arithmetic.

Gary Chase - Barclays Capital

Okay, well I think the important thing is just understanding that it’s really only $0.07 realized loss. Apologies for that -- Laura, could you just remind us how much was -- you know, for the quarter, do you feel like the $10 million you referenced in the pets and unaccompanied minors and so on, is that -- should that be viewed as a full-up number? I just can't remember the exact timing of when all that went into place.

Laura H. Wright

Well, we had $10 million in the quarter. The UMs and the pets we rolled out in mid-June, and the early bird fee wasn’t rolled out until early September, so that one certainly should have some potential to grow from the run-rate that we had for the quarter. So definitely some upside from the third quarter numbers. I think $10 million in total for the third quarter.

Gary C. Kelly

And again, Gary, that has bags in it, the $10 million.

Gary Chase - Barclays Capital

Yeah, and the revenue management, when did that go into effect?

Laura H. Wright

That was kind of mid-September, so certainly some benefit there and that is really on the passenger revenue side.

Gary Chase - Barclays Capital

Okay. And then -- look, one way to look at next year -- this is kind of the strategic question, and I’m not sure that you’ve actually provided guidance that you are going to be flat but that’s how I’m interpreting your remarks -- I mean, one way to look at that is that you are not growing but another way is to take a look at where you are in the fourth quarter, where you have gone through this big optimization, at least it looks to us like it’s really working and generating some good revenues, especially if you think of what went into effect in September. And based on that run-rate, it depends on what baseline you use, based on where you are in the fourth quarter, flat capacity next year would actually be growth from the baseline that you are on. And I guess the question is should we take, when you say no intention to grow, should we take that to mean that you are going to be flat? And if you are going to be flat, which reflects growth from here, what’s the thought process, just because as I would observe, it looks like it is really working well.

Gary C. Kelly

Well, I would have to -- I’d really have to think about your question. We just announced our March schedule and March basically is unchanged from January except for the move with seasonal flying so we are probably going to have a little bit -- so in other words, the fourth quarter is not going to be representative of the capacity that we would want each quarter going forward, with this notion of quote flat. But yeah, we may have -- we’re going to be down in the first half of the year and we may find when we publish our schedules that we are up slightly in the second half of the year, if that’s where your mind is going but no, we agree with you. We are really happy with the schedule and we’ve gotten more and more aggressive with each schedule in terms of pruning, so if we add some flights that we evaluate and we don’t like them, we’ll pull them out. So I think the idea is to keep it roughly flat but -- knowing that we are going to continue to have some changes to the flight schedule and in particular, if we add some more new cities next year, that will require some adjustments with the rest of the schedule.

Laura H. Wright

And Gary, just going back to the math, with only 10 airplanes, based on our fleet size, you know that isn’t going to be -- when we say flattish, it’s going to be close to flattish, so that’s not going to move the needle a whole lot if we do some incremental either way.

Gary Chase - Barclays Capital

Right. I though you had said in the past you would actually be up one, is what I remember for some reason but --

Gary C. Kelly

Up what, a percent?

Gary Chase - Barclays Capital

If you think about the progression of this year, you are down a lot more in the fourth quarter than you’ve been for most of the year, so flat means you’ve got to be up in some of those periods. That’s what I am driving at and that feels like incremental investment in the business from where you are right now.

Laura H. Wright

I think just think of it in terms of zero to 10 airplanes, and we haven’t made a decision on zero to 10 yet.

Gary C. Kelly

And I would just further say -- I know you are asking us about an annual plan, but our plan is more every schedule. We are making up-to-the-minute decisions about whether to deploy flights on a schedule by schedule basis. But it does feel like at least when we get into the January/February time period for 2010, we are going to be in a trough.

Laura H. Wright

Yeah, it’s going to be down.

Gary C. Kelly

The first quarter capacity is definitely going to be down compared to first quarter of ’09.

Gary Chase - Barclays Capital

Okay, guys. Thank you very much.

Laura H. Wright

Thank you. Thank you, everybody for calling in today and please feel free to call our investor relations group if you have any questions. They will be ready. And have a great day. Thank you.

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Source: Southwest Airlines Q3 2009 Earnings Call Transcript
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