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Southwest Airlines (NYSE:LUV)

Q4 2009 Earnings Call

January 21, 2010 11:30 am ET

Executives

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

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

Analysts

Mike Linenberg – Bank of America/Merrill Lynch

William Greene - Morgan Stanley

Hunter Keay - Stifel Nicolaus

Gary Chase - Barclays Capital

Duane Pfennigwerth - Raymond James

Helane Becker - Jesup & Lamont Securities Corporation

Will Randow – Citi Investment Research

Daniel McKenzie - Next Generation Equity Research

Operator

Welcome to Southwest Airlines fourth 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 Kelly Lang

Thank you. Thanks everyone for joining us. Obviously we are at the end of this roller coaster year we are delighted to be able to report that our profitability string is intact and to be able to report even a very modest profit in this environment I think is a huge accomplishment.

I am very proud of our employees. It has been a real roller coaster. A lot of changes. A lot of challenges but I think they more than proved they are up to the task. The earnings for the fourth quarter if we start there were $74 million on a non-GAAP basis and that is $0.10 per share better than a year ago. Better than the Wall Street estimate and certainly better than what we thought 6-8 months ago.

For the full year we did $143 million of earnings again on a non-GAAP basis. That is $0.19 per share down from the 2008 levels but certainly understandable given the very challenging economy we faced in 2009.

A lot of remarkable things about the fourth quarter though. The fourth quarter to the best of my recollection has never been the best quarter in a year and this year it was by far. It was the best unit revenue performance of the year but that means that we set an all time record in terms of quarterly unit revenue in the fourth quarter of a recession. That is remarkable indeed.

You might say it is because we adjusted our capacity but that doesn’t explain it because our traffic was actually up and we had a record level of traffic for a fourth quarter and that is despite a near 8% drop in our capacity. It is probably not too surprising to find that we also had a record load factor performance for the fourth quarter as we did for the full year.

So a number of very strong metrics if you will measuring our revenue performance and so we are just delighted all the way around. It is not just our marketing department. Not just our operations. Not just revenue management. It took literally every employee at Southwest Airlines to produce those kinds of results and make the kinds of changes that we did in 2009.

At this point we have strong bookings in place for the balance of the quarter here in the first quarter of 2010. January, February and March bookings look really good. Just glancing at yesterday’s bookings this morning we had another strong day yesterday. The trend so far in January Laura will speak to in a minute but we are very pleased with the trend we are seeing so far in 2010.

Just to give you a very quick recap of the things we did in 2009 to boost our revenue I think first and foremost was the focus on a very high quality operation. We have had the best on-time performance we have seen in years. We are turning out some of the best baggage handling numbers that we have ever had in our history and once again we lead the industry in the fewest customer complaints. A very, very high quality operation once again despite all of the aggressive changes that took place.

The other, again first and foremost, step that we took is we just focused on our low fare brand. We had some very successful aggressive fare sales. We launched a series of advertising campaigns that really drive home what we stand for and of course we are all very proud of our bags fly free campaign. You can’t find a customer now who isn’t aware that Southwest doesn’t charge for bags. We are getting a lot of credit for that and I think that of course is certainly one of the reasons we are seeing a pretty significant share shift to Southwest Airlines.

Our capacity is down but our traffic is up. We had a number of aggressive changes to the schedule this year. I have already mentioned our fare sales. We introduced our Early Bird product. We now take pets. We added three very large cities to our route network launching Milwaukee as our fourth city link in the year. We have seen huge gains in our Denver market and Denver in August of this year will be up to 144 daily departures making it the fifth largest city in our route network and by far the most successful new city we have ever had. We also have some very nice opportunities that are unfolding in St. Louis.

The sequential improvement we have seen in our business in the fourth quarter is very broad. That is compared primarily to the second quarter earlier this year but I do think it is fair to say our short-haul markets are still lagging behind some of the other markets and I would also attribute that to a softness in business travel.

Finally before turning it over to Laura I just wanted to make a point that even though the earnings weren’t at record levels for the year we did have a very respectable fourth quarter earnings performance. If you compare it to the last five years it is not our best but it ain’t bad. I think more importantly for the year we had near $1 billion in operating cash flow that was generated and to be able to do that in a recessionary environment we have already managed our capital spending much lower was again just a very, very encouraging sign.

It has been a very gratifying year for us. I think without a doubt we are very, very confident about how we think about our future. With that I would just like to turn it over to Ms. Laura Wright, our Chief Financial Officer.

Laura Wright

Thanks Gary. Good morning everyone. We are very pleased to report a profit for the fourth quarter and the full year. Our fourth quarter net income of $116 million included a net gain of $42 million relating to non-cash, mark to market and other items associated with FAS 133.

Excluding these special items our fourth net income was $74 million or $0.10 per diluted share which was far better than we thought possible just months ago and easily exceeded Wall Street’s estimate of $0.07 per diluted share. Our fourth quarter revenue results were outstanding and our unit revenue trends have continued to outperform the industry.

For the fourth quarter our operating unit revenues were up 7.4% year-over-year. We continue to gain market share with our traffic up over 5% in the quarter despite an almost 8% reduction in our capacity. We posted monthly record load factors beginning with July and ended the year strong in the fourth quarter record performance of 77.3% which was up almost 10 points from a year ago. This surpassed our record performance of 70.3% from the fourth quarter of 2006.

In July we launched a sale for travel post Labor Day through mid-November. It set all time bookings records and helped drive our load factors during this period to new highs. We are also seeing a positive customer reaction to our Bags Fly Free campaign and as a result our year-over-year unit revenue comparisons were favorable in October, November and December.

November and December’s year-over-year unit comparisons were impacted by the Thanksgiving shift which boosted our November revs between 1-2 percentage points. For the two months combined our unit revenues were up almost 8% compared to November and December of 2008.

Strong bookings in year-over-year revenue trends are continuing into 2010 and month to date our January passenger RASM is estimated to increase between 14-15% year-over-year. Keep in mind that our January capacity is estimated to be down almost 7% compared to a 4-5% reduction in February and March which will make our comparisons a little more difficult in the February and March time period.

Based on our full fare mix we believe that our full fare business traffic has stabilized but we are definitely not back to pre-recession levels and for the fourth quarter 2009 our full fare mix was 18%. Again, our employees have done an extraordinary job responding to the weak demand environment and we couldn’t be more pleased with their efforts. As Gary mentioned we launched a number of unit revenue initiatives during the year although on plan we introduced our new pet fare, our unaccompanied minor charge, Early Bird check in and we are very pleased with the revenue contribution of these initiatives.

Our Early Bird revenues which are included in “other revenues” were approximately $13 million in the fourth quarter. Our business select revenue in the fourth quarter held steady at about $18 million and for the full year was $72 million. In addition to that we generated over $10 million in other revenues for our new pet fare, unaccompanied minor charges and excess heavy bag fees.

Our schedule optimization efforts have been a huge success and we are significantly benefiting from our capacity cuts and the realignment of our network. We have eliminated approximately 10% of our flights that were unprofitable over the past year and we kept our fleet flat because of weak travel demand. Our own capacity cuts, the successful schedule optimization represented the majority of our 7.4% year-over-year RASM increase.

Through our optimization efforts we were able to open Minneapolis St. Paul, New York La Guardia, Boston Logan and Milwaukee as well as going to markets such as Denver and St. Louis. We continue to advance our revenue management structure and technique and are very pleased with the results of the steps we took late in the third quarter to restructure our fares to provide an array of low fare options that better respond to the impact the recession has had on demand. The fourth quarter revenue impact was greater than expected and produced tens of millions in incremental revenue for the quarter.

We have also upgraded Southwest.com and are seeing higher book to look rates and higher average fares from our shoppers. With respect to freight and other revenues our freight revenues were down about 16% year-over-year due to the weak economy. We expect our freight revenues for the first quarter 2010 to be in line our fourth quarter 2009 freight revenues. Our other revenues were up significantly year-over-year in the fourth quarter and as I mentioned before the ancillary revenues from pets, UM’s, Early Birds and bags combined for almost $25 million during the quarter. We expect the strong year-over-year improvement in our other revenues to continue into the first quarter of 2010.

Turning to our fourth quarter cost performance our fourth quarter operating expenses excluding special items decreased 2.7% versus fourth quarter last year largely due to lower fuel costs. Our economic fuel costs decreased 3.1% to $2.20 per gallon for the quarter which was slightly better than we anticipated. Fuel prices remain volatile and we continue to actively manage our portfolio and our associated premium costs. We recently restructured our 2010 fuel hedge portfolio and we are currently about 50% hedged in 2010 at prices up to about $100 per barrel.

We recently sold call options which decreased our protection to 20% if the market prices settle in the $100-120 per barrel range and we added another layer of purchase call options to provide catastrophic protection at levels above $120 which increases our protection to approximately 40% hedged if the market prices exceed $120.

Our 2010 hedge portfolio includes a combination of swaps, callers, call options and call spreads. The premium costs associated with our 2010 fuel hedge portfolio which are recorded below the line in other gains or losses are estimated to be approximately $115 million in 2010 or about $30 million per quarter which is less than the $148 million spend in 2009.

Based on current market prices we are estimating our first quarter 2010 fuel costs including fuel taxes but excluding premiums to be in the $2.35 per gallon range. Our first quarter 2010 fuel price estimate includes a $0.10 per gallon hedge penalty based on current market prices. This is significantly improved from the $0.17 penalty at the time we hedged in the fourth quarter of 2008.

To provide you with some sensitivity with respect to our first quarter 2010 fuel hedge, if first quarter prices drop and average $60 per barrel for the quarter our hedging penalty increases to about $0.24 per gallon as the current gains we have in the hedges priced in 2009 are reduced and no longer offset the loss from the 2008 de-hedging. If first quarter prices rise an average $95 per barrel for the quarter we would expect to have a $0.09 per gallon hedging benefit.

Volatility makes it quite difficult to provide precise guidance for 2010. However, our best touch point based on the current forward prices and our existing hedge portfolio is in the $2.30 to $2.35 per gallon range which is about $0.10 above current market prices. For 2011 we currently have about 40% of our estimated fuel consumption hedged with a majority using callers and we have modest positions in place for 2012 and 2013. As of two days ago the total net liability of our current fuel hedge portfolio was around $500 million.

Excluding fuel and special items our unit costs were up 8.6% year-over-year to $0.0745. This performance was in line with our expectations and slightly under our guidance of $0.075. One of the drivers of the increase in our unit costs was the reduction in our capacity which was down 7.7% in the quarter. The remaining is inflationary pressures in such areas as salaries, wages and airport costs.

Based on current cost trends and headwinds from lower first quarter capacity, we currently estimate our first quarter 2010 unit costs excluding fuel and related taxes will increase from fourth quarter 2009 to $0.0745. Our year-over-year unit cost pressures are more heavily weighted towards the first half of 2010 in particular the first quarter due to our capacity reductions.

Our first quarter 2010 available seat miles will be down in the 5-6% range while we expect our full-year ASMs to be roughly flat. For the full year 2010 we are projecting our X fuel unit costs to be up in the 5% range as a result of our flat capacity and inflationary pressures in many cost categories. We can assure you we know this is not acceptable and adjusting our cost structure and improving our productivity to support the changes we have made with our schedule will be one of our top priorities in 2010.

We have swiftly adjusted our schedule to adapt to a higher underlying cost structure, energy prices and a weaker demand environment. Now is the time to adjust our costs to our more flexible schedule and it is our intent to do so. That being said, it cannot be done overnight and it will take us time to build and make the necessary adjustments.

With respect to our airport costs our landing fees and other rentals on a unit basis increased 18.5% to $0.77 primarily due to airport rate increases. That was partially offset by some favorable airport adjustments. Based on the continued rate inflation at various airports which is really being driven primarily by capacity reductions, we expect our first quarter airport unit costs to exceed fourth quarter’s $0.77 and we are currently estimating that first quarter 2010 airport unit costs to be in the mid $0.80 range.

Our salaries, wages and benefits increased on a unit basis to $0.0366 over fourth quarter last year. Higher wage rates accompanied by our 7.7% capacity reduction contributed to the year-over-year increase. Based on our current cost and capacity trends we expect our first quarter 2010 salaries, wages and benefits unit costs to increase from fourth quarter’s $0.0366. On a year-over-year basis we expect the unit costs to be up in the 8-9% range.

Our maintenance unit costs decreased 11.5% year-over-year which was better than anticipated primarily due to fewer than expected events. Based on the planned events and reduced capacity we expect our first quarter 2010 maintenance unit costs to be in the high $0.70 range.

Turning to the balance sheet our liquidity remains strong. One of our main goals for 2009 was to protect our financial health and we succeeded by maintaining a healthy cash balance, an investment grade rating and modest levels of debt. As of yesterday we had core unrestricted cash and short-term investments of $2.4 billion. Our $600 million credit facility remains fully undrawn and available. Our leverage including aircraft leases is in the 45% range and we have very manageable scheduled debt maturities in 2010.

For 2009 our cash flow from operations was $985 million which was net of a $90 million increase in our fuel hedge collateral deposits. After capital spending and scheduled debt payments we generated free cash flow of $400 million which we used to repay our revolver. For the full year 2010 we expect that our capital spending will be in the $600-700 million range.

With respect to our fleet we ended 2009 with 537 Boeing aircraft. During the fourth quarter we did not have any scheduled firm orders from Boeing but we reduced our fleet by four aircraft. Our fourth quarter available seat load capacity decreased 7.7% and our full year capacity was down 5.1% compared to 2008. We remain very cautious with our capacity plans for 2010 and we are not planning to grow our fleet this year and expect our full year available seat mile capacity to be roughly flat with 2009.

As I mentioned earlier our year-over-year capacity declines are weighted to the first half of the year with our largest quarterly decline planned for the first quarter. Our forecasted quarterly ASM capacity is as follows: In the first quarter we will be down in the 5% range. In the second quarter our ASMs will be down in the 1% range. In the third quarter we are currently projected to be up in the 1% range and the fourth quarter up in the 2% range.

As we have done successfully for the past several years we will continue to optimize each published schedule. We have firm orders with Boeing this year for ten 700 aircraft and we have a like amount of class leased aircraft with expiring leases as well as the ability to retire our owned classic aircraft. We have included an updated Boeing delivery schedule in the accompanying tables to the press release issued this morning.

Marvin, with that I think Gary and I are ready to take questions.

Question and Answer Session

Operator

(Operator Instructions) The first question comes from the line of Mike Linenberg – Bank of America/Merrill Lynch.

Mike Linenberg – Bank of America/Merrill Lynch

With respect to the hedging you provided that 2010 you were 50% hedged at up to $100 a barrel. The way to think about that, is the larger portion of that hedge book closer to $100? Do you have a weighted average number so when we model depending on how oil prices move we can come up with a number?

Laura Wright

Think of it as the amount that is hedged up to $100 is with protection beginning kind of in the mid 70 range so it is protection in that arena. Then it drops to 20% protection if prices are above $100 and then 40% if prices exceed $120.

Mike Linenberg – Bank of America/Merrill Lynch

So then that would suggest some of the hedges are in the money and you are getting the benefit of it now?

Laura Wright

That is correct which is why that hedge penalty has decreased from where we were a year ago.

Mike Linenberg – Bank of America/Merrill Lynch

You gave us the fare mix for bus travel. You said it was right around 18%. I want to make sure is that 18% of revenue? What does that compare with what it was a year ago? What is a more normal number for you? As things get back to normal is that somewhere in the mid-20’s?

Laura Wright

I will answer in several steps. A year ago our full fare mix was 24% so it off about 6 points. That is certainly the fact we had a 9.5 point load factor increase distorts that drop somewhat because so much of that gain is driven by the discretionary leisure traffic so we would expect in a record load factor to see more of a drop in traffic. But I would say mid 20’s is probably reasonable to what we would like it to be when we get back to more normal times.

Operator

The next question comes from the line of William Greene - Morgan Stanley.

William Greene - Morgan Stanley

I am wondering can you talk a little bit about how soon you think you would ramp up the capacity growth? What are the things you are watching for because you used to grow quite a bit faster and you mentioned Laura’s remarks the unit cost pressure. So how do we think about timing a return to normal levels? And what is normal for you now?

Gary Kelly

Flat is the new up. Well, I don’t think we have anything specific beyond what we are reporting today. Laura mentioned we are managing schedule by schedule. You know what we have been describing over the past couple of years in terms of transforming Southwest Airlines capabilities to deal with a new reality. I think one of the new realities of course is much higher energy costs. I just don’t think we are there yet. So 2010 for Southwest Airlines as you know will probably be the highest hedged jet fuel costs for Southwest Airlines in our history.

We need to be prosperous to afford to grow. We need to be hitting our return on investment targets or believe we will soon hit those targets before we add to the fleet. On the heels of what I saw the ATA reporting yesterday this is the worst drop in revenues the airline industry has ever experienced. I certainly agree with that as that is the way it felt. I don’t think any of us believe that now is the time to be talking about growth. We want to grow. We will be looking for opportunities to grow. We would like to be bold but the risk reward will just need to balance out there in terms of thinking about new opportunities.

For the time being you should just expect if our results are like they were in 2009 we would not want to grow the fleet.

William Greene - Morgan Stanley

So it will be financially driven?

Gary Kelly

Yes sir. Absolutely. Just trying to be not quite so vague, we will be open to acquisitions and opportunities that could unfold in an environment like this but absent that in other words yes we will be looking for some confidence our revenues are going to overcome these higher operating costs and we are not there yet.

William Greene - Morgan Stanley

You didn’t mention an ability to start flying to international or near international destinations. Is that because that is not a near-term thing and you just don’t have the technology to get there?

Gary Kelly

Well, yeah. We had major technology implementations in 2008. We had even more major installations in 2009 and we have two big projects underway still for 2010 and one of those is international and coach air. When that work is completed in 2010 we won’t be prepared yet to fly our own metal to international markets. That will be a future project and a future deliverable and is something we are interested in but it is not 2010 and probably not 2011 for that matter. Our other major priorities in the near-term as you will recall is the next generation Rapid Rewards program. So a big effort underway in 2010 to wrap that up.

William Greene - Morgan Stanley

Correct me, wasn’t the $1.5 billion you were targeting in non-fare revenue opportunities didn’t that include international or do I have that wrong?

Gary Kelly

Going back to 2007 when we laid out our transformation strategy it was coach and international. It was not flying our own metal international. I don’t think we have ever said we aren’t interested in pursuing that. As time has gone by if you from 2007 to 2008 to 2009 I think we have gotten more interested ourselves in flying international. No, that was not part of the 1.5 back in 2007.

William Greene - Morgan Stanley

Do you have an estimate of how close you are to the 1.5?

Gary Kelly

Back in 2008 I thought we were more than half way there already. Of course we had a setback in 2009 with the recession. We will have to circle back up on that because we had a very pleasant development in the second half of 2009 and a lot of things are working really well. So I think we will need to re-evaluate that target. The $1.5 billion relative to 2007 is very realistic but the target has moved. So energy prices are very different in 2010 compared to where we thought we were going to be in 2007. 1.5 isn’t going to be enough so we have got to up that target and have internally.

Operator

The next question comes from the line of Hunter Keay - Stifel Nicolaus.

Hunter Keay - Stifel Nicolaus

How many more bags have been checked per passenger since the bags fly free campaign really started to get ramped up?

Gary Kelly

Well I don’t think there has been any change in our customer behavior except that we have seen a very significant increase in our load factors. So I think that has been the big change. I think there are of course more bags coming with more customers. I think that is one of the points that I would just re-emphasize is despite a very radical change in load factors our operations have held up extraordinarily well. I have been very proud of the quality of the operations all the way around. We haven’t seen any change in customer behavior. So the same applies to the carry on’s. We haven’t seen anything remarkably different at Southwest. Other carriers obviously they have had customer behavior changes but we haven’t seen it at Southwest.

Hunter Keay - Stifel Nicolaus

I noticed there was a big sequential uptick in other operating expenses. Presumably some of that is increased ad spend from the marketing of the bags fly free campaign. Can you tell me if that is correct or incorrect and maybe quantify for me the incremental ad spend?

Laura Wright

We definitely had increased advertising in the fourth quarter. I think it was up about 10%. The real driver in the other operating expense increase is revenue related. So charge sale discounts grow as revenues grow. You see the charge sale discounts grow significantly so that is really a bigger driver of the increase in other operating than advertising.

Operator

The next question comes from the line of Gary Chase - Barclays Capital.

Gary Chase - Barclays Capital

A couple of things I wonder if you could elaborate on more I think during your prepared remarks you stated the comps on RASM get tougher through the quarter. That is kind of opposite what I would think. If I just look at where you were you were positive January of last year and pretty substantially negative by the time you hit March. I just wonder if you could elaborate a little bit on what you are thinking there.

Laura Wright

I agree with you that we really started to see travel deteriorate in late January but definitely February and March. Really the point there was just to point out that there is other factors in there and the biggest being our own capacity reductions and the fact we are going to have 7% ASM reduction in first quarter versus kind of 4-5 versus February and March will distort that but I do agree with you. You have some easier comps on one hand but tougher comps as a result of our capacity reductions.

Gary Chase - Barclays Capital

Could you, you said down 7% in Q1. Can you go through the months where you are going to be?

Laura Wright

What I really meant to say was down in January we are going to be down about 7% in ASMs. In February and March our ASMs are only going to be down between 4-5%. That was really the point that our own capacity adjustments have a less favorable year-over-year comp as we move throughout the quarter.

Gary Chase - Barclays Capital

But clearly the sort of overall environment gets a lot easier just in terms of….

Laura Wright

I completely agree. I think that is fair.

Gary Chase - Barclays Capital

You mentioned the cost issue and said you weren’t satisfied and these things take time. I guess my question is could you maybe walk us through what it is about that plus five you think with more time you can address? You talked about sizing the cost structure to a more flexible schedule. What is it you think you will be able to deal with over time that isn’t really feasible to tackle during the course of this year?

Laura Wright

I think if you look at we have made some pretty significant adjustments in how we schedule and you can see that. We have a lot more demand in the second and third quarter than there is in the first and fourth quarters. So we have a little bit heavier ASM weighting and we have done those changes in the schedule over a very fast period of time. I think the point is it takes time for us to adjust our operations and improve our productivity to adjust to those changes.

Gary Kelly

I think Laura said it very well but I will just try to say it a little bit different way to see if it helps clarify. We have had a long history of producing what for all practical purposes was a static schedule and the only changes to our static schedule were more airplanes and more flights. Now what we are forced to do is to react to higher energy costs which means higher costs per trip so you can’t fly your way into lower unit costs with energy. What you are seeing now in 2010 is the most exaggerated scheduling for us adjusting to seasonality. So I think that is the point Laura was making is that we have really pulled down capacity in January because the demand is lower and we are purposefully bringing it back in a more flexible way in February when we think demand will pick up seasonally. We have never done that before. That is that.

Then underneath that we basically have the same staff in place in a fixed way on the ground to a lesser degree in the air whether we have a reduced schedule in January or a full schedule in March. We have not quite cracked that nut on how we make our cost structure a little bit more flexible although we are determined to do that. So I don’t think either one of us are prepared to describe today what we are going to do or what our ideas are and none of it will necessarily come easy. But that is the challenge and we just repeat like what I said in the beginning I think our people are more than up to that challenge.

Our focus right now has been improving the customer experience and transforming Southwest’s capabilities and we are performing exceptionally well there. We will turn our sights on in 2010 is getting our productivity enhanced even further. If you look at our employees per aircraft it improved yet again in 2009. So we are making progress. We just need to make more rapid progress. I think just finally one of the things that we are faced with here on the airports that Laura pieced that one out, our airport costs are going up for two reasons. One is the nominal costs are going up which is painful in and of itself. Secondly, the overall activity in the industry is going down and I know you understand all of that. That is one of our bigger cost issues in 2010 and what I described won’t address that. So we are going to have to find offsets to that very significant cost pressure that we are incurring at this point.

Operator

The next question comes from the line of Duane Pfennigwerth - Raymond James.

Duane Pfennigwerth - Raymond James

With regard to other revenue it looks like on a per passenger basis that increased sequentially to the 450 range. I am wondering what you think the longer term targets for other revenue per passenger could approach.

Laura Wright

I am not sure we have given any real guidance out there. We definitely saw a nice increase in our other revenues per passenger in the fourth quarter and we have a lot of initiatives we still have underway with Southwest.com. We have talked about some of the things we have to improve our sales, cars, hotels and so forth. That work is still in the plan. So we think there is a significant opportunity to increase our other revenues per passenger. I am just not sure we are ready to give you a target yet.

Gary Kelly

I agree. The only thing I think that we have done some modest things on the ancillary revenue area this past year with Early Bird, pets, the much needed fee for unaccompanied minors. The big opportunity out in front of us is with our Rapid Rewards program. We are looking for a very significant revenue contribution there. Off the top of my head I can’t convert that to a per passenger target but I can at least tell you where the source of the increase in ancillary and that is clearly within our frequent flyer program.

Duane Pfennigwerth - Raymond James

So this quarter for the first time in awhile total RASM grew faster than passenger RASM. Should we expect that spread to continue to increase there?

Gary Kelly

Freight has really lagged and it still is. It is down double digits. We have seen a lot better strength in the passenger side of our business. That is a pretty big piece of that whole “other” category so it would be nice to see some improvement in the economy that would drive moving the goods and we will get more than our fair share I think. We do a great job with our cargo products. As time goes by we are adding more and more. We have Southwest.com phases that will continue to come that will create better opportunities for hotels and rent cars so you should see that. Then of course our frequent flyer program will come much later next year or early 2011. I think for the time being that is probably a reasonable assumption.

Laura Wright

Certainly for the first three quarters of this year the full-year impact of the initiatives we talked about; Early Bird, pets, etc. we are going to see some good gains year-over-year. Hopefully by that time a lot of these new initiatives we have should be rolling out too. So we should continue to see that per passenger growth.

Gary Kelly

I think there is leverage here too. In other words our mantra is to win more customers. We continue to believe we have more opportunities to win more business customers as well as a subset of that. More customers will drive more stuff. I definitely think we have very strong momentum with our brand and there is every reason for us to believe we will continue to drive more ancillary revenues because of for no other reason we have more customers.

Duane Pfennigwerth - Raymond James

In terms of you X fuel CHASM I apologize if you have already said this but given your flat sort of capacity plan for the year how should we think about X fuel CHASM relative to the 5% growth you are seeing in the first quarter?

Laura Wright

I think the guidance is that for the full year of 2010 we expect that our X fuel CHASM will be up in the 5% range. For the first quarter of 2010 or really the first half of 2010 the unit cost pressures and our X fuel costs will be greater than the system average because of the capacity reductions. So the first quarter I think what I mentioned was we expect our first quarter X fuel unit costs to exceed our fourth quarter 2009 unit costs which were 7.45%. That is going to be a higher increase in the first quarter than the 5% we expect for the whole year.

Operator

The next question comes from the line of Helane Becker - Jesup & Lamont Securities Corporation.

Helane Becker - Jesup & Lamont Securities Corporation

Can you say in terms of actually talk about the experience in La Guardia and how successful that has been so far? Are you seeing share shift away from Islip and if that hurt operations at all? At one point in the past you had talked about kind of taking fare increases $2 to $3 here and there maybe once a year in the May timeframe. I think last year you may have had a few other fare increases during the year. Can you talk about how you are thinking about that going forward?

Gary Kelly

I will take that in reverse. The days of the annual fare increases are long gone. We have essentially in 2008 with the obvious pressure we had with energy costs we had a number of aggressive fare increases that year and it worked very well until we slammed into November really in the fourth quarter of 2008. Even in 2009 our normal mantra is it is really hard to price yourself out of a recession. Even in 2009 we have had a series of, they have been broad but very tactical and I think very wise efforts to increase fares. I think a fair evaluation of the success of those is that most of those worked well. Obviously the first fair increase has a better chance of driving revenue than the last one because they sort of compound. We are in a mode back to a comment I made earlier we must adjust as an industry and as an airline to higher operating costs.

We are doing that as aggressively as we dare and the results of all of our various actions over the last couple of years I am very pleased with. I think the evidence is very strong that our folks are doing a great job there. We will continue to look for fare increase opportunities because we are not hitting our profit targets yet and we are expecting to have cost hurdles to overcome. So we are trying to do that in a way that we maintain our low fare brand and I think that is one of the reasons why the Bags Fly Free has become such a meaningful weapon in our arsenal. It is just another way for us to demonstrate to the customers we do stand for overall low fares and it is something our competitors can’t match and at the same time we can keep the rest of our fare structure relatively low even though we will be increasing it over time.

On the New York question no share shift is visible to us at all from Islip. I don’t see any cannibalization there at all. The La Guardia operation for Southwest is quite small. It is eight round trips. On time performance for those flights has been slightly below average but nothing we have been concerned about. We are obviously doing our best to make sure if there are some operational integrity issues there that don’t affect the rest of the system. Again, we have the best on time performance year in 2009 that we have had in many years even with the addition of some challenging places like that. The business for us in New York La Guardia has been spectacular. It has been a huge contributor right off the bat. I don’t think any of us are shocked with that because we did have a very conservative schedule. We have far more demand for southwest into New York than what we can satisfy with eight flights and the revenue performance certainly provides evidence of that.

Helane Becker - Jesup & Lamont Securities Corporation

Does it make sense to add more capacity there? How are you thinking of that?

Gary Kelly

I would have to answer that right now as a hypothetical because we physically cannot. We can’t get another gate. We don’t have access to another slot. I can’t tell you how we would. If we could get more gates and more slots we would definitely want more flights but I don’t think we have an unlimited appetite here. Denver is going to go to 144 flights in August. We are not thinking about La Guardia in the same way.

Helane Becker - Jesup & Lamont Securities Corporation

At one point in the past the average trip length I think for flights was something like 75 minutes. So the incidences of people that would want to take bags was fairly slim anyway. What is that number now?

Gary Kelly

Our average flight distance is around 650 miles. It is less than 2 hours I think. So your memory is good on the 75 although you have to go back quite a ways. We have a very challenging operation. We don’t hub in spokes. Unlike our competitors where they have large bag connecting complexes at just a couple of places, we connect all over our system. I don’t know that we know how many bags we checked per customer compared to the industry. That is not a statistic we have been able to get our hands on. We check a lot of bags now. I can’t remember if you go back 20 years ago when we were much shorter haul how that would compare but we certainly carry a bunch of them now.

Operator

The next question comes from the line of Will Randow – Citi Investment Research.

Will Randow – Citi Investment Research

Can you discuss how we should think about your ability to grow capacity if industry revenue improves by the 10% currently factored into the consensus? What if we were above that? How flexible can you be?

Gary Kelly

I’m sorry, what is the 10%?

Will Randow – Citi Investment Research

In terms of North America industry revenue if you do roll upon consensus where the street is looking for 10% for this year. When you think about that if we hit that number or a better number than that how flexible are you to grow capacity?

Gary Kelly

I think we are very flexible to a point. For example, in 2010 we could probably squeeze in a number of ways, hold onto some airplanes, we could go to the used market, we could probably fly even the airplanes that are in service we could fly a little bit more. So there is a number of techniques we could use in the near-term. In the longer term I think there is even more flexibility. The problem of course in this business is if we are forced today to make decisions about 2012 it is just a crap shoot. I think we have plenty of flexibility to add capacity at least to a degree in the near-term if that is what we want to do.

We are published out through August 13th. So even that we could jam in more airplanes and more flights in that time period if we wanted to but it would be a little painful and it wouldn’t be optimized. I think the best thing for us it is to be able to have more flights after August 13th and have them all integrated on what we are working on right now.

Will Randow – Citi Investment Research

In terms of bag fees, one of your competitors recently raised by about $5 or so, plus or minus $5. What kind of incremental share gain do you think that offers you? Secondly, I know you have thought about the potential of the bag fee kind of as a hedge against $100 plus per barrel oil. How should we think about that and other ancillary opportunities to protect you from higher oil? Obviously you have one of the best hedging portfolios but the other opportunities.

Gary Kelly

I think you should cheer on our competitors to charge really high bag fees and you will continue to see record load factors at Southwest Airlines. Again I will repeat that we reduced capacity in the fourth quarter 8% and at the same time we grew our passengers, grew our RPMs and achieved record load factors. It is very clear we are seeing a share shift. Those are the facts. My guess is and our folks have made several different calculations on this but it all sort of points to roughly 1% share shift in the domestic US which is huge. Somewhere between half a million and $1 million worth of additional customers. That is what we are trying to do. We are trying to win more customers and we would love to sell them more stuff. So we have all that work underway as well. We are not going to be charging for bags. I hope they charge $100 per bag. That would be terrific. We will have 100% load factors. It would be great.

Will Randow – Citi Investment Research

Lastly in terms of when you look at your balance sheet and capital structure your net debt to EBITDA leverage is [rising], free cash flow has turned positive and you can’t say about a lot of airlines. When you think about limited maturities what are your ratings goals as well as the initiatives you may take on the balance sheet as we think about the next year?

Laura Wright

We certainly haven’t changed our views in running a strong balance sheet and investment grade rating. I think the wisdom of doing that was pretty clear that we achieved what we did over the last year and a half. Our leverage is around 45%. I think we are pretty comfortable in the 40-45% range. We certainly want to maintain our investment grade credit rating. We haven’t changed our goal there.

Will Randow – Citi Investment Research

In terms of what initiatives would you take on the capital structure next year?

Laura Wright

The biggest initiatives we have taken over the last couple of years is to reduce our capital spending which has really allowed us to raise a lot of money last year because we wanted to increase our cash balance. As we look into 2010 with very modest capital spending and very modest debt retirements we don’t anticipate we have a need to go back to the market and raise additional money and increase our interest expense and all of those things. So that is really our goal is to shore up the balance sheet.

In the future in terms of our longer term things what we might do with free cash flow I think it is still a little early to tell because we have to see what happens with the economy and when do we want to really start growing again and so forth. Those will be the types of things I can assure you we will be very focused on.

Operator

The next question comes from the line of Daniel McKenzie - Next Generation Equity Research.

Daniel McKenzie - Next Generation Equity Research

Following up on the revenue initiatives underway I am not sure if you are ready to put a number around what they are worth but I am wondering if you can provide some additional color about how investors should think about the materiality of the initiatives or perhaps even the timing?

Gary Kelly

Well as we were here on the call we just kind of penciled out what we have done so far and what remains. It is relative to Bill Green’s question earlier about where are we with the $1.5 billion target. I think with what you all know if you kind of put these things together what we have been reporting all year long I think we are probably with new things that have been added, Business Select, Early Bird, pets, just a long list of things we are probably close to $1 billion in incremental revenue with just that stuff.

I don’t think it is a leap at all to believe that what we have keyed up for 2010 and 2011 will easily fill out the 1.5. I think the only other point I would make is we all recognize our target is now more than $1.5 billion and we know that and of course you all should know that. But again, I think the things that are in front of us are international coach share, which should provide a very meaningful contribution. It is a no brainer it will add revenue. We know we have a very powerful domestic network. We have a very strong brand. We will definitely add customers and revenues once we get those up and running.

Then secondly as our next generation Rapid Reward program it is very straight forward. In addition to the ambitious goal of desiring more loyalty we are just looking at getting our current members to be a little stickier with them so they will fly us more and encourage more of them to use the Southwest credit card. So it is not a pie in the sky thing here that we are contemplating because we have a very meaningful revenue opportunity certainly relative to our peer group that we have not realized yet and we think we [inaudible] and we intend to close that gap.

Daniel McKenzie - Next Generation Equity Research

I am wondering if you could provide a little bit more granularity on where the demand is coming from. Would you characterize it as being driven primarily by business or leisure? I know on the website when you book your ticket one of the questions that Southwest prompts everybody buying the ticket is whether the trip is for business or for leisure. I am wondering if there is any further perspective or color you can provide with respect to that?

Gary Kelly

Let me give it a shot and then I would be curious to hear if Laura has a different view. We have been very open about the typical decline in business travel demand. That has occurred as expected in the recession. It was worse than what we thought. It hasn’t gotten worse since summer time. If anything it may have gotten better. We are certainly not seeing a large return of business traffic nor are we predicting that for 2010. So the strength in our revenues I think is pretty easily demonstrated. It is not the short-haul markets. It is the medium to longer haul markets. It has more of a leisure flavor to it and again in addition to all of the things we have added like Early Bird we are just getting more customers and they are more leisure customers.

The domestic market isn’t growing in the US but Southwest is growing even without adding capacity so that is the share shift we are talking about. With a low fare brand in a recessionary environment where people are trying to spend their money more wisely I think we are hitting a real nice crease here and when business travel does pick up I think you are going to see a very nice boost in our revenues yet again. We are doing very well on the revenue front.

Laura Wright

I think from a regional basis there was no sector of the country that didn’t see an improvement. So it was pretty broad. Certainly we have certain areas where we have little short-haul traffic or bigger short-haul markets and those don’t show quite as good as improvement as some of the destinations that have a little more of a long-haul and medium haul focus but the improvement was across the board.

Operator

At this time I would like to turn the call back over for any additional or closing remarks.

Laura Wright

Thanks everybody for joining us today. The Investor Relations team will be awaiting your calls. Thanks again.

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Source: Southwest Airlines Q4 2009 Earnings Call Transcript
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