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Southwest Airlines Co. (NYSE:LUV)

Q2 2010 Earnings Call Transcript

July 29, 2010 11:30 am ET

Executives

Gary Kelly – Chairman, President and CEO

Laura Wright – SVP and CFO

Analysts

Michael Linenberg – Deutsche Bank

Duane Pfennigwerth – Raymond James

Gary Chase – Barclays Capital

Bill Greene – Morgan Stanley

Hunter Keay – Stifel Nicolaus

Jamie Baker – J.P. Morgan

Dan McKenzie – Hudson Securities

Glenn Engel – Bank of America/Merrill Lynch

Operator

Welcome to the Southwest Airlines second quarter 2010 conference call. Today's call is being recorded. We have on the call today, Gary Kelly, Southwest Chairman, President and Chief Executive Officer and Laura Wright, the Company's Senior Vice President, Finance and Chief Financial Officer.

Before we get started, please be advised this call will include forward-looking statements. Because these statements are based on company's 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 the company's financial results press release and the investor relations section of our web site at southwest.com, for further information regarding forward-looking statements and forward reconciliation of non-GAAP results to GAAP results. At this time, I'd like to turn the call over to Gary Kelly for opening remarks. Please, go ahead sir.

Gary Kelly

Thanks, Mervin and I thank you all for joining us this morning for our second quarter results. We had a very strong performance. We are very pleased with the profit for the quarter x items $216 million, which is $0.29 a share, each of those represents more than a tripling of our year ago results.

Of course, all the credit goes to our people. They've done a marvelous job getting Southwest Airlines to this point. Certainly performed extraordinarily well in the quarter. They've managed a tremendous amount of change, not just over the last couple of years but for the last decade. So, I'm very, very proud of them and very proud of these results. We continued to set a number of company records relating to revenues during the quarter and we placed first in the domestic airline industry in two very important categories.

First of all, revenue growth, revenue growth of 21.1%, is the best in the industry, domestically and, that comes on slightly down capacity growth at Southwest Airlines. And, that means that we also placed first in the domestic industry in terms of year-over-year unit revenue growth, at almost 22%.

Our passenger counts were up, our traffic was up. Very strong yield performance in the quarter, yields were up over 17%, at record load factor of 79.3%, up 2.3 points, compared to 09. And, Laura's going to spend quite a bit of time talking about revenues as well, because it's a revenue story that's what drove our earnings growth and a number of factors are in involved, of course, driving our revenue growth.

All that led to the second best quarterly profit in our history, second only to Q2 of 2006. From this point forward, beginning in the third quarter, our year-over-year comps change a great deal. Last year was significantly off of normal trends based on our current July results. So far, in the bookings, for the rest of the quarter, we don't expect any significant deviation from normal years, seasonal trends, just our continued strong revenue production.

Talking a little bit about Panama City beach, we added to our route system in May, we're off to a great start there. Customers response has been tremendous and, I do want to say that we really appreciate all the support we've gotten from the St. Joe Company but, also the airport and the entire community.

And, again, thanks for helping us to get off to a good start and, hopefully, we're doing a small part to help the community as well. And, I've been there and I can report that the beaches look great, by the way. So, everyone should don their swimsuits and get down there ASAP on a southwest flight. I'll turn it over to Laura to take us through the quarter.

Laura Wright

Thank you, Gary and, good morning, everyone. Our second quarter GAAP net income was $112 million or $0.15 per share. Excluding special items totaling a net of $104 million, relating to mark to market and other items associated with FAS 133, our second quarter net income was $216 million or $0.29 per share. A significant improvement over second quarter last year's earnings of $59 million or $0.08 per share.

Our second quarter operating income, excluding special items, was $414 million resulting in an operating margin of 13% and, our pretax income, excluding special items, was $350 million, resulting in a 11% pretax margin. Overall, it was a very strong second quarter performance, the second best in our history and I'd like to congratulate our employees on these results and thank them for their hard work and their outstanding customer service.

The revenue momentum that started in the second half of last year continues into the second quarter producing another record revenue performance. Our passenger revenues increased over $500 million to $3 billion and our other revenues increased nearly 50% or $38 million, compared to last year.

With both record lows and record passenger yields, we also had a record 20.7% year-over-year improvement in our passenger unit revenues, leading the industry in domestic revenue results. More importantly compared to the second quarter of 2008, our unit revenues grew 14%.

Our total revenues of $5.8 billion for the first six months of 2010 represents a revenue increase of over $1 billion from our revenues for the first six months of 2007 while our capacity for the first half of this year is approximately 1% less than the first half of 2007. The plan that we set forth in 2007 to grow our revenues is producing results even despite the still weak economic environment and even with business travel well below pre-downturn levels.

Our revenue strength in the quarter was driven by our revenue initiatives, fewer fare sales and strong overall consumer demand. The yield improvement strengthened throughout the quarter, with April and May up 16% and June up 19%, resulting in an all time record 17.3% growth in RPM yield. Business travel demand continued to strengthen during the quarter and our full fare mix was just under 20%, up almost two points from Q2 of last year and down less than a point from the Q1 of 2010.

The sequential decline of under one point was better than historical sequential trends, suggesting some stabilization in our full fare demand and, in our short haul markets we saw more than a three point year-over-year improvement in our second full fare mix.

We are very encouraged by the improvement in our business trends, but we also recognize business travel has not fully recovered. We had strong demand for our business select products with 24% more business select passengers than a year ago, producing $24 million in incremental revenue, up from $18 million in the second quarter of last year. We also had strong demand for our early bird product, generating $23 million in early bird revenues, compared to $17 million in the first quarter of this year and $13 million in the fourth quarter of 09.

We have not seen any noticeable impact to our business select revenues from the introduction of our early bird product. Our early bird passengers continue to increase as the percentage of total passengers, while our business select passengers are above the early bird introduction levels.

Our Wright amendment revenues were $55 million in the quarter, compared to $37 million second quarter a year ago and overall, we are very encouraged by our passenger revenue trends. Month to date, our July passenger unit revenues are up in the 17% range from the respective year ago period and bookings, thus far, for August and September also look strong.

Based on revenue and booking trends thus far, we're currently expecting another significant year-over-year improvement in third quarter passenger unit revenues, but at a lower year-over-year rate than experienced in the second quarter. As the current quarter and remainder of the year progress, our year-over-year comparisons become more difficult due to our industry leading improvement and unit revenue trends in the second half of last year.

Our freight revenues increased 13.8%, to $33 million, primarily due to higher average rates and we expect that our second quarter freight revenues will be comparable to the second quarter. Our other revenues increased almost 50% to $119 million, due to our fall 2009 revenue initiatives. As I mentioned earlier, we generated about $23 million in early bird revenues. And, we also generated approximately $13 million in revenues from our pet fares, unaccompanied minor service charges and excess heavy bag fees.

We expect another year-over-year increase in our other revenues in the third quarter but at a much lower rate than experienced in the second quarter due to fewer charters anticipated and also to reaching the anniversary on the introduction of some of our revenue initiatives. As a reminder, in the third quarter of last year, we generated $12 million in revenues from these same revenue initiatives.

Turning to our cost performance, our second quarter operating expenses, excluding special items, increased 13%, which results in the 13% unit cost increase. Although we had non-field cost pressure contributing to our overall unit cost increase, the most significant pressure came from higher fuel costs.

Our economic fuel costs increased 32.4% to $2.37 per gallon, which was slightly better than expected due to lower crude oil prices offset by higher heating oil crack spreads and jet differentials.

Based on the third quarter fuel hedge provided in our press release this morning and the July 26 forward curve, our guidance for the third quarter economic fuel price is in the $2.40 per gallon range. This estimate includes fuel taxes that excludes fuel hedging premiums.

We are currently estimating a slightly higher third quarter fuel price than the second quarter, due to higher jet disk as we move in to the hurricane season and a slightly higher fuel hedge penalty. Our premium costs associated with our third quarter fuel hedge, which are recorded below the line in other gains and losses, are estimated to be in the $36 million range.

And based on market prices, as of July 26 and our hedge for the second half of this year, we're estimating our 2010 economic fuel price, including taxes, will be in the $2.40 per gallon range. We have factored the various price points and percentages of our current hedge position, plus the impact from the hedges that were unwound in 2008, into our fuel price guidance and the sensitivities that we will provide in the form 10-Q. We continue to actively manage our hedge portfolio with the philosophy of protecting the business against catastrophic energy prices.

And we've included our current hedge positions for 2011 and beyond, in this morning's press release. Excluding fuel and special items, our second quarter costs increased 6.4% on a unit basis. Although still up more than we would like, our second quarter nonfuel cost performance was better than anticipated primarily due to the deferral of advertising costs and a refund of excess security fees paid to TSA.

Regarding our advertising spend, we chose to defer about $8 million, originally planned for the second quarter, to later in the year including some to the third quarter. Higher profit sharing and 401-k accounted for approximately three points of the 6.4% CASM ex-fuel increase. We accrued $62 million in profit sharing and $49 million in 401-k, for a total benefit to our employees of $110 million this quarter.

Our revenue related charges, which are primarily charge sell discounts, accounted for another point of the nonfuel CASM increase. Of course, we're always happy to talk about higher profit sharing and revenue related charges. With that being said, we also continue to have inflationary cost pressures, most notably in our airport and labor costs.

Based on these continued cost pressures, we currently expect our third quarter nonfuel unit cost to increase from third quarter 2009, to $0.0711 and we currently expect that increase to be in the 6% range year-over-year, which is similar to what we saw in the second quarter.

Although it's reasonable to expect that our third year-over-year unit cost pressure would ease, due to the modest capacity increase that we have planned for the third quarter, keep in mind that the $18 million security refund and the deferral of the advertising spend benefited our second quarter nonfuel unit costs by about 1.5 points.

For the full year of 2010, we are expecting our unit costs, excluding fuel and special items to increase in the 6% to 7% range, compared to last year. This estimate is higher than the 5% estimate we provided at the beginning of this year and is being driven by increased profit sharing and revenue related expenses.

Before I move onto the balance sheet, I'd like to quickly talk about our labor and airport costs. As expected, our labor costs increased 9.8% on a unit basis versus last year, primarily due to wage rate inflation and profit sharing. And based on current trends, we expect our third quarter labor unit costs to be comparable to second quarter's $0.0371.

With respect to airport costs, our landing fees and other rentals unit costs increased 15.7% year-over-year, primarily due to airport rate increases and fewer favorable airport audit adjustments this year. Based on the continued rate inflation at various airports, we're expecting our third quarter airport unit costs to fall in the mid $0.80 range.

Now, moving to the balance sheet and cash flow. We currently have $3.4 billion in core unrestricted cash and short-term investments and our $600 million credit facility remains fully undrawn and available. Our leverage, including aircraft leases, is forecasted to be in the low 40% range by year-end.

We generated about $400 million in free cash flow in the second quarter, with $540 million of cash flow from operations and capital spending of $159 million. Year to date, our cash flow from operations are over $900 million and we generated over $600 million in free cash flow. Based on current trends and projected 2010 capital spending of less than $600 million, we currently expect to generate free cash flow for the year.

We're currently working on our strategic plan for the next decade and capital planning is certainly a significant part of that exercise. We recently updated our fleet plan with Boeing, which I will go over shortly, without any material change to our total future capital spending.

In regards to our fleet and our capacity plans, during the quarter we acquired three 700's from Boeing and we ended the quarter with a fleet of 544 aircraft. We're well underway in evaluating our long-term fleet plans. And, as part of that planning, we've decided to slightly accelerate the retirement of our classic fleet. Accordingly, we worked with Boeing to update our future from orders and options scheduled, with no net change to our fleet plans. We converted six purchase rights to options and exercised 25 options for firm orders from 2011 through 2016. We've included the updated Boeing delivery schedules as an accompanying table to this morning's press release.

We do not intend to significantly grow the fleet until our financial goals are achieved or in sight. Further, we're planning for flat capacity to share. Third quarter, our ASMs will be up about 2.5% year-over-year and in the fourth quarter they're going to be up approximately 4.5% year-over-year. For 2011, we're projecting a modest capacity increase and flat fleet.

And, keep in mind that the modest increase in our 2011 capacity, will be heavier weighted towards first half of the year, as a function of our 2010 flight schedule adjustments. As always, we'll continue to closely monitor demands and remain prepared to adjust our flight schedules accordingly. And Mervin, with that overview, Gary and I are ready to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) And, we'll go to our first question from Michael Linenberg with Deutsche Bank.

Michael Linenberg – Deutsche Bank

Hey, guys. That was actually a nice interlude there.

Gary Kelly

Very Southwest-like, don't you think?

Michael Linenberg – Deutsche Bank

Exactly. Very calm, peaceful and no rodeo music.

Gary Kelly

Come here on Halloween, pal.

Michael Linenberg – Deutsche Bank

I want to actually – I want to talk about revenue, Gary. I think back over the years, over the many years, where you had the conversation. You know, we have talked about the sensitivity of your passenger base. Where you would move fares up a few dollars and it was always the proverbial family of four not taking the trip. I then look at this quarter and I see your one-way fares go from $110 or $112 to $132. I mean, these are high by historical levels for Southwest. And then, I look at where the unemployment rate is in the U.S., it's close to a 30 year high at 10%. We know that the consumer is constrained discretionary spending is just – it's tight.

And yet, even then, it's not coming on the business side. I mean you've seen some modest improvement. So, the question is, is it that your network has evolved, your breadth of your network today, you're in a lot of business markets, you're the biggest domestic carrier, plus the fact that you have a more advanced revenue management system. I mean, is it easier today for Southwest to raise fares, or has your passenger base changed? Has their price elasticity of demand come down? I mean, what's – I know this is a very long and winded question here but when I look at these numbers I've never seen fair improvement of this magnitude given a challenging macro-backdrop.

Gary Kelly

So, Michael, I take that's not a complaint?

Michael Linenberg – Deutsche Bank

It's a high quality problem to have. And, I'm just wondering what are you guys seeing? There's definitely been some evolution here.

Gary Kelly

Well, we'd have to, we started working together in 1991 or 92, right.

Michael Linenberg – Deutsche Bank

Right. That's right. So, it's been a few cycles.

Gary Kelly

You have to pick your time slice here, but over a 20 year time horizon, of course, much as changed. But, I was just glancing at the earnings release and the average length of the passenger haul is now 883 miles.

Michael Linenberg – Deutsche Bank

Okay. So that's part of it.

Gary Kelly

That's at least part of the fare. But, there is a lot going on here, Mike. And, you know, Laura referenced in her remarks, the strategy that we put forth in 2007. And, we'll want to summarize this better for the investment community this fall and just show you where we are vis-à-vis that plan but the point is a lot has changed. Now, we have – we have argued and can demonstrate to you, that there is a significant market share shift that's taking place over the last several years. You know that costs are up. We'd already admitted, years ago, we were going to have to find a way to adjust our fare structure upwards to deal with higher costs and we're doing that.

So, I think you've got a combination of shifting out of short haul markets in to longer hall markets, which is helping. You've got the fact that has Southwest offered more choice to people who want more service and are willing to pay for it and Laura pointed out 24% increase in business select as an example. We've seen weeks where it's up 30% and 40%. So, we're finding opportunities to bring new products and services to the market that people will pay us. And, of course, the other material change just over the last 12 months is early bird.

There was concern, when we introduced early bird that it would cannibalize business select and, obviously, Laura is reporting no evidence of that. So, there's a few pieces in there, in terms of just overall fares though, getting to our core fare structure, our revenue management has evolved dramatically in 36 months.

They are much more skilled at setting inventory levels at various prices and not giving away anymore than they have to and so I think there's a significant benefit associated with that. And, then the other thing that you've seen from an overall schedule perspective, if you took 100% of our flights three years ago you trimmed out the flights that weren't very good which is what we've done, and instead you came back with a flight schedule that was more powerful, which is what we done, then that's a way to ring out revenues as well.

So, in the old days Mike, we would have flights at the end of the day that might have 20 people on them. And, you're not getting very good yields on them either. Those days are gone. So now, you have much more condensed flight schedules with much higher load factors, many more itineraries being published, a few more connecting customers on board. So, we've created better demand for our own product in addition to the fact that we're taking share from our competitors.

Michael Linenberg – Deutsche Bank

Okay. Well, very good. Great quarter. Thank you.

Gary Kelly

Thank you so much.

Operator

Thank you. Out next question comes from Duane Pfennigwerth with Raymond James.

Duane Pfennigwerth – Raymond James

Hi, thanks. Good morning.

Gary Kelly

Hi Duane.

Duane Pfennigwerth – Raymond James

Just wondering if you could provide little more detail about your second half seasonality commentary, because it seems like the years you referenced actually imply a pretty wide range. Specifically, I think 2006, 3Q RASM was down about 8% sequentially and 2008 it was actually up modestly. So, can you just help us with how we should interpret that?

Laura Wright

Duane, I think, if we look at Q3 versus Q2, or let's talk about July since we given where we are for July. Typically, July PRASM, compared to what you see in June, is flat down a couple of points year-over-year, if you really start looking at sequential trends versus year-over-year comps. Our July revenue results are actually exceeding – slightly exceeding what we normally see on the average from month to month.

That's what we are trying to talk about in terms of seasonal trends versus year-over-year trends, that the results we're seeing in July and the bookings that we have thus far for August and September, relative to the nominal results that we had in the Q2 makes sense to us. So, we really haven't seen any drop off in the momentum that we billed up in the Q2.

Gary Kelly

Duane, I would just add to what Laura said by saying it is rare that you see an increase in revenue performance, in other words RASM performance, in the Q3 compared to the Q2. It is very normal for us to have a peak in the year in the Q2 and that's what we're expecting this year.

The normally, if you average some of those years that you were describing. I think all we were trying to point in the earnings release is that 2009 is really off, it's off of normal trends, the Q4 was the best quarter of the year. And it's hard to go back in history and find a year like that. Normally, I would say, this is just Gary talking, is we're normally down RASM, Q3 versus Q2, in the 2% to 3% range.

And, some years, June is the best month of the year, some years July is the best month of the year and it's possible that July, I think this is a point Laura is trying to make, is that when we look at the strength of our revenues coming in to the Q3, they are very good. And, in fact, July may very well be the best month this year. September is still September and will not match an April or May. So, that's what you're typically contending with seasonally.

Duane Pfennigwerth – Raymond James

Thank you. That is helpful. Just wondering, in terms of sort of no net fleet growth, how we should think about new markets? How many new market a year for a Southwest? Should we be reading anything in to the Panama Citys, the Greenvilles and the Charlestons? Is that a new sort of attractive target for Southwest?

Gary Kelly

Well, we've done a variety of cities, historically of course, some years we had big cities and some years we've added smaller cities and that's true in the 80s, 90s and the past ten years. So, I wouldn't read anything in to it other than that's what we've chosen the do in 2010 and 2011. The flat fleet I wouldn't take literally, I'm sure we'll be up a few units or down a few units from time to time. It's just more of the direction that we want you all to know that we don't have plans to materially increase the fleet. In 2011, I don't think we can add anymore new cities other than the two in South Carolina, unless we make a change to our fleet plans.

So I think that answers your question for next year. For 2012, really all we're telling you all at this point about 2012 is that we are not currently committed to any change in the fleet for 2012. On the other hand, we've made no plans for 2012. So, if we are going to add new cities, those are decisions that will be out in front of us. As well as how we fund those new cities in terms of airplanes. So, we're not telling you a prediction, that we will not grow fleet in 2012, it's just at this point our baseline is no change in the fleet. I'd love for us to add a couple of cities in 12. And, we certainly a have long list that we're contemplating and we are working a lot of those opportunities. There's a chicken and egg question here to some degree, but, at least, that'll give you some guidance for the near term which would be a 2011.

Duane Pfennigwerth – Raymond James

Okay. Thanks Gary and Laura.

Operator

Thank you. Our next question comes from Gary Chase with Barclays Capital, please go ahead.

Gary Chase – Barclays Capital

Good morning everybody.

Gary Kelly

Good morning Gary.

Laura Wright

Good morning Gary.

Gary Chase – Barclays Capital

Wanted to just a quick one on this, on the July RASM, just curious if there's anything we should be thinking of that's quirky about July? And, I understand you've given a lot of thoughts on the revenue outlook, but is there something that we might not know that is in the comp that makes it a little tougher, than say, August might be? Just in terms of year-on year change?

Laura Wright

I think, when you look at last year, Gary, our July we really started turning our results in the second half of last year. So, our July RASM last year versus what we saw in June was a significant improvement and again far above what would've been expected sequentially. So the year-over-year comps are definitely difficult there but, really, there's nothing. If you look at July versus June, just on a nominal what you should expect from a RASM basis, our trends for July show that we are outperforming what we would normally expect sequentially from June to July.

Gary Kelly

Gary, just let me offer up a couple of hints here. And, I agree with Laura, I don't see anything odd about July at all or June for that matter. In other words, I think they both look normal. As I said earlier, some years June is better, some years July is better and have to think about the fourth of July and what impact that holiday timing might have on those months.

But our RASM in 09, from Q2 to Q3, was up five points. And that just doesn't happen. So, if you buy my normal trend of Q2 to Q3 is down two, that's a seven point swing, so, that's, that's what I would urge you to look at and think about and of course then, based on that, the July comp to June fits pretty well. So and, again, it's because last year's July was off trend relative to last year's June. It's a comp issue more than it is a seasonality issue. This year June to July is going to be something. Laura will have to tell you what she wants to tell you on this year's July. But I guess you have to wait a couple of days to hear those results, but, this year's July looks really good.

Gary Chase – Barclays Capital

Okay, then. How are you measuring your success? I mean, when you think about generating business traffic, business select might be a way to think about that, there are probably other ways you are thinking about that. I'm wondering what metrics are you guys focusing on, because, obviously, business traffic could show up in any fair class. What are you focusing on to see if you're really getting that incremental revenue on to your network and could you share with us some of the metric as you look at them?

Gary Kelly

I think we can and I think that's something we're going to want to continue to refine as we go forward. And, just in the terms of the way we're reporting to you all now, just in terms of the recovery of business travel we look at it in a variety of ways. Fair class gives you some insight but certainly not a complete picture. We look at bookings within the travel date. We have corporate accounts, just like everybody else does. That's less than 10% of our business. We look at those accounts. The business is up year-over-year in the Q3. What would you say Laura?

Laura Wright

I'd say traffic's up in the twenties, passengers up 25% and revenues up probably 40%.

Gary Kelly

Right, so. And, again, a minority of our business and not even the majority of our business travelers, but at least some indication we're seeing some strengthening there. She's reported business select. Then, the other thing I think that Laura mentioned is the short haul markets. It's the short haul markets where we find most of our business travelers. The only way we know they're on business is we ask them. We do continuous surveys and our short haul markets are continuing to lag the overall system in terms of recovery, although they are recovering at a pretty nice rate. Now, if I understand where you're headed with our question.

We want to drive more business travel on Southwest. I think the share shift we are seeing right now is mostly on the consumer side but, prospectively, we'll be growing out Wi-Fi on the fleet. We'll be upgrading our frequent flier program. We have, obviously, added some products, like business select, that will meet the needs of business travelers but we'll have a bigger push and a stronger message, for business travel over the course of the next 12 months.

Laura Wright

I just want to correct my corporate accounts. We're actually up over 30% in tax and over 50% in revenues from a year ago, Q2.

Gary Kelly

That sounds more like what some of the others are seeing.

Gary Chase – Barclays Capital

Okay, guys. Thanks very much.

Gary Kelly

Okay. Thanks, Gary.

Operator

Thank you. Our next question will come from Bill Greene with Morgan Stanley, please go ahead.

Bill Greene – Morgan Stanley

Gary, I hate to beat the dead horse in this. But, I just want to make sure I understand it because it kind of suggests the seasonality comments that we have to lower RASM expectations. And, I thought Laura said July is seasonally, sort of stronger than expected seasonality but I thought you said it wasn't? And, I'm only trying to get it because it suggests August and September are below trend and I was just hoping you could just clarify it because I think I'm not clear on exactly what it is.

Gary Kelly

Well, I was vague, so that's fair. I'm going to let Laura answer but what I did not say is that it was weaker than seasonally, but I'll let Laura give you an idea of how strong it is seasonally.

Laura Wright

Tom, if you look at normal sequential trends, from June to July, they're usually flat to Gary's point, sometimes June's a little better and sometimes July's a little better because of the timing of the fourth of July. But, usually, July versus June is flat to kind of down a percent or so and, I think, based on – - and, that's nominal RASM, not year-over-year increase.

So, if you look at the year to date trends, that we disclosed for July, which is up 17%, and, again last year we were up significantly in July versus June. Compare that to where we were in June, we're not out of line seasonally. In fact, I was going to say, we're looking a little bit better than what our normal June to July trends would indicate.

Bill Greene – Morgan Stanley

Okay. So then August and September would need to be below trend to get normal seasonality for the quarter.

Gary Kelly

Well, it just depends on what you call normal. So, I think, Duane was pointing out that some years Q3 is up a little bit and some years it's down eight and the average is sort of down for the quarter two to three, that's the best guidance I can give you and the other is just that quarterly hint and it's too close to call July, at this point. And, I know, I did say that it's possible that July could be the best month this year. So, I wouldn't conclude from that – if July is better than June, that that means that August and September are weak, I wouldn't conclude that at all.

Bill Greene – Morgan Stanley

Okay. Okay. Got you. Alright, sorry. If I can turn to balance sheet, $3 billion, almost $3.5 billion in cash, no significant growth plans next two years or so. Should we think about a much bigger buy back, you didn't do any in this quarter, one time dividend. What do we do with this? When we think about our ROIC targets it would seem that could be very supportive. It could get you there sooner, but maybe that's not a part of how you mean to get there, maybe it needs to be organic.

Laura Wright

Well, first of all, we're in a good situation, Bill, because we are generating free cash flow and as you know that wasn't top of mind a year ago. But, first of all, we haven't changed our philosophy of running a strong balance sheet and retaining our investment grade rating. Our leverage is forecast to be back to 40% by the end of year and as you know, we have reduced or capital spending.

So, what we're doing right now is we're exploring all of our options which as you know are limited. We've looked at our fleet plan, we're thinking about protection on fuel prices. Of course, we've got a steady share repurchase, debt retirements, we've got about $400 million. That matures at the end of 2011. And, about $300 million, I think, in first quarter of 2012. We've got to be prepared for opportunities that present themselves, and we're also kind of looking at this financial reform legislation. So, through all that we're working with our board right now.

We haven't made any decisions and what we want to do with the excess cash. As you know, our focus is on maximizing shareholder value. So, I think you can expect us to come back to you at some point in the future with an answer to that question but we have not made a decision yet.

Bill Greene – Morgan Stanley

Okay. Thank you.

Operator

Thank you. Our next question comes from Hunter Keay with Stifel Nicolaus. Please, go ahead.

Hunter Keay – Stifel Nicolaus

Thanks, guys. Congratulations.

Gary Kelly

Thanks,.

Hunter Keay – Stifel Nicolaus

I appreciate you guys publicly setting a 15% ROIC target. I'm wondering if you could actually calculate – - or, share with us how you calculate that metric? And, maybe, tell us what it was on a trailing 12 month basis? Because I'm getting about, maybe 6.5% for 2010, maybe 4% LTM, which tells me future growth could be far off if that's actually the hurdle that you're going to want to hit. But, I might be calculating it differently than you guys are. Can you maybe share how you look at it?

Laura Wright

Absolutely. So, if you just look at rolling twelve month basis, through June 30. We're around 7%. Which is obviously well off our 15% target. But, that includes the back half of 2009. So, with our increased earnings outlook for the second half of this year, we do expect that our ROIC for the 12 months, in to 2010, will be significantly better than that 7%. So, we are making some really good progress towards that 15% target.

Although, we don't expect that we're going to be there. In terms of how we publish it, it's on our website, in our IR tab. But, our numerator is our non-GAAP operating income, less the gains and losses from the time value of hedges and, then, we also neutralize the P&L impact of leasing aircraft versus purchasing them. And, the denominator is the average of our debt and our equity, net of the balance sheet other comprehensive income and hedging ineffectiveness and net present value of future aircraft grants – but we we'd be happy to. Marcy and Ron would be happy to walk you through those calculations and you can look them up on the web site also.

Hunter Keay – Stifel Nicolaus

That's great. I didn't even know it was there, I'll do that. Thank you for pointing that out.

Gary Kelly

The net income target, Laura, to hit 15% is roughly $800 million. So, it's somewhere in the eights.

Hunter Keay – Stifel Nicolaus

Hunter, just another way to rule of thumb at least for the purposes of this morning.

Laura Wright

Exactly.

Gary Kelly

We're making good progress. But we're – we've got a ways to go. I think if you then extrapolate from that, if this is a revenue generation, solution, then we probably need about a half a billion dollars-ish of annual revenues to hit that target.

Hunter Keay – Stifel Nicolaus

That is really, really helpful. Thank you so much if that color. One quick one, looks like, this might be sort of fine tuning of the schedule but looks like you may be tacked on a little bit of ASM's in the fourth quarter relative to where you were in April. Is that – is there some stage length in there, are you adding frequencies, is this utilization, or is there really not much of a change over the last few months?

Gary Kelly

I saw Laura's comparison of what we said last to where we are. I don't know that it's anything material. I think we had a forecast before and now we've come back with an actual schedule. So, it's same number of airplanes. So, somehow we've inked out a little bit more utilization than what we really thought initially. But, there's nothing of any significance that I can think of.

Laura Wright

I agree.

Gary Kelly

That would account for that variance.

Hunter Keay – Stifel Nicolaus

No notable, say, frequency additions in business markets or anything that comes to mind or anything like that?

Gary Kelly

No. And, again, the schedule's been out there for a while, so it's published through January 7. That's just the way the math added up I guess.

Hunter Keay – Stifel Nicolaus

Okay. That's great. Thank you, guys again.

Operator

And, our next question comes from Jamie Baker with JP Morgan. Please, go ahead.

Jamie Baker – J.P. Morgan

Hi, Gary, hi Laura. Based on what seemed to emerge from Farnborough, it really sounds as if Boeing doesn't have much interest. At least near term and re-engineering the (inaudible) and I'm just wondering if that potentially influences the fleet plans? I personally just wondered if the decision to stop growing might be based on some part, on wanting to wait for the re-engine plane? So, if it turns out the plane isn't coming after all, could you settle for the existing model and resume growth? I'm wondering how that factors in the at all to the fleet plan.

Gary Kelly

Well, Jamie, I understand your question. Very fair question. We have – we're under nondisclosure, as you would guess, with Boeing in terms of what their plans are, so those Boeing-type questions obviously have to be directed to them. So, if you'll just permit me not to offer you much color here and just say that our near term fleet plans certainly tend, 11 and 12, are not dependent upon questions that you pose. However, we have enormous interest in the topic that you raise.

And, if I could just say that we are engaged deeply with Boeing on the retirement of our classics, on the replacement of the classics, on the re-engining opportunity, and then the complete next generation airplane opportunity. So, we're deep in to that with Boeing. I'll defer to them to tell you where they are in that process. We are clearly, first of all we are huge fans of Boeing. They are great partners with us, have been for four decades. And, we, secondly, we are in need of a more efficient cost effective aircraft. And that's, – that is our mission. We're obviously very hopeful that Boeing can meet our needs there going forward.

Jamie Baker – J.P. Morgan

Okay. I appreciate that color and secondly, simply because it hasn't come up yet on the call. US airway margins were healthy in the quarter. Delta's margins were healthy as well. United and Continental continue to March down – - down the aisle. I'm just curious if anything you are seeing going on around you changes your perspective on consolidation? Southwest has thrived in a fragmented industry in the past and I'm just curious if a potentially consolidated industry affects your game plan going forward at all?

Gary Kelly

Jamie, I don't think so. I'm not, we've had pretty massive consolidation this past decade assuming that the United – Continental deal goes through. We serve 69 cities, soon to be 71 next year with the introduction of South Carolina to our route system. There are many more cities that we would like to serve in the United States. And, of course, we are pondering whether we want to prepare ourselves to fly international. And I would expect a decision on that sometime this year. We want to continue to grow is my point.

We think we got the cost structure and the customer experience package and the people to do that. I think consolidation works in our favor in that regard. And it certainly has to this point. I think just the fact that we can demonstrate to you that we're winning customers right now in significant revenue gains as a share of the domestic market, gives us a will the of encouragement going forward. So, we're going to continue to invest in our own customer experience and, if consolidation continues, again I think that, that – I just don't see that that's a negative for us, in that regard, no I don't think that changes our strategy here.

Jamie Baker – J.P. Morgan

Okay. Very helpful. Thanks, guys. Thanks, Laura.

Operator

And, our next question comes from Dan McKenzie with Hudson Securities. Please, go ahead.

Dan McKenzie – Hudson Securities

Thanks. Good morning, everyone.

Gary Kelly

Hi, Dan.

Dan McKenzie – Hudson Securities

I know Southwest has a number of products under construction, but I wanted to follow up on the record rewards comment, Gary. How should investors think about the revenue contribution from a more sophisticated rewards program? And, then, I guess I'm wondering, if you can help us understand, what percent of the wallet spend you are getting from your most loyal passengers? And, then, potentially, the revenue opportunity here from the wallet that's being left on the table?

Gary Kelly

I think I can give you some color there. I think Laura and I have not provided a lot of specific details at this point but more information obviously is coming on that when we get ready to launch that program. But, I think the headlines are pretty straight forward. We don't get our fair share of frequent flyers relative to our seat chair if you will. The frequent flyers that we have we don't get our fair share of their flights and then of the frequent flyers that we have we also don't get our fair share of credit cards. So, then of course, one has to understand what do you mean by fair share and is there truly an opportunity there.

So, we delve into that, we believe there is a very significant opportunity to win more business customers, win more flights from the customers that we get, and then get a whole bunch more Southwest visa credit cards and wallets out there. The combined value of all that is gigantic. The value of just the credit cards, quite frankly, is a very, very large number. But admittedly, I think this is why Laura and I have been reluctant to share targeted numbers is they're all speculative and in – whenever you're talking about getting a market share change, that may take some time to build. So, I think the easiest penetration, from a revenue generation, will be with the credit card and that's what we really hung our business case on. But when we've surveyed business customers over the last decade the single biggest point they made with us is they want a different frequent flier program. Single biggest issue and, we believe them.

So, we have been in design and construction for some time now and looking forward to having that project wrap up this year and then launch next year. It's very exciting for us. We're obviously hopeful we can make it a game changer. That, you couple that again with some of the other amenities that we're bringing forward, most notably wireless in the cabin. I think we're going to have a very, very compelling sales pitch for business travelers. We already get a whole bunch of business travelers, so it's not like we are starting from scratch there. We just think we can get more.

Dan McKenzie – Hudson Securities

Thanks for that. I guess in terms of the Wi-Fi on board, I'm wondering if you can give us a little more specificity on sort of the timing of when that would be implemented? And, I guess in terms of the timing of the other revenue initiatives, with respect to the rewards program or the credit card, is that something we could see start phasing in 2011, or is there some IT. or infrastructure challenges – hurdles that you have to overcome first before you can implement those kinds of things?

Gary Kelly

Let me just talk about row 44 or the Wi-Fi first, the – I wouldn't say that we're relaxed about this, we are working on this effort. We have various certifications that we have to sort through in terms of installing new equipment on the fleet. We have, in essence, from that perspective we got a couple of different fleet types, the next Gen equipment and classics, we are in the process and it's been slower than I would like. On the other hand, as you know, the take rate among customers on this product has been slow to take off so I don't think we're missing out on anything yet. But, our target is still to have the fleet implemented in the 2012, I'm sorry the 2013 time frame and I'm very comfortable with that. Again, I think this is investment for the future and, in the meantime, our overall customer experience I think is performing very well. I'm sorry, Dan, I forgot your second question.

Dan McKenzie – Hudson Securities

Yes, just whether there was infrastructure impediments or IT impediments to implement in the more sophisticated credit card or rapid rewards program, sooner rather than later.

Laura Wright

Yes. It's in full build and development, and we have been working on it for a couple of years but we made great progress and expect to launch with the technology enabled to do that.

Gary Kelly

It is from scratch my friend and custom built for Southwest, for our unique design, and as Laura just said and I pointed out earlier, that construction is on track and scheduled to end this year. And, then we'll collect ourselves and train all of our Southwest warriors and launch this sometime in 2011, that date has not been shared yet.

Dan McKenzie – Hudson Securities

Okay. Great. Thanks very much.

Gary Kelly

Yes, sir.

Operator

Thank you. We have time for one more question, so we'll go with our last question from Glenn Engel from Bank of America/Merrill Lynch.

Glenn Engel – Bank of America/Merrill Lynch

Hello, folks.

Gary Kelly

Welcome back, Glenn.

Glenn Engel – Bank of America/Merrill Lynch

Thank you. I'm going to ask about cost. You've made the schedules more variable and that's been very successful at getting the RASM up, but it's also pushed the cost up. What are you doing to make your cost structure more variable and what do you need to get from your work force? What changes do you need to get from them to be able to get your costs to be more variable?

Gary Kelly

Well, that's the problem and, I don't know that we have all the answers yet. But we're very mindful of the challenge there. We've made very dramatic schedule changes for this company frequently over the last several years and it is, very admittedly, it is very difficult for our operation to adjust to that. So, it's just another reason for me to praise our people and how hard they've worked and how well they've done. There is definitely a cost penalty that we need to go in there and try to extract.

One of things we've been waiting for, Glen, is some stability. In other words, to try to attack the cost question, and then to come back with yet another radical schedule change, sort of renders some of that work worthless. So, we do seem to be getting in to more stability. We might actually, and I'm sure what's happening here in the Q4 is we're adding a few frequencies back in, which will certainly help that cost question. I'm not at all satisfied in fact with the quality of our flight schedule.

In other words, while it's been good for revenue production, we've actually taken some of the convenient flight times out from a customer perspective and even a competitive perspective. So, our desire is to be able to add capacity back here with the existing fleet in a way that satisfies both. It's revenue positive and it also helps on the cost side. Otherwise, we'll be looking at making sure that we take full advantage of the variability of staffing that is available to us. We have not taken full advantage of that at this point.

So, we got some, I wouldn't call that a constructural constraint but it's just more of a operating style change we're going to need to be making. And, as I said we are in the midst of pursuing that. That's a fancy way of saying we might want to use more part time employment in certain areas of the company in the future as compared to what we've done historically.

Glenn Engel – Bank of America/Merrill Lynch

Do you have any restrictions in your contracts, particularly the pilot contract in terms of making your cost more variable?

Gary Kelly

There are restrictions in all contracts on a variety of things, but we certainly have the ability to utilize more flexible work force than what we have done in the past. So that's not a restraint that we are bouncing up against at this point.

Glenn Engel – Bank of America/Merrill Lynch

All right. Thank you.

Operator

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

Laura Wright

I thank all of you for being here we appreciate your support. The investor relations team will be ready to take any calls and hope everybody has a great week. Thank you.

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Source: Southwest Airlines Co. Q2 2010 Earnings Call Transcript
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