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Executives

Gary Kelly - Chairman, President and CEO

Laura Wright - SVP, Finance and CFO

Analysts

Jamie Baker - JPMorgan

Hunter Keay - Stifel Nicolaus

Glenn Engel - Bank of America Merrill Lynch

Daniel Mckenzie - Hudson Securities

Duane Pfennigwerth - Raymond James

Michael Linenberg - Deutsche Bank

William Greene - Morgan Stanley Smith Barney

Gary Chase - Barclays Capital

Bob McAdoo - Avondale Partners

Southwest Airlines Co. (LUV) Q3 2010 Earnings Call October 21, 2010 12:30 PM ET

Operator

Welcome to the Southwest Airlines Third Quarter 2010 Conference Call. Today's call is being recorded. We have on the call today Mr. 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. 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 include references to non-GAAP results. Therefore, please see the company's financial results, press release and the Investor Relations section of its website at southwest.com for further information regarding forward-looking statements and for a reconciliation of our non-GAAP results to our GAAP results.

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

Gary Kelly

Thanks everyone for joining us this morning. Oh my, what a difference a year makes. We are very, very pleased to report what is a record third quarter earnings performance. I want to start out by thanking all of our employees. Our people have done an extraordinary job operating an excellent airline, providing outstanding customer service and all the while building for the future enhancing our customer brand and our customer experience.

The result is another long list of revenue related records including a record third quarter load factor of 80.9%. Of course, as many of you know, we've deployed a number of revenue initiatives over the last several years. We have deployed a number of revenue management techniques that are designed to drive revenues per flight. We are continuing to optimize each published flight schedule with an emphasis on optimizing our five relatively new Southwest destinations along with a real emphasis on Denver, which has now become our fifth largest operation, and that in less than five years.

We continue to advertise and promote our low cost, low fare competitive advantage and our nationwide low fare leadership and in particular with our 'Bags Fly Free' campaign. We have added new sources of revenues, such as EarlyBird and pets on board. We continue to see strong growth from relatively new sources, relating to areas such as Rapid Rewards, Business Select and our Dallas Love Field new [item] in the itineraries.

We will soon launch our marketing and distribution agreement with Volaris to Mexico. Next year, we will launch the Rapid Rewards 2.0 product. Yesterday, we announced schedules and fares for a March 13, 2011 launch of Greenville-Spartanburg and Charleston, South Carolina. Soon we will announce schedules and fares for 2011 launch of New York-New Jersey. Finally, and I hope a very soon, we will acquire AirTran Airways and that will provide a host of route destination, profit and growth opportunities for Southwest Airlines.

In the meantime, we are evaluating the timing of bringing up a new reservation system, which, among many things, will bring us international capabilities.

Finally, we are in the final evaluation phase of whether to add the 737-800 to our fleet, beginning no earlier than 2012. No commitment has been made on the Dash 800 GF. Needless to say, we think we have got a very exciting future. We have a very full agenda for the first half of the next decade. We have the leadership team, we have got the people, and we have got the financial resources to make all this happen

If I wasn't clear in the beginning, I will just say, I am extremely happy with where we are, with these results. There are always challenges and this very difficult airline business, but I am just glad I'm at Southwest Airlines.

With that very brief overview, I would like to turn it over to our tremendous Chief Financial Officer, Ms. Laura Wright.

Laura Wright

Our third quarter GAAP net income was $205 million or $0.27 per diluted share. Excluding special items, our third quarter net income was $195 million or $0.26 per diluted share, a significant improvement over our third quarter 2009 earnings excluding special items of $31 million or $0.04 per diluted share. This net income excluding special items produced 6.1% net margin. These results exceeded Wall Street's mean estimate of $0.25 per diluted share.

Our third quarter operating income excluding special items was $388 million resulting in 12% operating margin. Our pretax income excluding special items was $315 million resulting in a 10% pretax margin. On a rolling 12 months basis, our pre-tax return on invested capital is approximately 10%.

Overall, we had a very strong quarterly performance delivering a record third quarter profit excluding special items. I would like to join Gary in congratulating our employees on these tremendous results.

Our revenue performance was very strong, continuing the momentum that we had in the first half of the year. Our passenger revenues for the quarter increased by nearly $500 million to a record $3 billion. Our other revenues increased nearly 50% or about $40 million, primarily due to $29 million of EarlyBird revenues this quarter.

When combined with our 11% improvement in freight revenues, our total operating revenues for the quarter increased almost 20% to a record $3.2 billion. On a unit basis, our passenger revenues grew 16.3% and our operating revenues grew 16.1% on a unit basis compared to the third quarter of last year.

Our unit revenue performance in the third quarter, as compared to the second quarter, produced a sequential trend that was better than historical average change from the second quarter to the third quarter. Further, compared to the third quarter of 2008, our total revenues grew by $266 million on about 3% last available seat miles, resulting in a two-year unit revenue increase of 13.5%. It truly was a phenomenal revenue performance.

Our third quarter traffic levels were high resulting in record monthly load factors each month throughout the quarter to produce a record third quarter load factor of 80.9%. Besides carrying record loads, our passenger yields were up 13.4% due to an increase in full fare passengers and less discounts in sale fares. Our third quarter full fare mix was 18%, which is up about a point from the third quarter of last year and down about 1.5 points from the second quarter of 2010.

Demand for our Business Select product remained strong with 21% more Business Select passengers from a year ago producing $22 million in incremental revenue, which is up from $18 million in the third quarter of last year. We were also very pleased to see 40% year-over-year increase in our Wright Amendment revenue with $59 million of revenues in the quarter compared to $42 million a year ago.

Month-to-date, our October passenger unit revenues are up in the 11% range from the respective year ago period. Our October results, thus far, suggest a sequential change in nominal CASM for September that again exceeds historical sequential average changes for this time period.

Bookings thus far, for the remainder of October and for November and December, also look strong. However, our year-over-year present comparisons leave may become more difficult in November and December, compared to October due to last year's CASM acceleration as the quarter progressed.

Additionally, we have more difficult year-over-year capacity comparisons as we move through the fourth quarter versus what we saw in the third quarter.

Although we are encouraged to begin the fourth quarter with a similar year-over-year run rate as we experienced in September, our year-over-year comparisons for the rest of the quarter should be more difficult. That being said, the good news is that despite the mixed economic data that we read about every day, our bookings and price and our sequential revenue trends, at least thus far here in October, indicate sustained momentum of our year-to-date revenue results.

Our freight revenues increased 10.7% to $31 million, primarily due to higher average rates, and we expect that our fourth quarter freight revenues will be comparable to the third quarter. As I mentioned earlier, our other revenues increased almost 50% to $129 million, which includes $29 million in EarlyBird revenues and $14 million in revenues from pets, unaccompanied minors and excess bag charges combined versus $2 million a year ago for EarlyBirds and $10 million a year ago for pets, unaccompanied minors and bags.

We expect another year-over-year increase in our other revenues in the fourth quarter but at a much lower rate than experienced in the third quarter, taking into consideration that we had $24 million in ancillary revenues in the fourth quarter of last year on these initiatives versus only $12 million in the third quarter of last year for the same initiatives as they were just being introduced.

Turning to our cost performance, our third quarter operating expenses, excluding special items, increased 10.5% year-over-year. The increase was 7.1% on a unit basis, which once again, was due largely to higher fuel costs. Our economic fuel costs increased 11.7% to $2.38 per gallon. The decrease in crude oil during the quarter was essentially offset by an increase in crack spreads.

Based on the fourth quarter fuel hedge which we provided in our press release this morning and using the October 15 forward curve, we are currently expecting our fourth quarter economic fuel price to be in the $2.45 to $2.50 per gallon range including taxes. Premium costs associated with our fourth quarter fuel hedge are estimated to be in the $36 million range.

We will also provide a fuel sensitivity table for your reference in our Form 10-Q, which we plan to file soon. As a reminder, the sensitivity table that we have in the 10-Q factors in the various price points and percentages of our current hedge position as well as the locked in losses from the hedges that were unwound in late 2008.

For 2011, the recent volatility makes it quite difficult to give 2011 fuel guidance with any precision. However, based on the current forward curve, crude is averaging in the mid to high $80 per barrel range next year. Clearly, if that occurs that would create a year-over-year headwind for us in terms of price per gallon. Using this forward curve in our existing hedges, our current estimate is about $2.60 per gallon range, which is about $0.10 above the current market price for 2011.

Excluding fuel and special items, our third quarter costs increased 5.1% on a unit basis. Higher salaries, wages and benefits accounted for over 3 points of the year-over-year increase, a vast majority of which was due to significantly higher profit sharing expense in the third quarter compared to a year ago.

We accrued $56 million in profit sharing and $49 million in 401 K expense for a total benefit to our employees of $105 million in the third quarter, up from $55 million a year ago. Excluding fuel, special items and profit sharing expense, our unit cost increased 2.5% from a year ago. Airport costs, higher revenue-related charges and advertising costs accounted for the remainder of the year-over-year increase.

Looking forward to the fourth quarter, we continue to have inflationary cost pressures, most notably in airport and labor costs. Our labor cost typically increase sequentially from the third to the fourth quarter due to seasonal flying and associated increases with holiday pay. In addition, based on the existing contract we have with our pilots, our pilots are eligible for a profitability-based rate increase effective September 1 at 3%, and that's due to the company's earnings performance for the 12 months ended September 30. If you remember, a year ago, under the same formula, they did not receive our rate increase. We also anticipate advertising cost to increase year-over-year in the fourth quarter due to targeted ad campaigns that we have scheduled.

Finally, we expect our fourth quarter maintenance unit cost to be similar to third quarter's $0.077, which is higher than last year's fourth quarter maintenance cost of $0.069. Based on these cost trends, we are estimating another year-over-year increase in our fourth quarter non-fuel unit cost currently in the 6% range.

Moving on to the balance sheet and cash flow, as we reported in this morning's release, we currently have approximately $3.7 billion in core, unrestricted cash and short-term investments. Our $600 million credit facility remains fully un-drawn and available. Our leverage including aircraft leases is forecasted to be around 40% by year-end.

We generated $285 million in free cash flow for the quarter, and our year-to-date cash flow from operations are approximately $1.3 billion with almost $900 million in free cash flow. We currently expect that our 2010 capital spending will be less than $500 million. For 2011, we are currently forecasting capital spending to be in the $800 million to $900 million range.

Turning to fleet capacity, during the quarter we acquired three 700s from Boeing and we ended the quarter with a fleet of 547 airplanes. We expect to take delivery of one more aircraft from Boeing this year and we are picking up three leased aircraft in the secondary market, one of which is expected to be delivered by the end of the year and the other two early next year. The three additional aircraft are being leased solely to cover additional maintenance lines needed for elective maintenance needs that we have opted to accelerate over the next several years.

Based on six planned retirements this year, we expect to end the year with 546 airplanes. For 2011, we have 14 firm orders from Boeing and with the two leased aircraft that I just mentioned, and we are going to have a 16 retirements. We will end 2011 with flat fleet. Absent the AirTran acquisition, we are not planning for any fleet growth next year.

As far as capacity plans, our fourth quarter capacity is expected to be up approximately 5.3% year-over-year and our full year 2010 capacity still remains flat with 2009 at 0.4%. For 2011, as demand has continued to strengthen, we have attractive opportunities to better utilize our existing fleet and we are currently expecting to increase our capacity in the first quarter of next year in the 8% range and in the second quarter in the 5% range.

Our schedule authorization is allowing us to add three new cities next year, two of which are Charleston and Greenville, which we announced service plans for yesterday. At Charleston, we will have seven daily departures to four cities beginning on March 13, and Greenville-Spartanburg will have seven daily departures to five cities also beginning on March 13. As previously announced, we are excited to begin service to New York in March of 2011 as pursuant to our lease agreement with Continental for 36 slots.

In closing, we continue to closely monitor demand and we do remain prepared to adjust schedule accordingly.

Tom, with that overview, Gary and I are ready to take questions.

Question-and-Answer Session

Operator

(Operator Instructions). We will take our first question from Jamie Baker with JPMorgan

Jamie Baker - JPMorgan

Gary, on the morning of AirTran announcement you indicated that you would shortly be reaching out to Boeing Capital on the issue of 717s. I am wondering if you've had a chance to do so. Whether the 717s are going to figure into the potential 737-800 negations? It's hard for me imagine that they wouldn't, but I'd love to get you perspective.

Gary Kelly

We've talked to Boeing and other suppliers for that matter about things that we can talk them about. At this point, clearly we're not in a position where we can talk to Boeing about another company's situation. Laura can chime in here. The only update that we have for you all with respect to AirTran on the aircraft is that as now we've been able to embrace a number of additional experts within our company and also talk to the Boeing company about the airplane. We're pretty excited about it. We've only confirmed what we thought before about adding it to the fleet with respect to opportunities we might have with regards to economics. Those are all in the hands of our integration planning teams. I don't know that we can provide you much more insight. Laura, is there anything that you want to add?

Laura Wright

The TBD is shelved so.

Gary Kelly

We've done, Jamie, in other words what we said. It's just that at this stage it's premature to have any further in-depth conversations. Again, there is not a whole lot that we can report at this point.

Jamie Baker - JPMorgan

A follow-up on the regulatory front. There are a handful of two-to-one markets where post deal you would be the sole operator. It's hard to see how DOJ can mandate, forcing another carrier to come in. These aren't slot controlled facilities in the first place. It's a free market. Other carriers could already be in there if they wanted to. The question for you is, whether you'd be open to any divestiture, service reduction mandates that the DOJ might come up with?

Gary Kelly

I don't want to speculate at this point about what they might ask us to do. We've done our Hart-Scott-Rodino filing. We are planning to meet with them soon. There's a 30-day period that they have to provide additional request for information. We're in that phase. There is nothing to report at this point. We think we have a strong case. I don't want to speak for AirTran, but I know they wouldn't have entered into the agreement unless they felt the same thing. Everything you said, we are aware of and is true. We will just have to manage this as best we can and hopefully as quickly as possible.

Operator

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

Hunter Keay - Stifel Nicolaus

I'm hearing mixed things on the capacity front. I'm wondering if you can help us flush this out. Your fleet is going to be flat next year, you have opportunities for getting some new aircraft on lease, 8% ASM growth in 1Q, 5% in 2Q. Did you give a full year number?

Laura Wright

We didn't. Hunter, our schedule is only out there, it's for June right now. So, we certainly have some decisions to make for the back half of the year. You are correct; we only give the first and second quarter.

Gary Kelly

We have ramped up our capacity through the year. From here, where we are in the third quarter, we're not anticipating any significant capacity growth. We cut very sharply in the first quarter of '10 and based on the recovery that we've seen and Laura made some very key points, which is seasonally we're seeing more strength and what we are accustomed to in the third quarter and we're already seeing that continuing here in October. So, I am very comfortable in not cutting the capacity from where we are in the first quarter like we did early this year. So, a lot of that capacity growth in the first half is simply due to a choice on our part not to cut sharply.

Laura Wright

Pre-utilizations, Hunter.

Hunter Keay - Stifel Nicolaus

Given the fact (inaudible) is larger than the utilization base and you mentioned before you can easily take that up to 5% or 6% growth annually, you said you see utilization alone, but if you run rate that then certainly the rate of year-over-year growth should probably pullback a little bit in back half of the year, but if it is utilization, am I correct in thinking that there's probably some pretty good opportunities to keep CASM ex-fuel maybe relatively flattish?

Laura Wright

We haven't given CASM guidance, but there's no question, as you know, that if we have some ASM growth next year that will greatly alleviate a lot of the cost pressures that we'll have.

Gary Kelly

The cost pressures are the things that you would know that we're grappling with right now. We're concerned about fuel cost and Laura spoke to that. The other thing just to be mindful of and just to remind you of is that the airport costs are in escalating cost category for us. If I were to complain about one category it would be that. Elsewhere, We're doing a pretty darn good job and we'll launch Rapid Rewards next year with a new product and that will require some marketing support. We're again in the planning stages for how much we want to spend there, but you're exactly right, we've got, from what we have published we can probably increase capacity next year a low of 3.5%. Just again with no additional aircraft, you're right we can probably hit a run rate of something ahead of 5% for the year.

Operator

We will take our first question from Glenn Engel with Bank of America Merrill Lynch

Glenn Engel - Bank of America Merrill Lynch

Can you give us the full fare mix this year versus last third quarter?

Laura Wright

Yes, I can Glenn. It was 18% and that was up a little over point from last year. We were about 17%.

Glenn Engel - Bank of America Merrill Lynch

You said in the past that you have been doing a lot to change your schedules around to maximize revenues and that when those schedules stabilize, you'd be able to figure out better how to get your cost more in line with those new schedule. Are you at that point yet where you can start taking actions?

Gary Kelly

We've been doing that continually, but I don't think that we are at the point where I would say no, I would say that we're still in a process of settling our flight schedule, optimizing the flight schedule, number one. Number two, we have more connecting passengers today, without a doubt, than what we have had historically. We have not fully adjusted our operation to that fact yet, number one.

Number two, in the way that we are trying to accommodate delays, cancellations, weather issues, mechanicals all of that, we have several different options that we're exploring as to how we manage our aircraft swaps, as an example. Think that once we have a view on those several things, think that we'll demand for different scheduling, different staffing, add in the field to meet our operational needs and our customer service requirements.

We're not quite ready to make any radical adjustments there yet, but on the other hand, we've been doing that continually and you can tell by the productivity numbers that they're not getting worse. They're just not getting better at the same rate that they have been over the last five years.

Laura Wright

As we talked about that we've always noted that it was taking us some time to make those adjustments just the same way it took us time to adjust our revenue model. It's a work in process.

Gary Kelly

Glenn, what has happened is AirTran. AirTran is a big deal. The Company is going to have to rally and will rally around the integration of AirTran into Southwest Airlines operations as a top priority. Some of the things that we have been contemplating, absent an AirTran deal, are going to have to get reprioritized and that may very well be one of those.

Operator

We will take our first question from Dan Mckenzie with Hudson Securities.

Daniel Mckenzie - Hudson Securities

Assuming the merger with AirTran goes through, does Southwest really -are you getting the presence you need or want at the slot constrained airports Reagan National, LaGuardia?

Gary Kelly

We're approaching what could be fairly characterized as something close to the minimum that we're comfortable with. None of us are overly ambitious about how much we can accumulate over time, so if we have opportunities to add additional slots with those two airports, and New York for that matter, we'll certainly look at that. Eight is just not enough, eight dailies at LaGuardia is just not enough.

We'll be in the neighborhood of something that we're comfortable with. We're okay with the national and New York position. Dan, if we can get more, we're interested in more, I'm just not assuming that will happen, though, this is a long-term view that we'll be fine with that level of capacity in those three airports.

Daniel Mckenzie - Hudson Securities

As you think about growth next year, what kind of return requirements are you factoring into your thought process? I guess asked differently and to an extent that you can provide some perspective on a scale of 1 to 10, how confident are you that you can still hit internal return on invested capital objectives.

Gary Kelly

We're confident that we will. I guess when is the question.

Laura Wright

In terms of the growth for next year, Dan, we're really using the existing fleet. In terms of the invested capital base, we're not growing that. It's not like that we're going out and buying airplanes to do this growth. So, certainly we reduced the capacity earlier this year with the thought that the economy and our results wouldn't be nearly as good as they are. So, with the capacity that's coming back, we feel good, but it should just enhance our returns on that invested capital that we have deployed. That's the near term 2011.

Gary Kelly

The incremental margin we believe that the capacity that's been deployed through June, it will add to profitability. So, in other words, what we're telling you is that we'll have more profits with the plan that is being pursued as opposed to less. It's all an effort. It's a task that we're on to hit our return on capital goals. Obviously, we're very hopeful we can do that next year. The biggest wildcard for us is tell what fuel prices are.

We've done a lot of good in a short period of time, and everybody at Southwest is proud of our 2010 results compared to the 2010 plan that we laid out three years ago. Fuel prices are much higher than what we contemplated in '07. So, if there is a concern in the plan next year, that's it, but the revenue production is better with the capacity plan that we're deploying as compared to now.

Operator

We will take our first question from Duane Pfennigwerth with Raymond James.

Duane Pfennigwerth - Raymond James

Just thinking about your commentary about the tougher comparisons but yet the continued strength that you are seeing, do you think we move away from a two-year comparison here in unit revenue? Specifically, as about November, would you be surprised to see a flat RASM number given the difficult comp or are we seeing enough strength over that holiday period to continue to expect positive numbers?

Gary Kelly

The fourth quarter of '08 was really the beginning of the difficult revenue environment. So, if you compare fourth quarter '10 to fourth quarter '08, at least with the forecast that I have in my mind, it's going to be a very handsome increase. Obviously, we started to see three significant improvements in fourth quarter '09, so that one won't be as good. At least for the fourth quarter of '10 that the two year ago number is still a decent comparison. We've started looking back at '07. We've started looking back at a basket of years to compare to because you run into such distortions, with '09 and even the latter part of '08, but every way we look at it. Laura, again, just have to reemphasize her point, the fact that October appears to us the way it does compared to September, August, July is very meaningful.

It suggests that we're continuing to build momentum. That logical because you haven't seen the full return of the business traveler. If one believes that that is gradually occurring over time, all else being equal, you ought to continue to see strengthening of revenue momentum.

That would be a prediction earlier this year, and so far that's playing out pretty well. We're not seeing the levels of business traffic in Southwest that we had in '07 and '08. Certainly, what I've heard from counterparts around the industry, no one is representing that their business travelers recovered to that level. You've got that upside in any event.

Duane Pfennigwerth - Raymond James

The AirTran acquisition was characterized on another call as a high-cost airline, purchasing a low-cost airline, and that the only way synergies could be delivered would be for fares to go up, I was wondering if you could respond to that?

Gary Kelly

You are saying that was on a call by one of our competitors?

Duane Pfennigwerth - Raymond James

Yes.

Gary Kelly

You believe what they said about us?

Duane Pfennigwerth - Raymond James

Just asking you to respond to it?

Gary Kelly

That was a joke. Obviously, we're not a high-cost airline and I don't think there is any use in wasting anybody's time trying to prove what is obvious to everyone. We are leading the industry in virtually every economic category with our low fare approach. We're the only one who doesn't charge all the ridiculous fees. So, of course, that's not what our strategy is. Our strategy is to keep our fare as low, continue to be the low fare leader in the United States, not nickel-and-dime our customers. We already see a host of opportunities, particularly in Atlanta to go in and reduce the fares by half, to what Southwest Airlines' levels are and enjoy the famous Southwest effect of stimulating traffic. It is not our plan to convert ourselves from a low fare carrier to a high fare carrier. You won't see that happen.

Operator

We will take our first question from Michael Linenberg with Deutsche Bank.

Michael Linenberg - Deutsche Bank

Gary, when about bringing on the 717, there's always the possibility that you have a different rate and I know in the past, historically, Southwest has always been loathe at having different rates for different airplanes, and the best evidence of that is your recent contract on the 800. It looks like it's going to be similar to the other 73s.

On your call that you had announcing the AirTran merger, you did indicate, maybe it was an aside, but you kind of said, what we don't want is to create a situation where the pilots jump between the different airplane times. It got me thinking about that second rate. What did you mean or maybe do you continue to take that view that single rate across the fleet is the best thing for Southwest that makes the most sense?

Gary Kelly

I was purposefully incomplete in my comment and it's not because I like to be evasive with you all. It is more of a respect that we have for the negotiation process and we don't have a rate negotiated for the 717 with flight attendants or pilots, and I'd rather not negotiate that publicly. I'll stand by my qualitative comment, which is clearly we don't want to create a scenario that's inefficient for the airline to operate, but I didn't intend to take you so rapidly to a hard conclusion on that. We need to talk to our pilots. We need to talk to our flight attendants. There may be other issues that we haven't had any discussions yet. We don't even have the 717 yet, so I just think it's inappropriate for me to speculate on that at this point.

Michael Linenberg - Deutsche Bank

Just back to the comments that Laura and you followed up with, on October versus September, this sequential improvement or sequential change that is above and beyond what you've seen historically. Realizing that your business mix is only up one point, but then again, that's just mix and that doesn't necessarily. I presume that's just based on volume, that's not based on a revenue number? You could be getting higher quality revenue. Did you feel that it's the network, it's the better technology, its EarlyBird, Biz Select. Is that got to be what's going to be or do you just feel like as you mature as a company, you're just becoming more attractive to a higher quality corporate traveler, anything that you can comment on in that regard?

Gary Kelly

Marketing has recently done and we'll share this with you all in December when we meet in New York. Marketing has recently has done some surveys to try to get a sense of what our mix of business travelers is compared to other airlines. If you extrapolate that into the number of customers that we carry, we're among the leaders in the country in terms of the number of the business customers that we serve. Arguably, historically, at least last couple of years, we've been the largest with Delta, Northwest combining and now United Continental, they will probably outboard us in terms of business customers. The point is, we already serve a whole bunch of business customers.

Clearly, we're gaining share. That's an undeniable fact domestically. We're gaining share relative to the last several years. A lot of that share is to consumer, but it's also business travelers. Just with the product enhancements we've made, giving the road warriors more choice, we do believe that we're seeing more business customers come Southwest way. There is variety of things going on in our 16.1% unit revenue improvement. We've deployed 10 different initiatives or more and it's hard for us to piece apart what value is being driven by each one, but again we want to share that with you all when we'll have more time to do that. What I hear from business customers is the fact that we've introduced an enhanced boarding process with the Business Select product, with enhanced frequent flier benefits, has caused them to change their flying behavior and bring their business to Southwest.

The fact that we allow more flexibility in changing flights where we do not charge the change fee is huge with business customers. The bag fees may be not so much. That's probably more benefit for consumers, but even the bag fees is an attribute that some business customers like. It's a basket of things. Clearly, there is much better revenue management than there was three years ago. There is much better schedule optimization than there was three years ago. We've created itineraries that are more marketable for connecting customers or connecting passengers are up more than our non-stop passengers. They are not at the expense of non-stops. We're still carrying the same amount of non-stop passengers.

The increase in the load factor has been driven more by carrying more connecting passengers. So, one would infer that could be more heavily weighted towards consumers. It's a variety of things, and in fact, Mike, with the recession, which you know you'll always find with a drop in business travel, that's our bread and butter, short-haul markets, and they are lagging in the recovery compared to our medium and longer haul markets for that reason. I do think that when the business traveler does come back, we're going to see, hopefully, a very strong response, especially in our shorter haul routes.

Operator

We will take our next question from Bill Greene with Morgan Stanley Smith Barney.

William Greene - Morgan Stanley Smith Barney

Gary, I want to touch upon basically a competitive theme that you already alluded to. One of the things you mentioned in your press release is the 'Southwest Effect' and you referred to it earlier, but there is also a countervailing view that AirTran stimulated a lot of demand in Atlanta already with low fare. How do I reconcile those two that there is this opportunity for you to simulate in markets where I would have thought they already had some pretty low fares.

Gary Kelly

Bill, you are right. That's a fact. That is true. The opportunity for us is twofold, but the easier one to visualize is there are at least two dozen cities in our route system that AirTran does not serve. So, those are simple. You go in, we see that the fares are quite high, we know we can come in, lower the fares, and stimulate the market. It will be additive, in other words, to the AirTran route system. That is huge. Campbell-Hill came up with an estimate of 2 million incremental O&D passengers. We just looked at that subset of markets. Our number wasn't 2 million, but it was still really big. In addition to that I'm moving on to the next argument.

The AirTran route system is probably not fully fleshed out. In other words, even where they do have service, especially if it's serviced to an existing Southwest city, we see the opportunity to at least consider adding frequencies and tap into the strength that we have on the destination markets. We loathe to tell our competitors our game plan, but an obvious one is Chicago Midway where we have a lot of customers in Chicago. It's one or our largest cities that we operate from. We may very well have opportunities to add to the AirTran route map and generate a lot more customers. Then there are probably places that we don't serve that AirTran does where they may not have enough frequencies either. Of course, in 2008, they were forced for economic reasons to withdraw a lot of capacity from Atlanta because of high fuel prices. Some of that could, at least in theory, be considered for restoration. So, I really think its three basic pools of opportunities there, but again, according to Campbell-Hill if you look at all of those three in aggregate, it's an annual opportunity of about 2 million incremental passengers.

William Greene - Morgan Stanley Smith Barney

The other question I have is, again, something you referenced before, but there seems to be an impression among your competitors that they'd competed with you for a while, you are relatively rationale in your approach to your business, and therefore, they actually would prefer to compete against you versus, say, an AirTran or one of the smaller carriers. I'm just curious why you think there would be that impression that it's better to compete against a Southwest versus an AirTran?

Gary Kelly

Bill, I don't know, but I'd tell you what. I hope they get their pick there. When we get this deal closed, we can give them what they want, which is more competition.

Operator

We will take our next question from Gary Chase from Barclays Capital.

Gary Chase - Barclays Capital

I wanted to just clarify something. When you said you are starting the quarter on the same tone as September, was that to suggest that the month-to-date October was 11%? '

Laura Wright

Correct. Year-over-year increase, month to-date, so up 11%.

Gary Chase - Barclays Capital

We're hearing this from a lot of people through this earnings season that there seem to be acceleration, at least by my perception, versus normal seasonality. I wondered if maybe you could describe what it is that you think is driving it? What's driving this good tone to business? I didn't think the September numbers were particularly impressive for Southwest and for some others, but October and certainly the commentary on November sounds like it is. Is there something that you've maybe put your finger that is contributing to it?

Laura Wright

First I'd like to say, we thought we were very pleased with our September results, because we started showing decent acceleration a year ago in September well ahead of the rest of the industries. If you kind of compare us to two years ago, our unit revenues are up about 13.5% in a still pretty depressed economic environment. We were pleased with the results. In terms of why the sequential trends, it maybe goes back to some of the discussion that we had with Mike Linenberg, and Gary's response to his question, there seems to be a lot of factors working together out there. Certainly, what we've seen at Southwest is increased loads, record load factors in 14 of the last 15 months. We're slow at picking up business traffic, but at the same time we seem to be picking up more incremental leisure traffic as well. It just seems to be a very good combination for us. I’m not sure I can answer what's driving the overall macro recovery.

Gary Kelly

I’ll just throw in. I was trying to think while Laura was talking there and it's possible that the air travel demand, and Gary, you all may have a better sense of this than I do since you look at every airline, and you aggregate these things at least faster than we do sometimes, but there could be a pickup in the air travel demand market. I would project that over time there is a gradual return of the business travelers. That might help support and that was a point that I made earlier. This is a view that we have and I don't know that it's shared by all. It's just a view, but I do think that the economic environment.

It's hard to find anybody who thinks that the economy is really strong, so I do think that the environment is such that consumers, especially, are looking for value. I read all the time about business travelers looking for value and buying in advance to get better ticket prices as an example. That's an environment where we really shine and the 'Bags Fly Free' message of course just pounds home what a low fair philosophy that we have at Southwest Airlines. I continue to believe that we're going to continue to outperform our competitors. Now, these are Laura Wright's comments, saying that, at Southwest Airlines we are seeing this escalation seasonally.

I don't know that we're going to find if that's true for the industry. That our product is getting better every year and we're continuing to add new features and functions, and that that's all a plus and there is just a fair amount of excitement that we feel within the Company and I sense that without it that we're doing some things. The fact that we've added five new cities in the last 18 months is huge, because it's not just exciting for the people in Boston, LaGuardia, Minneapolis, Panama City and Milwaukee it's the rest of our system that has now another flight opportunity on Southwest Airlines. There aren't any real competitors they are able to offer the same kind of it's a 'wow' factor. There are others that might say it's not such of a 'wow' factor, but its great fun for us to be able to announce yesterday South Carolina, as an example.

Gary Chase - Barclays Capital

I am a little surprised to hear that you are going to be running quite as much capacity as you were in the first and second quarter. If you think about the schedule optimization you undertook last year at this time, at least, I understood as you wanted to get a lot of capacity out of these off peak periods, where revenue wasn't so good. It just seems like you're kind of coming back to that and you could clearly see it in a way you utilized your network this year. Summer schedules were tight, but they weren't in first quarter. Now, it feels like you're going to be much more back to a more leveled schedule, where you're really filling in those off-peaks. Is there some story there that we don't understand that is going to allow you to generate the turn to returns that you couldn't last year at that time?

Gary Kelly

Gary, and we'll just have to work harder at trying to share it and articulate it. If you look at the current and you all will get tired of me repeating this, but what Laura said earlier is very meaningful, the fact that we are seeing such strength in October is very material to what we are contemplating for the first quarter. We're going to have another record load factor in October. We'll have another record load factor in November. I'm not predicting it. I'm just trying to set the stage for why we believe that the capacity plan for next year is appropriate. We see very strong demand for the next 60 to 90 days, which we think will carry through to the first quarter of next year.

With an optimized schedule that has new markets in it that at least in our view will justify that amount of flight activity. Dan made this point earlier that the fact that we can add that capacity at an incremental cost makes the profit opportunity quite handsome for all the obvious reasons. I'm comfortable with it, and hopefully what I'm doing it with more airplanes, so it's just utilizing the assets that we have and the workforce that we have to provide better flights, and again, we're confident that the revenues would be there. My concern for next year is more fuel personally than it is the capacity plan that we're talking about.

Laura Wright

If you've looked at what we were doing in the first quarter with ASMs, they are actually down from what we had in the fourth quarter. It's not like we're adding a lot of ASM from what we're doing in the fourth quarter, we just cut really deep in the first quarter last year. We'll just get better utilization, and again, we're using that capacity to add new cities. It's not replacing necessarily the flights we took out. We're having better and more productive flights to replace them with.

Gary Kelly

One final thought. As I was preparing for today yesterday, so a lot of this is really fresh on my mind, it is interesting with a lot of we're nationwide now and we're different than we were 25 years ago. Some of our markets peak in the first quarter. That one of the things that schedule planning or network planning is doing is taking advantage of that. Where we do have strength in the quarter, we're putting the capacity there. Where we have more weakness, we are pulling that capacity out. It's still very active. It's not simply publish something in August and let that carry through for the next six months. They are still active with their adds and their deletes. Again, we think that given the overall strength in the demand, we think we've got a good schedule out there for next year.

Operator

We will take our next question from Bob McAdoo from Avondale Partners.

Bob McAdoo - Avondale Partners

Just a couple of quick ones. You talked about increased airport costs and once before we've talked about how St. Louis cost went up when American pulled down their capacity. Are there any other airports of note where you've had similar kinds of cost or where alternatively there's a big building project that's going on that's going to drive costs up in particular?

Gary Kelly

Unfortunately, Bob, it's a long list.

Laura Wright

Las Vegas, just one in particular that had capacity come out. We've seen our rates go up there.

Gary Kelly

Chicago, Baltimore, San Jose just opened up a new terminal.

Laura Wright

Sacramento.

Gary Kelly

Sacramento. It is a long, long list.

Bob McAdoo - Avondale Partners

It's as much as people adding to their airports as it is competition disappearing?

Gary Kelly

It's a combination, yes. Of course, it's not coming in a very good time. We all understand how long-lived those construction plans and projects and processes are, but that's a fact that's confounded us. Far we've seen very significant increases in our airport cost this year. The concern is that we'll see another significant increase next year. That's just an advanced warning on that and something that we'll have to factor into our plans accordingly. Our capacity plans, again, actually help mitigate that to a degree because a lot of those cost increases are fixed. So, to the extent that we can add more capacity, it drives down the unit cost. The other point to reiterate with the capacity increase is that we believe we drive more revenue and more profits with that approach as opposed to not. It's a way of saying what are we going to do about our airport cost pressure? One of the answers is, fortunately, we have some opportunities to add some profitable capacity here in the near term.

Bob McAdoo - Avondale Partners

Then, just quickly, you went through your long list of things, that's why you are glad you're at Southwest Airlines at the first of the call. There were some other things in there, the timing is obvious, there were two, three things that I was wondering if you could just take a second and say, when it's going to be announced or when I'm sure maybe you're not ready to announce the actual start date, but at least when we'll start to know more about things like the Volaris and like your Rapid Rewards program enhancements and when we might know more about the new reservation systems, not necessarily the international flight, but just the reservation system itself, timing on some of that kind of stuff?

Gary Kelly

We'll get this stuff done eventually. Volaris, we'll share some specifics on that soon. Next in line would be Rapid Rewards. We'll share some specifics on that pretty soon. Then the new res system, what we need to have done first is a good effort on our integration planning here with AirTran. We may have to delay a little bit the spooling up that effort, Bob. So, in any event, that the attributes associated with a new reservation system likely won't begin to come online for probably 18 to 24 months at the earliest, and then all up, I can't imagine that we'll be completely converted to a new reservations system given this new AirTran initiative for three year would be my guess. We'll probably stat that work in earnest in a couple of months, but even that is just a target date. Volaris and Rapid Rewards are very, very close and you'll find more about those two very soon.

Bob McAdoo - Avondale Partners

Just kind of things we might hear about in December when we get together?

Gary Kelly

You're really tough on me.

Laura Wright

Bob we can say is that, the kind of the rough timeframes we have given you in the past have not changed, so we'll be out with specifics.

Gary Kelly

You'll know one of those before December. How about that? I just want to tell you which one.

Operator

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

Laura Wright

Thank you everyone for joining us this morning. The Investor Relations team will be ready for any calls that you have and Tom thank you. Everybody have a great week.

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