Southwest Airlines (LUV) Gary C. Kelly on Q2 2016 Results - Earnings Call Transcript

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Southwest Airlines Co. (NYSE:LUV)

Q2 2016 Earnings Call

July 21, 2016 12:30 pm ET

Executives

Marcy Brand - Managing Director-Investor Relations

Gary C. Kelly - Chairman, President & Chief Executive Officer

Tammy Romo - Chief Financial Officer & Executive Vice President

Robert E. Jordan - Chief Commercial Officer & Executive VP

Linda B. Rutherford - Vice President and Chief Communications Officer

Michael G. Van de Ven - Chief Operating Officer & Executive Vice President

Analysts

Mike J. Linenberg - Deutsche Bank Securities, Inc.

J. Yates - Credit Suisse Securities (NYSE:USA) LLC (Broker)

Duane Pfennigwerth - Evercore ISI

Jack Atkins - Stephens, Inc.

Hunter K. Keay - Wolfe Research LLC

Andrew George Didora - Bank of America Merrill Lynch

Darryl Genovesi - UBS Securities LLC

Savanthi N. Syth - Raymond James & Associates, Inc.

Jamie N. Baker - JPMorgan Securities LLC

Joseph DeNardi - Stifel, Nicolaus & Co., Inc.

Andrea Ahles - Fort Worth Star-Telegram

David Koenig - The Associated Press

Richard Velotta - Las Vegas Review-Journal

Operator

Welcome to the Southwest Airlines' Second Quarter 2016 Conference Call. My name is Tom and I'll be moderating today's call. This call is being recorded and a replay will be available on Southwest.com in the Investor Relations section.

At this time, I'd like to turn the call over to Ms. Marcy Brand, Managing Director of Investor Relations. Please go ahead, ma'am.

Marcy Brand - Managing Director-Investor Relations

Thank you, Tom, and good morning, everyone. Welcome to today's call to discuss our second quarter 2016 results. Joining the call today, we have Gary Kelly, Chairman, President and CEO; Tammy Romo, Executive Vice President and CFO; Bob Jordan, Executive Vice President and Chief Commercial Officer; and Mike Van de Ven, Executive Vice President and Chief Operating Officer.

Please note today's call will include forward-looking statements, because these statements are based on the company's current intent, expectations and projections, they are not guarantees of future performance, and a variety of factors could cause actual results to differ materially. As this call will include references to non-GAAP results excluding special items, please reference this morning's press release in the Investor Relations section at Southwest.com for further information regarding forward-looking statements and reconciliations of non-GAAP results to GAAP results.

Following the prepared remarks, we will open the call for questions. We ask that you please limit yourself to one question and one follow up, so that we can accommodate as many questions as possible.

At this time, I'll turn the call over to Gary for opening remarks.

Gary C. Kelly - Chairman, President & Chief Executive Officer

Thank you, Marcy, and good morning everyone and thank you for joining our second quarter 2016 earnings call. As we speak, we are recovering from a system-wide Southwest technology outage that occurred yesterday about 1 PM, there was a network equipment failure and the planned redundancy or backup failed as well, and this hindered the recovery efforts, and especially with some of our older legacy systems.

Ultimately, the network was virtually fully recovered and restored around 12 hours later, roughly 1 AM or 2 AM this morning. And since then, the operation and that is airplanes and flight crews and customer re-accommodations have been working to catch up. I want to apologize to all our customers that were affected yesterday and today, this is absolutely not the kind of service that our customers expect or what we expect of ourselves.

And of course our 50,000 employees, jobs to serve our customers became significantly more difficult as a result of the computer failure, and I do want to thank them from the bottom of my heart for their collective efforts to recover, those efforts have been truly heroic. So, hopefully after a day of recovery, things will be back to normal tomorrow morning.

Tammy's going to take us through the quarterly results and I just wanted to point out a couple of highlights. First of all, we had a record performance in many ways, traffic, revenues, load factor, earnings, return on invested capital; it was a very strong quarter also in terms of customer service and operations.

Next, we had very solid revenue growth on 4.8% growth in capacity, and that was driving industry leading but modest unit revenue growth of 0.6%, and that was in line with our expectations.

Revenue trends have been up and down all year. Now we're seeing softer fare trends in July, August, and notably with close-in bookings, given overall industry revenue and capacity trends that we've been monitoring, none of this is shocking, but it is disappointing.

We're still anticipating strong third quarter margins and profits, strong cash flows and continuing shareholder returns, but we will need to factor these softer trends into our future plans. So, for now, our second half 2016 plans are unchanged, but we'll continue to look carefully and evaluate our 2017 growth plans.

2017 is going to be an exciting year; we have the 737-8 being launched next year, we've got new technology being deployed next year, we are opening an international terminal at Fort Lauderdale, we've gotten our preliminary approvals to serve three cities in Cuba, and we have an outstanding request to add Mexico service to LAX. So a lot of exciting things going on and certainly 2017 is going to be a very big year.

I want thank our people for all their hard work and the tremendous success in driving these results, and also congratulate them on another quarter of record profit sharing. And with that, I'd like to turn it over to Tammy to take us through the quarter.

Tammy Romo - Chief Financial Officer & Executive Vice President

Thanks, Gary, and welcome, everyone.

We are pleased with our second quarter earnings results, which were an all-time record quarterly performance. Our GAAP net income was a record $820 million, and excluding special items, our net income increased 9.6% year-over-year to a record $757 million and we grew our earnings per share almost 16% to $1.19. This was a little shy of consensus, but it was right in line with our expectation and the guidance we provided last month at our Investor Day. Our operating margin of over 23% represents a 36-year high performance. And we grew our pre-tax ROIC excluding special items for the 12 months ended June by more than five points to 33.5%.

I'd just like to also join Gary in congratulating our outstanding employees on our 13th consecutive quarter of record profits, excluding special items and their record quarterly profit sharing of $206 million. This brings our profit sharing accrual to $361 million for the first half of the year alone.

Second quarter revenue performance was a significant driver of these strong results. Our operating revenues grew 5.3% and our passenger revenues once again grew to record levels. The growth in our revenues exceeded our capacity growth, resulting in unit revenue growth of 0.6%, which was in line with our guidance.

This RASM performance outperformed the industry and on a stage-length adjusted basis, our RASM performance was even better. Despite the challenging fare environment, our core business was solid, with strong demand for our low fares. Load factors were at record levels throughout the quarter and we closed second quarter with a record load factor of 85.6%.

Revenues related to Rapid Rewards continue to be very strong. Our second quarter results reflect a net benefit of approximately $135 million related to the amendment of our Chase agreement, effective in July last year.

Our strong revenue performance was also supported by continued growth in other ancillary revenues. Corporate sales were also strong, although at softer yields. We continued to benefit from tailwinds from our development markets, and we're very pleased with their performance, especially in light of the challenging fare environment.

International markets continued to perform in line with our expectations, with several of them producing revenue results well above system averages. Our freight revenues were in line with second quarter of last year. So, to close revenue, we are very pleased with our record operating performance.

So turning to our third quarter revenue outlook. Thus far, traffic and booking trends remain strong, but the fare environment continues to be a challenge. We're seeing heavy discounting in fares including close-in, which as we noted in the release has softened in recent weeks.

Based on these trends and our current bookings and including the yield trends we're expecting third quarter RASM to decline in the 3% to 4% range year-over-year. And as a reminder, we expect an ongoing benefit from the Chase amendment and 2Q's approximately $135 million benefit is a reasonable run rate for 3Q. But we won't see the 2 point to 3 point year-over-year RASM improvement in future quarters, of course, as we've lapped the July 2015 amendment date. We currently expect third quarter 2016 freight and other revenues to increase from third quarter 2015.

And now, I'll move over to our cost performance. Our second quarter costs were right in line with our expectation. Our operating unit cost excluding special items decreased modestly year-over-year, largely from lower jet fuel prices. Despite a 4.8% increase in our capacity, our fuel gallons only increased 4.1%, reflecting our fuel efficiency gains, largely from our fuel modernization efforts.

Our economic fuel price per gallon declined 10.4%, to the lower end of our guidance of $1.80 to $1.85. And based on our market prices as of Monday and our current third quarter hedge position, we expect our third quarter fuel price per gallon to be approximately $2.05.

We're also currently forecasting that level for fourth quarter. This brings our estimate for the full-year 2016 to the $1.90 to $1.95 range, which is down a bit, due to the recent drop in market prices. The fair market value of our fuel hedge portfolio beyond third quarter 2016, based on prices as of Monday, is a net liability of approximately $775 million.

And excluding fuel, special items and profit sharing, our second quarter unit costs were also in line with guidance, up approximately 2% year-over-year. This increase is due largely to the acceleration of the depreciation of the Classic fleet, the timing of advertising and technology investments along with airframe maintenance. Based on current cost trends, we expect third quarter 2016 CASM, excluding fuel, special items and profit sharing to also increase approximately 2% year-over-year.

Roughly 1 point of that year-over-year increase is driven by accelerated depreciation from our Classic retirement with the remainder associated with increased salary, wages and benefits costs from ratified agreement since third quarter 2015 as well as costs associated with technology projects. For full-year 2016, we continue to estimate a modest 1% increase in our unit costs excluding fuel, special items and profit sharing, which again is driven entirely by the accelerated depreciation.

And I am going to move now to our balance sheet and cash flow and I'll just make a few quick comments regarding the strength of our balance sheet and as well as our cash flows. Our cash and short-term investments were $3.4 billion at the end of the quarter. As we reported at Investor Day, we deferred $1.9 billion of aircraft CapEx to beyond 2020 as a result of our recently restructured order book with Boeing.

Our capital spending remains on track to reach approximately $2 billion this year, with $1.3 billion in aircraft CapEx and about $650 million in non-aircraft capital spend. With operating cash flows of $2.7 billion, thus far this year, and manageable capital spend, our free cash flow has remained strong, enabling us to continue to return value to shareholders through buybacks and dividends.

To quickly recap, what we discussed at Investor Day. Last month, we completed our previous $1.5 billion buyback authorization with a $200 million accelerated stock repurchase program in May and launched a $500 million ASR under our new $2 billion program, which was authorized by our board back in May.

We completed that ASR last month and we intend to launch another $250 million accelerated share repurchase here soon. Once launched, we have returned $1.6 billion to shareholders this year and we will have a $1.25 billion remaining under our authorization.

Our leverage, including off-balance sheet aircraft leases remains in the low-to-mid 30% range. And I'll just make a few comments on our fleet, but we have not had any changes to our plans since we announced the restructuring of our order book with Boeing last month at Investor Day. We ended the quarter as planned with 719 aircraft in our fleet and continue to anticipate ending the year with the fleet of 723 aircraft.

We are still managing to an average annual net fleet growth for the three years ended 2018 of no more than 2%. And as Gary has mentioned, our year-over-year capacity growth for this year remains unchanged in the 5% to 6% range. While we continue to evaluate a rate of capacity growth beyond 2016, especially in light of the current revenue environment, we still expect annual capacity growth in 2017 and 2018 to be less than this year. We remain disciplined and our approach to growth with a focus, of course, on flexibility to adjust, if needed, with a goal to preserve our strong returns and margins.

And now just to quickly recap for you. This was another quarter of record profits, outstanding margins and strong cash flows. Demand for low fares is strong and we continue to produce record load factors. The revenue yield environment remains challenging with heavy fare discounting. We are working hard to control costs and this year's inflation and non-fuel cost is explained almost entirely by the depreciation associated with our accelerated retirement, and we still expect cost savings and an EBIT improvement of at least $200 million.

Lower fuel prices continue to benefit earnings, but second quarter earnings would've improved with or without the benefit of lower fuel prices. Our balance sheet is strong as ever, and our commitment to return value to shareholders is unchanged, having already returned as much in the first half of 2016 as we did in all of 2015. And of course, we also announced in this release, our intentions to launch a $250 million ASR.

Our capital spending remains in check and are very manageable, and pre-tax return on invested capital was just phenomenal at 33.5%. As we look ahead to third quarter, we are expecting another quarter of strong margins. And with that overview, I'd like to close by thanking our employees for another fantastic quarter and for their extraordinary efforts over the last 24 hours. So, Tom, with that, we'll be happy to open it up for questions now.

Question-and-Answer Session

Operator

Thank you, ma'am. And thank you for waiting. We'll begin with our first question from Michael Linenberg with Deutsche Bank.

Mike J. Linenberg - Deutsche Bank Securities, Inc.

Hey, good afternoon, everybody. Hey, Gary, I appreciate your comments about 2017, I think you said you're monitoring the situation closely and obviously trying to determine what the right amount of capacity growth will be for next year. But when I look at sort of the guidance for the latter part of 2016, I think fuel's going to be up year-over-year, CASM's going to be up and it also looks like RASM could be down a bit. Why no change or move away from the 5% to 6% growth for this year? I mean is it a systems issue that you can't change the schedule for the latter part of 2016, or what's holding you up, or maybe preventing that, any color, your thoughts on that that'd be

great? Thanks.

Gary C. Kelly - Chairman, President & Chief Executive Officer

Well, and sure Mike, and a very logical question, one that we know that we're going to get from you all here today. We're different than the industry. So, we don't publish 330 days' worth of inventory and the other aspect of the – our competitors' approach is they mostly over-schedule. So, they'll publish more, they'll claw that back and we just don't use that technique as you know. We don't publish as much inventory and what we do publish we very much intend to fly. So, we rarely go out into a published schedule and make changes.

It is easier for us to hold a few flights in reserve and then publish them later, as opposed to taking flights out and re-accommodating customers. So, it is a – I don't know if it's so much a philosophy, but it is certainly a practice that we've used. The modeling that we've been – and second, the trends that we are complaining about this morning are very recent, and that's one reason that I mentioned to you all in my opening remarks is that we've seen inconsistent trends over the first seven months of the year.

Really going back to December, Tammy, I think of last year. So, we don't know that weeks will make a trend, the bookings right now for the fall were quite good. I wouldn't want you to conclude that that means that we're predicting positive unit revenue comparisons yet in the fourth quarter, but what I mentioned earlier that I was disappointed, that is our goal, our goal is to have positive unit revenue growth every single quarter and certainly for this year. We're falling short of that right now for the third quarter and that obviously will give us a cause to rethink our plans.

The final point is, as we have discussed this in recent weeks about the opportunity to reduce the schedule primarily in the fourth quarter, we've not been able to model a scenario where it was profit positive for us to do that. And so this – in dealing with these incremental capacity choices, we think that actually would be harmful to Southwest in the near term as opposed to helpful. So I think the more productive work effort for us right now, on July 21, is to think about our next schedules and what our plans are for 2017. So hopefully that's responsive to your question.

Mike J. Linenberg - Deutsche Bank Securities, Inc.

That's very helpful. When does that next schedule roll out? What's the next schedule rollout date for you guys?

Gary C. Kelly - Chairman, President & Chief Executive Officer

Bob, what are you working on right now?

Robert E. Jordan - Chief Commercial Officer & Executive VP

We're working on the basically the spring break – post-spring break period, and that'll be published here in the next couple of months.

Mike J. Linenberg - Deutsche Bank Securities, Inc.

Okay. All right. Very helpful. Thanks, Gary. Thanks, Bob.

Operator

We'll take our next question from Julie Yates with Credit Suisse.

J. Yates - Credit Suisse Securities (USA) LLC (Broker)

Good afternoon. Thanks for taking my question. Tammy, what does your 3% to 4% guidance assume as we enter the shoulder periods? One of the other carriers gave guidance that assumes some improvement in September. Are you also assuming a similar improvement or are you more cautious as we enter into shoulder periods, I know a lot of these changes have been rather recent but just trying to figure out what your base case is in the down 3% to down 4%?

Tammy Romo - Chief Financial Officer & Executive Vice President

Sure, Julie. Yeah, as we look forward, September does look to be a little bit easier comparison. But what our current forecast represents is really just a continuation of the trends that we're seeing here more recently. So, as we updated you at Investor Day, we knew our year-over-year comparisons were going to be difficult here in the second half, simply because of the lapse of the Chase agreements, but we have factored in the recent softening that we've seen particularly in our close-in bookings.

So, we've – it's our best guess on our current trends, and obviously, we'll keep you updated as we move along here in the quarter.

J. Yates - Credit Suisse Securities (USA) LLC (Broker)

Okay. And is there a tailwind from developing markets in the third quarter guidance or has that lapped at this point?

Tammy Romo - Chief Financial Officer & Executive Vice President

It's lapped largely simply because we're getting back down to a more normal percentage of development market as a percentage of ASMs.

Gary C. Kelly - Chairman, President & Chief Executive Officer

But year-over-year, yes, the developing markets are definitely down, but they're being overcome, if you will, that improvement is being overcome by increasing fare competition. So, obviously the industry is continuing to add capacity every month. And we can get the traffic, but we have to work hard with fares do that. The nice thing is we're seeing, in terms of more positives, we're seeing good strength with our corporate sales, very nice growth there, our Rapid Rewards program continues to grow very nicely, and those are sort of outside of the "fare environment" and then our ancillary products continue to grow. And that's primarily EarlyBird and the upgraded boarding product. So, we have a couple of tools. And I guess the other thought was that freight was relatively soft in the second quarter. So, hopefully, there'll be some opportunities to regain some growth with the cargo business there.

So we'll have a number of things that we'll be looking at to try to boost revenues, but certainly as time goes by here this year, the tailwind of the developing markets, I agree with Tammy, it's going to continue to wane, but we have some – we're 4% in development this year, and I think this time last year, it was closer to 20%.

J. Yates - Credit Suisse Securities (USA) LLC (Broker)

Okay.

Tammy Romo - Chief Financial Officer & Executive Vice President

And Julie, just to be clear, back to your question on trends. What was implicit in my comments on September is that we would assume a little bit of improvement there just simply because of comparisons, but we've done our best to extrapolate current trends out into the full quarter.

J. Yates - Credit Suisse Securities (USA) LLC (Broker)

Okay. And then have you guys talked about how much of your booking curve is weighted towards this close-in period, where you're seeing the weakness?

Tammy Romo - Chief Financial Officer & Executive Vice President

No. We haven't.

Gary C. Kelly - Chairman, President & Chief Executive Officer

I don't think we've talked about it.

Tammy Romo - Chief Financial Officer & Executive Vice President

Yeah. We haven't shared that, Julie.

J. Yates - Credit Suisse Securities (USA) LLC (Broker)

Okay. Thank you.

Operator

We'll take our next question from Duane Pfennigwerth with Evercore.

Duane Pfennigwerth - Evercore ISI

Hey, thanks for the question. So mine is real simple, can you give us a sense today for quite simply how you're going to grow, what the growth rate is in 2017 or even in the first quarter, as we try and model revenue and perhaps a recovery from this softer spot? What should we be punching into models for next year?

Tammy Romo - Chief Financial Officer & Executive Vice President

What I can give you right now to help you out is what we have through what we've got published with our schedules. So we are currently published through early March next year and our scheduled ASMs are up in probably the 6% range, and February I think is up a couple of percent for February. So that's where we are and as Gary indicated earlier, we're in the process of evaluating beyond that period. So I just don't have a forecast to give you beyond what's out there in the published schedule.

Duane Pfennigwerth - Evercore ISI

Okay. How about the latest on when you park these Classics, what date should we assume for that and what is the – I guess, we'll hang around the basket and wait for you to publish at least a full first quarter, but how should we be thinking about the cadence quarterly from that point forward?

Tammy Romo - Chief Financial Officer & Executive Vice President

We'll be retiring our Classics fleet here, as you know, between now and October 1, 2017. So – and as we described earlier, we'll be down to a manageable number of Classic and you can think of it as those being all out of our fleet by our fourth quarter schedule. So, we're still working through all of the details on that.

Duane Pfennigwerth - Evercore ISI

So would ASM growth be higher or lower for 2Q, 3Q, and 4Q than this mid-singles rate that we're at now?

Tammy Romo - Chief Financial Officer & Executive Vice President

Well, all else being equal, just simply because of the fleet, you would expect that to go down now. Again, Duane, we're just working through all of the details for next year's schedule. So, as we sit here today, I'm just not in a position to give you exact year-over-year ASM guidance for next year. But as we go through the year and as we work through the Classics, particularly in the second half, all else being equal, you would expect that to bend down.

Duane Pfennigwerth - Evercore ISI

Okay. And if we think about how Southwest revenue might hold up in a downturn, obviously there's a lot of data from prior cycles, but are you more of a corporate carrier, more reliant on that close-in customer today, given all the progress that you've made on that side of the business, than maybe prior downturns?

Gary C. Kelly - Chairman, President & Chief Executive Officer

I don't think so. What's interesting is, if you go back 20 years, we were, as you know, such a short-haul carrier. And I think what a lot of people misunderstood back in the 1990s is how much business travel we had, and some of that again was very natural with the short-haul orientation we had with high frequencies, those were convenient schedules that were built for business customers. So I don't – if anything, I'll bet you that we're less reliant on business customers today than we were 20 years ago. Business travel, as you know, is very sensitive to the cycle, and – if that's where you're going with your question.

The other tool that we have today to help manage through softer periods is we just have better connecting capabilities, and a lot higher load factors today than we did 20 years ago. So, I still think that we're very well positioned for a change in the cycle. I think we're obviously a low-cost producer, and have a low-fare brand, we have a very loyal brand, and people do travel during recessions, they just look for more bargains. So, generally that's worked very well in our favor in the past.

Duane Pfennigwerth - Evercore ISI

Thanks, Gary, for those thoughts. I mean, do you think that's where we are or is this industry dysfunction on pricing?

Gary C. Kelly - Chairman, President & Chief Executive Officer

Oh, I was just trying to be responsive to your question. No, I don't think that's where we are. I think GDP growth is pretty steady. It's – you all know all the macros, real GDP is 2%-plus and domestic industry seats are up closer to 5%. So, I think that's not anything new, we've been talking about that for quite some time. And as I mentioned in my remarks, I don't think it's shocking that we find this sort of ebbs and flows of fares. But right now, it's – we are at a spot where, in particular with the close-in pricing, fares are softer than what we were expecting.

Duane Pfennigwerth - Evercore ISI

Thank you.

Operator

We'll take our next question from Jack Atkins with Stephens.

Jack Atkins - Stephens, Inc.

Hey, good afternoon. You spoke earlier about the expectation to get back to positive RASM, or the hope, I should say, to get back to positive RASM in the fourth quarter. Can you speak to what you're seeing perhaps in your forward bookings and the potential revenue levers that you all have that could allow that to happen? Just sort of curious of the puts and takes there.

Gary C. Kelly - Chairman, President & Chief Executive Officer

Yeah. I'm glad you asked me the question. So, let me try to make sure that I'm being clear. I am not predicting positive RASM, I'm not remotely suggesting that, that is a possibility based on what we're seeing right now. I'm simply acknowledging to you all that that is our goal, that was our goal for the year and we're falling short of that goal and we can't be happy about that, that's all I was trying to point out. What we are able to do, in the meantime, of course, is continue to sustain very strong profits. We're enjoying low fuel prices and very strong operating margins are our expectation here for the third quarter. I don't have any reason to believe that that will change in the fourth quarter, but we have initiatives that come online in 2017 that bring with them the opportunity to boost our revenue production.

So, we're in a period here between now and then, where we're just going to have to focus on blocking and tackling good revenue management, excellent customer service, tweaking our route network to try to use those levers here for the next several quarters. I think all the capacity questions that we're getting here today are very appropriate and that's something that we're going to have to take a very close look at. I agree with Tammy's point earlier, if that is one of the main levers that we have, we're just not prepared to give any 2017 guidance yet. And of course, I'll just remind everybody that last year, when we did guidance well in advance, it was – I think it was somewhat misunderstood.

So, we've got to work to do in 2017, we've got the goal to boost unit revenues in 2017 and based on third quarter trends, we've got a little work to do.

Jack Atkins - Stephens, Inc.

Okay. Thank you for that, Gary. And then, I guess a follow up for Tammy. The maintenance line has been relatively elevated in terms of year-over-year growth for the past, I guess, three quarters now. How should we think about that line trending in the back half of the year and would you anticipate giving some relief there as you retire the Classic fleet and take delivery of your next gen aircraft next year? Just sort of how should we think about the maintenance line trending going forward?

Tammy Romo - Chief Financial Officer & Executive Vice President

Yeah. Thanks, Jack. Yeah, the maintenance – our maintenance costs, you'll continue to see that trending down as we retire the Classic fleet and I would expect our maintenance unit costs in the third quarter to show some improvement as well. So we'll continue to see a relief in that as we retire our Classic and so we're – that should be a favorable trend as we move forward.

Jack Atkins - Stephens, Inc.

Okay, great. Thank you again for the time.

Tammy Romo - Chief Financial Officer & Executive Vice President

Thank you.

Operator

We'll take our next question from Hunter Keay with Wolfe Research.

Hunter K. Keay - Wolfe Research LLC

Hi. Tammy, I'm sorry. Can you please clarify, what you said before about the capacity question, you said something about 6% and a couple percent; I just pulled capacity data in Diio and it looks like you guys are growing ASMs by 1.6% in 1Q 2017, is that not right?

Tammy Romo - Chief Financial Officer & Executive Vice President

We...

Gary C. Kelly - Chairman, President & Chief Executive Officer

No, that's not right.

Tammy Romo - Chief Financial Officer & Executive Vice President

No, that's not right. We don't have March.

Robert E. Jordan - Chief Commercial Officer & Executive VP

A couple of things. We don't have March published and then you also have the impact of leap year here this year.

Tammy Romo - Chief Financial Officer & Executive Vice President

Yeah.

Robert E. Jordan - Chief Commercial Officer & Executive VP

So, I think it's just probably missing the month.

Hunter K. Keay - Wolfe Research LLC

Okay. So, just to be clear, when you said 6%, Tammy's, then a couple percent, I'm just – what were you saying, how much you're growing, was that just like a January, February number?

Tammy Romo - Chief Financial Officer & Executive Vice President

Yeah, those were just January and February. So, January probably up in, would you agree 6% range in February, up year-over-year a couple of percent.

Hunter K. Keay - Wolfe Research LLC

All right.

Tammy Romo - Chief Financial Officer & Executive Vice President

Yeah, because of leap year.

Gary C. Kelly - Chairman, President & Chief Executive Officer

Because of leap year.

Hunter K. Keay - Wolfe Research LLC

All right. Of course, okay. Is there a scenario where you see Southwest growing capacity less than GDP next year?

Gary C. Kelly - Chairman, President & Chief Executive Officer

Well, that would be hard to do. I'm sure that just taking your question literally, I'm sure that there is a scenario. I wouldn't want you to think that it's a likely one, but as I think we pointed out, we don't want to – we don't see a compelling reason to tinker with the capacity that's published, certainly for the third quarter or the fourth quarter. So, these are recent trends and not ones that we're happy with. And so, as I think we've said several times, we've got some work to do. And as we typically do, we'll provide more guidance for the capacity plans here in the fourth quarter.

Hunter K. Keay - Wolfe Research LLC

Thank you.

Operator

We'll take our next question from Andrew Didora with Bank of America.

Andrew George Didora - Bank of America Merrill Lynch

Hey, good afternoon, everyone. Thanks for taking the questions. Gary, I'm just trying to get a sense of how much you have seen the fare environment change from, I guess, your little bit more positive commentary at Investor Day until today. Maybe can you give us some order of magnitude in terms of how much weaker close-in yields are right now as opposed to where they were on average in 2Q and I guess, what can Southwest do to try to fix this problem?

Gary C. Kelly - Chairman, President & Chief Executive Officer

Well, and as I'm assuming you know well it's – forecasting airline revenues is always treacherous. So, basically what happens is trends get extrapolated, there is – we'll start a month with half of the bookings in place that we would expect for that month. So, it's not necessarily a ground up – from the ground up kind of a forecast. I would say that the guidance that Tammy is offering today for the third quarter unit revenues of down 3% to 4% is much less than what we thought at Investor Day. So we've – in a short period of time in another words, we've reduced our forecast by 1.5 points to 2 points.

Tammy Romo - Chief Financial Officer & Executive Vice President

2 points.

Gary C. Kelly - Chairman, President & Chief Executive Officer

So to 2 points. Now, that's mostly weaker revenues that we're seeing here for July, August. There was a question earlier about September. September does look better than July, August, but it's not anything that we're willing to tell you that you can take to the bank at all. So, the trend could change. We could be overly pessimistic here, it is most of the change in the trend as, again we've attributed it a number of times here today to the close-in bookings. And that is just simply saying that our – we have a lot of competitors out there the week of travel that are offering very hot fares, and we must match to get that traffic, it's just that simple. So that is a change in technique and a change in trend for us. The all-in result is still quite good, still falling, still – as I said before, it's just below our goal.

The only other thing that I would mention is that there is a consistent quarter-to-quarter decline in revenues. Going back now all the way to probably the second half of 2014 when we began to see lower fuel prices. So, we're off-trend in the third quarter compared to second quarter, and the second quarter is also off trend compared to where we would expect to be relative to the first quarter. So these are, not having talked to you a lot personally, we call these sequential trends; you probably use the same term or technique. And that is basically the technique that we are using to arrive at this prediction of down 3% to 4% in the third quarter.

So, we'll take steps to try to arrest these trends and to get back to positive unit revenue comparisons and again, as I've said a couple of times, we've got quite a bit of work to do to try to – to get back there, at least here in the near-term.

Andrew George Didora - Bank of America Merrill Lynch

Great. Thank you for that color, Gary. And my second question, I guess, you mentioned in your remarks that you have not gotten to a scenario where taking capacity out as profit accretive. I guess how much further would unit revenues have to fall in order for capacity reductions to make sense?

Gary C. Kelly - Chairman, President & Chief Executive Officer

Well, I'm sorry, I just – I can't do that math in my head. And again my answer with Mike Linenberg earlier was specific to the fourth quarter. So, we looked at some fourth quarter capacity changes that we could make and none of those looked productive to us. So, it will be – we'll spend our time better working on 2017. So, the hypothetical you're asking, I'm not – I can't readily answer, but clearly that's something that we want to look out here for 2017.

Andrew George Didora - Bank of America Merrill Lynch

Fair enough. Thanks a lot.

Operator

And we'll take our next question from Darryl Genovesi with UBS.

Darryl Genovesi - UBS Securities LLC

Hi, guys. Thanks for the time. Gary, I realize I'm probably walking a thin line with the question, but I've heard you say a couple of times with regard to the fourth quarter at least that taking some capacity out, anyway that you sliced it wouldn't be profit accretive for Southwest. I mean I think if you look at what we've seen from some of the other carriers this quarter, most of the legacy carriers are trimming capacity. We can argue about what is the earliest you'd want to trim from the perspective of your customers, but those capacity cuts do likely help Southwest some way. And DOJ will, of course, complain about illegal price collusion or collusion of capacity levels, but there is also the opportunity, it seems, for some legal coordination, so to speak, on capacity levels and on pricing in the industry. And your comments suggest to me that you're perhaps resistive to playing that game. And I guess I just wonder, with Southwest having grown to be as large a player as it is in the industry today, isn't it kind of required that overall the industry is healthy in order for Southwest to be healthy?.

Gary C. Kelly - Chairman, President & Chief Executive Officer

You know what Darryl, I think I'm just not going to comment on your question.

Darryl Genovesi - UBS Securities LLC

Okay.

Gary C. Kelly - Chairman, President & Chief Executive Officer

I appreciate it, but I'm not going to comment.

Darryl Genovesi - UBS Securities LLC

Well, let me ask a simpler one then. Are you seeing any advantaged fares in the market today? And if so, what is your strategy for competing?

Gary C. Kelly - Chairman, President & Chief Executive Officer

Well, the advantaged fares are just a fare. It's a technique, it is a low fare. We predicted 15 years ago that all carriers were going to – have to become low fare carriers. It is a very competitive environment and carriers use a variety of techniques to offer low fares, that's from the lowest-cost carrier to the highest-cost carrier and that changes all the time. And we don't talk about our techniques and we are certainly not going to comment about our competitors' pricing techniques.

Darryl Genovesi - UBS Securities LLC

Okay. Thank you.

Operator

We'll take a next question from Savi Syth with Raymond James.

Savanthi N. Syth - Raymond James & Associates, Inc.

Hey, good afternoon. Just , Gary, well-worn question here on the call. But I'm just trying to understand something here, just from Southwest's perspective related to your comments that you were saying that if you're looking at industry capacity and then you were growing just as much as the larger players in the market that you were surprised but not disappointed. And what I was wondering is what you were hoping to see when you're growing supply like 3 times faster than GDP. So I'm just wondering what the expectation was? And just if this is just not – is this from a Southwest perspective, were you just adjusting to a new lower fuel price environment? Why you would be surprised if you're growing so much faster than GDP, and then Southwest isn't moderating capacity. I think most of your competitors showed moderating capacity into the end of the year, what the expectation was?

Gary C. Kelly - Chairman, President & Chief Executive Officer

Well, Savi, when we were having the same conversation three months ago, this was not the topic. So, we've got a change in trend. We'll need to evaluate that and see if we need to make some adjustments. I'll remind you that we had some secular opportunities to step up our growth in 2014, 2015. The added capacity that's coming online here this year is very modest, I believe, Bob, it's about 2%. So, you got the carryover effect of increasing the flying for the Wright Amendment, taking on the flying of the slots that we acquired for Reagan and LaGuardia. And then launching international service, which was a function of integrating AirTran and then what is true expansion, any way you look at it is launching international service as an example out of Houston Hobby. So, you have the full year carryover of that from the fourth quarter of last year.

So we are, as we've said many times, we peaked in that capacity growth in 2015, we're coming down here in 2016 and now I think we're getting into a point where for 2017, we need to be thoughtful about how fast we grow. The other thing that's going on with our capacity is a fairly significant changing gauge. We're not adding a lot of trips. We're adding more seats than trips because of the up-gauging, and then we're getting a little bit more productivity per airplane per day because we're flying a little bit longer, so there's just less time sitting on the ground.

So, all of those are adding up to more available seat miles than, I think, really tell the story about our growth, but I don't know – again as I've said, we're not shocked that this is where we are. We've been leading the industry consistently with unit revenue performances and I think has very much justified our growth. We've got record earnings and record returns on capital, so we have a little bit different economic and fare environment here that we're seeing in July, and again, we're going to react to that, and stay tuned.

Savanthi N. Syth - Raymond James & Associates, Inc.

Okay. And if I can follow up, Gary, then. As you talk about kind of looking into 2017 and kind of filling out your plans, is the opportunity to maybe shift more to international growth if domestic environment doesn't pick up here after September in that, because if I think about it, you're already retiring your Classic fleet. And if I remember correctly from your Investor Day, I don't think you have many retirements until 2023. So just what's the flexibility over the next few years to really kind of flex up or flex down capacity plans? Or is it just a mix between domestic and international?

Gary C. Kelly - Chairman, President & Chief Executive Officer

Oh, no, we have the absolute flexibility to flex up or down. And then we have tremendous flexibility to allocate capacity around the country or add or subtract international for that matter.

As I think about the international, that's higher risk and truly expansionary, that's real growth. What are wonderful opportunities for us to add capacity remain in the domestic markets with our point-to-point system, either adding frequencies in markets that are spilling traffic or alternatively, connecting to cities with new non-stop service; that has much lower risk than adding a new Caribbean destination. And that is part of the reason that as we look at – just taking the fourth quarter as an example, why we don't see a profit positive move that close-in given that we already have this fixed capacity, you already have the employees, we've already got the airplanes, we've already got the corporate overhead, it's real hard to justify pulling in the capacity that close-in. So we're much better served to look a little bit farther out where we can impact the cost in more of a variable way and avoid the capacity increases that way.

But we have plenty of opportunities to grow the airline. And whether we need to be growing at GDP or something faster or slower are all things that we're going to have to continue to judge, and I'm just not ready to give you an answer today.

Savanthi N. Syth - Raymond James & Associates, Inc.

Got it. Appreciate the thoughts, Gary.

Operator

And we'll take our next question from Jamie Baker with JPMorgan.

Jamie N. Baker - JPMorgan Securities LLC

Hey, good afternoon, everybody. Gary, the impression that investors have is that your priorities at the moment might be somewhat out of order. The impression is that passengers come first, then labor unions, and then shareholders. And that's certainly fine when all is right with the world, and it certainly worked well under Herb. But during a time of industry crisis, and I would suggest that's what current revenue trends imply, most companies would consider revisiting their sort of priority order, at least in the short run. So my question, as awkward as it may sound, is this. Are you prepared to suspend all labor negotiations until we solve for the industry's revenue crisis?

Gary C. Kelly - Chairman, President & Chief Executive Officer

No. No. I appreciate the question, but the premise I would push back on. I think that certainly more than any other airline – and I'd put us in there with top-notch industrials, we have done a very fine job of trying to balance the needs of all of our constituents. And we've taken very good care of our shareholders. And it's interesting that you describe the current period as a time of crisis when in the first half of this year, I believe we've had all-time record shareholder returns – in six months. So, if that's a crisis, I'll take it.

But the notion that we put one over the other is an unfair characterization. We must have good employees, we must take good care of the employees, we have a very intensive business and we truly care about people. We care about our people and then in turn we care about our customers. And it is a virtuous cycle, and to think that you can simply ignore that and say, we're only going to focus on the shareholders, doesn't work, it's not sustainable. But we're famous for telling everyone, and admitting, that's who we are and we're just not – we're not going to apologize for that. It's worked; this is the most successful airline in history, that is now turning out record earnings. And so we want to sustain that. We want to sustain the returns for our shareholders and the best way to do that is to continue to take very good care of our people.

Jamie N. Baker - JPMorgan Securities LLC

Second question – and thank you for that, Gary. I knew it was a challenging and potentially differentiated line of questioning. Second question; you've got weak PRASM. As Tammy pointed out, you've got load factors at record highs. You've inflicted a pretty sizable fuel headwind on yourselves. And you're guiding to a year-on-year earnings decline. So why do you routinely ignore initiatives, industry initiatives intended to restore pricing stability? Or put differently, why does Southwest potentially choose to be part of the problem instead of part of the solution? Thanks in advance.

Gary C. Kelly - Chairman, President & Chief Executive Officer

Well, I am unclear as to how we are part of the problem. So, feel free to elaborate and I'll do my best to answer.

Jamie N. Baker - JPMorgan Securities LLC

Well, I know you like to stay clear, understandably, of specific pricing questions. But sitting out the last Delta-led $2 to $5 one-way initiative, which at one point or another every other airline in the States participated in. I realize now I'm veering in Darryl's direction, and – but I mean, that sort of thing.

Gary C. Kelly - Chairman, President & Chief Executive Officer

No, I think you've arrived at his destination.

Jamie N. Baker - JPMorgan Securities LLC

Well.

Gary C. Kelly - Chairman, President & Chief Executive Officer

I will defer answering that question as well.

Jamie N. Baker - JPMorgan Securities LLC

Okay.

Gary C. Kelly - Chairman, President & Chief Executive Officer

What I would just roll up to though here, is rather than talking about any specific pricing or specific capacity questions that are really, as we all understand, off limits, our goal is to have positive unit revenues and we have seen that become – through the first half of the year we were doing a pretty good job there. The second half of the year now has emerged as more challenging for the reasons that we have articulated and I think it is incumbent upon us to figure out what we are going to do about that and we have all the tools that you are aware of. We have pricing, we have ancillary revenues, we have our capacity, and then of course new revenue initiatives, and we'll take a very close look at all of those and see what we can do to hit our goal.

Jamie N. Baker - JPMorgan Securities LLC

Okay.

Gary C. Kelly - Chairman, President & Chief Executive Officer

I don't think we had a decent – I don't think we have a reasonable prospect of having positive unit revenues in the third quarter. It probably is difficult to assume that for the fourth quarter. So that doesn't mean we won't make a hearty effort in that regard, but we'll certainly be looking very closely at that for 2017.

Jamie N. Baker - JPMorgan Securities LLC

I do appreciate it, Gary. Thank you.

Gary C. Kelly - Chairman, President & Chief Executive Officer

Yes sir.

Operator

And we have time for one more question. We'll take our last question from Joseph DeNardi with Stifel.

Joseph DeNardi - Stifel, Nicolaus & Co., Inc.

Yes. Thank you very much. Gary, just, I guess pretty simply, if RASM is down again 3% to 4% in fourth quarter, is that bad enough for you to cut capacity next year? What's the threshold that you're kind of looking at?

Gary C. Kelly - Chairman, President & Chief Executive Officer

I think again, I know you all are pressing for specifics, we're just not prepared to give you that kind of a capacity outlook for 2017 or a bright line. I'm not happy with down unit revenues of 3% to 4%. And hopefully that tells you what you need to know. I'm interested to see if those trends continue and then we will take action accordingly.

Joseph DeNardi - Stifel, Nicolaus & Co., Inc.

Okay. And then Tammy, what's the – just as we sit here today, what's the expected fuel hedge loss in 2017?

Tammy Romo - Chief Financial Officer & Executive Vice President

The full loss, let me see if I have that handy. As I have the fair market value beyond third quarter, which I provided, which was $775 million, the net liability, you're asking for our total portfolio, which would be a net liability of $775 million beyond third quarter. Is that your question or are you asking for a break-down between...

Joseph DeNardi - Stifel, Nicolaus & Co., Inc.

No. Just – I guess just for 2017, just how to think about how the loss is going to impact 2017.

Tammy Romo - Chief Financial Officer & Executive Vice President

Yeah. For 2017 is about $550 million range.

Joseph DeNardi - Stifel, Nicolaus & Co., Inc.

Okay. Thank you.

Operator

And that concludes the analyst portion of today's call. Thank you for joining. Ladies and gentlemen, we'll now begin our media portion of today's call. I'd like to first introduce Ms. Linda Rutherford, Vice President and Chief Communications Officer.

Linda B. Rutherford - Vice President and Chief Communications Officer

Good afternoon, Tom. Thank you very much. I'll go ahead and let you give instructions for folks to queue up and we'll go ahead and get into Q&A.

Question-and-Answer Session

Operator

Thank you, ma'am. And thank you for waiting. We will now begin with of first question from Andrea Ahles with Fort Worth Star-Telegram.

Andrea Ahles - Fort Worth Star-Telegram

Hey, good afternoon, Gary. I was wondering if you could talk a little bit more about the technology outage, the computer outage you had yesterday. And what sort of assurances do customers have that something like this won't happen again? It seemed pretty catastrophic yesterday.

Gary C. Kelly - Chairman, President & Chief Executive Officer

That is a very fair question. I think we have hard work (62:25) to answer that because we do have significant redundancies build into our mission-critical systems and those redundancies did not work. I think we need to understand why and make sure that doesn't happen again.

Every company has its challenges and things will break. We just need to make sure that they break and can be fixed in such a way that it doesn't have that kind of impact on the customer experience. So, we've got some work to do to restore confidence in our customers. We're obviously very passionate about serving our customers and determined to never have that happen again.

Andrea Ahles - Fort Worth Star-Telegram

Can you say a little more specifically, like was this an equipment failure that then sort of cascaded through your different systems? Or was it just everything kind of went down?

Gary C. Kelly - Chairman, President & Chief Executive Officer

Yeah. Mike, you want to describe it?

Michael G. Van de Ven - Chief Operating Officer & Executive Vice President

Yeah, it was a router failure in our network. And the recovery mechanisms did not work as planned with that router. And it slowed the rest of the applications down to such an extent that they weren't usable.

Gary C. Kelly - Chairman, President & Chief Executive Officer

And to my knowledge, we haven't had anything like this in our history. So, this is something that is unique for us. What we do understand is that the – some of our older legacy applications were the culprit, whereas a lot of the newer technology did recover as planned, but it's also integrated in networks that, again the whole system did not, it was not recovered and restored. Now eventually, it was, and there all of that was fixed through the course of 12 hours and over the course of 12 hours, multiple things were attempted to try to recover very quickly and ultimately they sort of went back to bedrock and rebooted everything, is probably a simplest way to describe it in layperson's terms.

Michael G. Van de Ven - Chief Operating Officer & Executive Vice President

Yeah. And I would also add that router failures are not uncommon.

Gary C. Kelly - Chairman, President & Chief Executive Officer

No, no.

Michael G. Van de Ven - Chief Operating Officer & Executive Vice President

And so, but the severity and duration of this on our operations was, as Gary said, extremely unusual and we're trying to dig into that detail to understand that better.

Andrea Ahles - Fort Worth Star-Telegram

All right. Thank you so much for the details. I appreciate it.

Gary C. Kelly - Chairman, President & Chief Executive Officer

You bet.

Operator

We'll take our next question from David Koenig with The Associated Press.

David Koenig - The Associated Press

Well, shockingly it's about the same topic. And I think you covered a lot of the ground that I was going to ask about. But just again maybe if you can take one more try and being as specific as you can. What is Southwest doing, either things that were already in the works or new steps since the failure, since the outage, to prevent a recurrence? This is your second one now in less than a year.

Gary C. Kelly - Chairman, President & Chief Executive Officer

Well, that's a fair question, David. I think this is – we're not even 24 hours into this. So, the first priority is to get the operation back up and running and serve the customers right now that need to get where they want to go. So that is our priority. Then to take a step back and understand why all the redundancy that we have invested in did not operate, that comes next. Mike, I don't know if you have any more information. Mike has been more involved with this as our Chief Operating Officer than I am, so.

Michael G. Van de Ven - Chief Operating Officer & Executive Vice President

So, David, we need to, as Gary was saying, we need to jump in and understand exactly what happened in this specific event. We will then have – add that learning to our recovery profiles with the intent, as mentioned earlier, with the intent of making sure that our recovery happens quicker and the issues don't expand quite like they did in this event. So, that's the first thing. The second thing that we're doing and have been doing is we are making significant investments in our technology, we've talked about, our Lone Star program, we've talked about our other operational investments, and all of those are going to bring our infrastructure and platforms up to a more up-to-date technologies. And that will allow us to recover faster than what we've been to do in this particular event.

David Koenig - The Associated Press

Okay. I know it's early. Any chance you would speed up that investment timetable?

Gary C. Kelly - Chairman, President & Chief Executive Officer

Well, the investment timetable, I don't know. I think in terms of – I think the simplest way to describe this is, you can relate to power and a backup generator, where if the power goes down for whatever reason, you flip a switch and you've got a diesel generator that kicks in. So that conceptual backup did not work. And we need to understand better why that is, and we're just not prepared to do that yet. In terms of accelerating our investment, we're making significant investments in the technology already.

And that – we've been talking about that, David, for some time, the need to do that. We have a legacy reservation system, as an example, and that is a major undertaking, and one that we're all looking forward to having that replaced next year. So, it will over the next three to five years, we'll have significant replacements of our legacy systems. I think we're already moving as fast as we can and in the meantime we'll just need to make sure that our business recovery processes are robust and will support the situation when another router breaks, because inevitably one will.

David Koenig - The Associated Press

Okay. Thanks, very much.

Gary C. Kelly - Chairman, President & Chief Executive Officer

Yes, sir.

Operator

We'll take our next question from Richard Velotta with Las Vegas Review-Journal.

Richard Velotta - Las Vegas Review-Journal

Good morning, Gary. Do you have any estimates on how much the outage is going to cost you in terms of vouchers, overtime, equipment replacement, that type of thing?

Gary C. Kelly - Chairman, President & Chief Executive Officer

We do. I think it's a little bit premature, but we're having a very good day today in terms of our business, but obviously with the system being down yesterday, we couldn't take bookings. So, I think that we'll be able to recover much of that, but that – just that alone may cost us in the $5 million to $10 million range on a net basis, but we've got some work to do to recover bookings for the future that we would have gotten yesterday.

So, Bob Jordan is here, I'll let him speak to this, but he is doing a couple of things to do more than just say we're sorry for our customers, and one of those is we're extending the fare sale that we had planned to end tomorrow, I believe. So, he is extending that a week. But Bob, do you want to talk about a couple of the things that we're doing?

Robert E. Jordan - Chief Commercial Officer & Executive VP

Sure. As Mike talked about, priority one is obviously to get back up and operating and then right attached to that is to make sure we take care of our customers. So, everybody affected yesterday and it's going to continue today. So, all of our customers affected yesterday and today, we'll be contacting every one of them in some form here over the next couple of days and handling them.

In addition, we just posted a full week extension of a major sale that we have going that was intended to end today. So, we're going to extend that for a full week to make sure everybody has access to those great fares, again that we're going to end – the sale was going to end today. So, – but again, priority one is to take care of our customers. So, everybody affected will be hearing from us.

Gary C. Kelly - Chairman, President & Chief Executive Officer

And I just wanted to add on to that quickly, Rich, yes, we're worried about the financial impact of this, but what is far more important is the inconvenience that we caused our customers yesterday and today. And I feel very bad about that, we're very apologetic, and we want to just work hard to again restore their confidence in us.

Richard Velotta - Las Vegas Review-Journal

Thank you.

Operator

And that is the final question we have today. At this time, I'd like to turn the call back over to Ms. Rutherford for any additional or closing remarks.

Linda B. Rutherford - Vice President and Chief Communications Officer

Thanks for joining us. If you all have any other questions, you can reach us at www.swamedia.com, and we will route that to an on-duty spokesperson. Thanks so much.

Operator

And that concludes today's call. Thank you for joining.

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