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Southwest Airlines Co.(LUV)

Q2 2007 Earnings Call

July 18, 2007 11:30 am ET

Executives

Gary C. Kelly - Chief Executive Officer

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

Analysts

Ray Neidl - Calyon Securities Inc.

Kevin Crissey - UBS

Gary Chase - Lehman Brothers

Rob Barry - Goldman Sachs

Bill Greene - Morgan Stanley

James Parker - Raymond James

Dan McKenzie - Credit Suisse

Frank Boroch - Bear Stearns

Michael Linenberg - Merrill Lynch

Presentation

Operator

Welcome to the Southwest Airlines second quarter 2007 earnings conference call. Today’s call is being recorded. We have on the call today Mr. Gary Kelly, Southwest's CEO; and Ms. Laura Wright, the company’s Senior Vice President of Finance and CFO.

As a reminder, today’s call includes forward-looking statements. These statements are based on the company’s current intent, expectations and projections and are not guarantees of future performance. These statements can be identified by the fact that they are not related strictly to historical or current facts. Actual results may differ materially from those expressed in the forward-looking statements due to many factors. For additional information regarding these factors, please refer to the company’s periodic filings with the Securities and Exchange Commission.

This morning’s call will also include references to economic earnings. A reconciliation of economic earnings with GAAP earnings is included in the company’s earnings release press -- I’m sorry, press release which is posted on southwest.com.

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

Gary C. Kelly

Thanks, Tom, and thank you all for joining us this morning. Our second quarter earnings were better than expected and better than the First Call’s mean estimate. I was pleased about that, of course. Our economic earnings per share, which excludes the SFAS-133 adjustments, was $0.25 a share and that was 24.2% lower than a year ago and we are not pleased with that.

Our financial plans for this year assumed a stronger revenue environment. However, with a slowing domestic economy and softer travel demand, we’re off our first-half revenue budget by several hundred million dollars. Thankfully, we are under our cost budget, although our costs are higher than ever before. So the year-to-date result is an unsatisfactory decline in our economic earnings per share of 29%-plus and we needed to make some adjustments to our financial plan to hit our profit targets, and those adjustments were previously announced and they include, on the revenue side, slowing our capacity growth by about two percentage points beginning in the fourth quarter of this year and extending through next year; introducing an enhanced fare structure, rapid rewards program, and revenue management processes and techniques beginning in fourth quarter ’07; unveiling a new boarding and/or seating method in fourth quarter; expanding our GDS participation and corporate account efforts; and then finally, launching a new advertising campaign.

By 2009, we’ll add international codeshare itineraries, we’ll add more cargo capabilities, and also enhanced ancillary revenue opportunities, which we have not announced yet. Our goal is to generate more than $1 billion annually from these new revenue sources, and even with an industry-leading fuel hedge, our unit costs in just two years time have gone from under $0.08 a seat mile to over $0.09 a seat mile, and that’s because of fuel. And that’s the essence of our earnings challenge. It’s not new, it’s not surprising, it’s not unexpected and we have been working to transform Southwest revenue generating capabilities to address that challenge and to enhance the low fare Southwest brand.

I am confident in our plans and we are in the process of implementing those.

On the cost side of the equation, I am very proud of the results over the years. We remain the low-cost producer and because of our profit challenges though, we’ll need to do more. Our employee productivity has improved 25% over the last five years and that for us is arguably the best level in our history. We will continue to do more on that front. Because virtually all legacy carriers have gone through bankruptcy, labor costs have been slashed and of course, we now find ourselves with higher unit labor costs than our competition. So we must control our salaries and benefits costs prospectively.

This week, as an example, we announced an early departure program for certain senior employees. It is completely voluntary and it is an effort solely to reduce higher labor rates with lower. It is not a program to reduce our headcount, so let me make that clear -- we will replace virtually all positions that get vacated through this voluntary early departure program.

Today we also announced an agreement with the Boeing company to change our aircraft delivery schedule beginning in 2008, essentially by deferring aircraft from 2008 to 2011, that four-year time period, to beyond 2011. The net effect, if we exercise all options, is that we’ll grow available seat miles capacity in 2008, ’09, ’10, and ’11 by 5% to 6% per annum, and Laura is going to go over that in more detail in a few minutes.

Our primary goal, of course, is to grow our profits annually and to hit our return on invested capital target. So this year, 2007, we may very well fall short of our targets and certainly that’s not acceptable to us but given the initiatives coming online in the fourth quarter, our 2008 earnings goal will be a minimum of 15% earnings per share growth.

I believe our plans for the next couple of years are very sound. If we continue to fall short of our profit goals, we’ll continue to make adjustments, and especially to our capacity growth rate.

A lot depends on the economy, fuel prices, and the competitive environment, but we are in a very, very strong competitive position and if the opportunities arise and the right conditions exist, then we can certainly accelerate our fleet growth.

Our balance sheet is very strong. We’ve completed $1.6 billion in share repurchases since 2005, and if conditions continue as they have, I have every intention of continuing our share repurchase program until it is prudent to slow it down. I think the bottom line there is that high leverage in this industry, especially with dramatically higher and more volatile fuel prices, is absolutely suicidal and we won’t create high leverage at Southwest Airlines.

One final thought on our new markets -- they’re doing superb. We’ve seen tremendous customer response. We believe we’ve got tremendous opportunities to grow with low fares and the admitted challenge, of course, is to get stimulating fare levels high enough to cover our higher cost structure. And that challenge is not unique to our new markets, of course, but once we get adjusted, we have every reason to believe our new service is much desired and very successful. Our employee morale is very high, our operations have remained very reliable. We remain arguably the most productive airline in the world. Our customer service statistics remain at the top and our brand rankings continue to be stellar.

The net of all of that is that we have a preferred product that is destined to get even better with the changes that we have planned beginning in the fourth quarter of this year.

So with that brief introduction, I would like to turn it over to Laura Wright, our Chief Financial Officer.

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Laura H. Wright

Thank you, Gary and good morning, everyone, including our webcast listeners. In addition to Gary’s comments, I’d like to take a few minutes to cover some additional aspects of our second quarter financial results.

Our second quarter GAAP net income was $278 million, or $0.36 per diluted share, compared to last year’s $333 million, or $0.40 per diluted share. Our economic net income, which excludes unrealized SFAS-133 items relating to contracts settling in future periods, was $195 million, or $0.25 per diluted share. This compares to $273 million in the second quarter of 2006, or $0.33 per diluted share. The $0.25 per diluted share in economic income exceeds the Wall Street mean estimate of $0.22 per diluted share.

As expected, our second quarter earnings declined from last year due to the continued increase in jet fuel costs combined with very difficult year-over-year unit revenue comparisons. Our economic net margin was 7.5% versus 11.1% and our economic operating margin was 12.6% versus 17.5% in the second quarter of ’06.

Although these are respectable margins, we cannot be happy with an earnings decline. We understand that our revenues are not increasing fast enough to offset our higher fuel costs and that we are falling short of the financial results needed to provide adequate return to our shareholders and job security for our employees. As such, we recently outlined our current and future initiatives and we are targeting incremental revenues in excess of $1 billion over the next several years to achieve our financial targets of 15% EPS growth in 2008 and 15% ROIC in 2009.

These initiatives have and will continue to require a significant amount of work but we intend to implement some of them, as Gary mentioned, as early as this fall. In the meantime, we remain focused on improving our revenue production and finding ways to improve our revenue management with the tools that we have today.

That said, our second quarter 2007 operating revenue increased 5.5% to a record $2.6 billion. On a unit basis, however, our operating revenue declined 3.4% to $0.1034. As expected, we had very difficult year-over-year comparisons from last year’s record unit revenue performance of $0.107. Furthermore, the softer first quarter revenue trends continued into the second quarter and we had to work hard to stimulate traffic with low fares and heavy promotions.

Our passenger yield declined 1.7% to $0.1302. As a result of these discountings, our full fare mix was approximately 27% in the second quarter of 2007 versus roughly 33% in the year-ago period.

Although yields were down, we were very pleased that we were able to stimulate demand for June, reporting an all-time high load factor of 82.1% for the month. For the quarter, our passenger unit revenues decreased 4% year over year to $0.0991 with our June PRASM down over 3%. On a sequential basis, our PRASM increased 11% from the first quarter of 2007, which was in line with historical performances.

Looking ahead, we are encouraged by the traffic trends and bookings thus far in July. Although our RASM to date in July is still down versus the year-ago period, our unit revenue trend year over year has improved from June. And of course, the comparison should get easier in August considering last year’s London terrorist threat on August 10th and the subsequent TSA liquid ban in carry-on bags.

Based on the current trends and the easier comparisons, our third quarter 2007 unit revenue should compare more favorably on a year-over-year basis than our second quarter 2007 performance.

We had a very strong other revenue performance, up 53.1%, which was better than expected. This was driven primarily by higher business partner income which were filtered from higher commissions earned from programs that we sponsor with certain business partners, such as our company-sponsored Chase Visa card. We also had higher than expected charter revenues.

We expect another year-over-year growth again in the third quarter of 2007 but not at the same rate that we experienced in the second quarter.

Our freight revenue decreased 13.2% to $33 million, primarily from our decision to discontinue carrying mail for the U.S. Postal Service at the end of second quarter last year. With easier comparisons, we expect a year-over-year increase in the third quarter.

Turning to costs, our second quarter economic unit costs were up 2.3% to $0.0903, primarily due to higher fuel costs. Our economic fuel costs were up 14.1% to $1.62 per gallon, despite $173 million in favorable cash settlements from our derivative contracts. The economic cost of $1.62 per gallon was $0.46 lower than our unhedged fuel price per gallon of $2.08.

Our economic fuel cost per gallon came in below first quarter $1.63 per gallon, which was lower than we had expected. As you know, most of our hedges have been converted to refined products, heating oil and gasoline. Coming out of the end of 2006, there had been a large build of refined products that remained in storage due to the fact that we had no hurricane activity in the Gulf, we had a milder and delayed winter in North America, and an even milder winter in Europe. As a result, these products did not perform as well relative to jet during the first quarter.

In the second quarter, the opposite happened, with the light winter and increased demand, the excess inventories were depleted and at the same time, we began to have significant year-over-year refinery outages due to maintenance, and that resulted in sky-rocketing product prices in the second quarter, especially with unleaded gas and, to a lesser extent, heating oil. And these product prices run more than jet fuel, even though we did experience significant increases in our jet differentials during the quarter for the same reason. Our second quarter jet differentials averaged $0.17 for the quarter, with prices as high as $0.22 in May. So for these reasons, our product hedges produced better gains for us during the second quarter.

For the third quarter, we have derivative contracts in place for about 90% of our estimated fuel consumption and based on this position and the current market prices, we currently expect our third quarter economic fuel prices per gallon to be in the $1.70 range. We are estimating a higher jet price in the third quarter versus the second quarter for a couple of reasons. To begin with, we are hedged for about 90% of our usage in the third quarter versus greater than 95% in the second quarter; the current market prices in the third quarter are higher than the second quarter; WTI, about $73 for the third quarter and it averaged around $65 in the second quarter; and finally, we don’t expect to experience the same hedging performance on the product hedges in the third quarter that we experienced in the second quarter, as supported by the current market prices.

The estimated fair value of our hedges was $1.6 billion at June 30th, and the premiums associated with the cost of our hedging program were $14 million in the second quarter versus $12 million last year. We expect similar premium costs for the third quarter of ’07.

Excluding fuel, we also had better-than-expected cost performance. We were down 1.2% to $0.066, and this was led primarily by lower profit sharing expense. Our salaries, wages and benefits per ASM were down 5% to $0.0326. Included in the salaries, wages and benefits is our profit-sharing expense, which was $55.1 million for the second quarter of ’07 versus $73.8 million last year. Our 401K contribution was $36.8 million versus $34.6 million, and our second quarter 2007 stock option expense was approximately $13 million, which was down 46% from $23 million in the second quarter of last year.

The remaining salaries, wages and benefits declined slightly from last year and the decline was driven primarily by lower healthcare costs. On our salaries and wages alone, they were up 1.3% on a unit basis due to higher wage rates, which were offset by improved productivity.

As Gary mentioned, our employees have continued to work hard to improve our productivity and we are very proud of their efforts. Our headcount per aircraft was 66.5 at the end of the second quarter. That was down from 68.7 last year and down from 67.9 at the end of the first quarter.

With the continued fuel cost pressures ahead, we must continue to find ways to control our salaries, wages and benefits, as they represent our largest cost item and as such, we recently offered certain employees a voluntary early out program that Gary referred to that we are calling Project Early Departure. Employees eligible under this program must make their election to participate by August 10th.

While there will be a third quarter 2007 charge for the cost of the program, we anticipate future cost savings will more than offset the cost of the program. We do not know how many employees will accept the program, therefore it is difficult to forecast the third quarter impact and future year savings.

Excluding any charge from this program and ignoring profit sharing, 401K, and stock option expense, we expect that our third quarter 2007 total salaries, wages and benefit unit cost will increase from third quarter 2006.

Our maintenance expense increased 19% on a unit basis during the quarter. Similar to the first quarter, the increase in air frame expense resulted from the transition of our classic fleet to the MSG3 air frame maintenance program, which we account for under the direct expense method.

Even with these transition costs, we should be in line with historical levels and we expect our third quarter maintenance unit costs to be in the high $0.50 range.

Based on current cost trends and excluding any charge from the Early Departure program, we currently expect our third quarter 2007 economic unit cost, excluding fuel, to exceed third quarter 2006’s $0.0638.

Our interest expense decreased by 14.7% during the quarter to $29 million. An increase in interest rates was more than offset by a lower debt balance outstanding during the quarter. Looking ahead, we have acknowledged that we are under-levered, so it’s reasonable to assume that we will issue additional debt by the end of the year, which would obviously increase our interest expense.

Our interest income decreased 33% due to less invested cash this year versus last year, and our second quarter 2007 effective tax rate was 37.8%. We currently expect our full year tax rate to be in the 38% range.

Looking at the balance sheet, we ended the quarter with cash and short-term investments of $2.1 billion. At the end of the second quarter, we held $1.1 billion in fuel hedge related cash collateral deposits and our $600 million unsecured line of credit remains fully available.

Based on our revised capacity plans for the fourth quarter 2007 and the full year 2008, and I’m going to cover those here in a minute, our estimated 2007 capital spending has been reduced from $1.5 billion to $1.4 billion, and our 2008 capital expenditures have been reduced from $1.5 billion to approximately $1.3 billion.

During the second quarter, we repurchased $32 million shares of common stock for $464 million, and as of yesterday, we have repurchased 102 million shares for $1.6 billion since January of 2006. At quarter end, we had 752 million shares outstanding, and as of close of business yesterday, we had 747.3 million shares outstanding. So the good news is our share count continues to decline, which is our goal.

We will repay about $100 million in debt next quarter, and our balance sheet leverage, including our aircraft leases, remains at around 35%.

During the quarter, we acquired 11 737-700s from Boeing, growing our ASMs by 9.2%. We expect to receive 11 dash 700 aircraft during the third quarter, with an estimated capacity growth to 7.5%, and during the fourth quarter, we will receive nine airplane deliveries and we will grow our estimated capacity, as recently revised, by 6%.

So for the full year ’07, we have 39 planned deliveries and an estimated capacity growth of 7.5%. For full year 2008, we recently revised our capacity growth downward to about 6% and we intend to increase our fleet in 2008 by 19 net aircraft, which is 15 fewer than originally planned.

We announced today that we have an agreement with Boeing to defer five of our 34 previous planned 2008 deliveries to 2013. These five deliveries include one 2008 option that we have exercised for delivery in 2013, so we will now take 29 airplanes from Boeing next year. We are currently exploring our other alternatives to reduce our fleet next year by the additional 10 airplanes, and that gets us to the planned net increase of 19.

As part of the agreement with Boeing, we also agreed to exercise 24 more options for delivery in 2013 and ’14, and that’s bringing our firm orders from 2008 through 2014 to 106. In addition, we have 86 options with delivery positions available in 2009 through 2012 and 54 purchase rights for delivery through 2014.

We’ve provided the revised yearly breakdown of the delivery schedule in the earnings release for your reference. With these changes, our baseline capacity growth plans for beyond 2008 is in the 5% to 6% range annually.

Given the continued cost pressures we face, we believe these are more prudent growth rates and if things improve, we can adjust accordingly. Our long-term plan remains to grow the airline while achieving our financial targets.

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

Question-and-Answer Session

Operator

(Operator Instructions)

We’ll take our first question from Ray Neidl with Calyon Securities.

Ray Neidl - Calyon Securities Inc.

Yes, just to clarify a couple of the stats you were throwing out, the 747 million shares as of yesterday, I guess, that’s basic, not diluted? Is that true?

Laura H. Wright

Yes, that is just outstanding shares, Ray, so that does not include the dilutive share adjustment.

Ray Neidl - Calyon Securities Inc.

Which would bring it up to what, about 760?

Laura H. Wright

At the end of the second quarter, the dilutive share adjustment was about 11 million shares, so obviously that adjustment varies based on the stock price, but it was about 11 million shares at the end of the second quarter.

Ray Neidl - Calyon Securities Inc.

And it’s obvious but I just want to ask you, why do you feel that you’re under-leveraged? Basically, I know the differential with the interest rate and interest costs are in there but why are you purposefully bringing up your debt levels? Is it going to be through secured debt through the aircraft? Are you going to do more financing of aircraft?

Laura H. Wright

Ray, I think if you look at our balance sheet, you can see that our leverage has been declining over the past five years and we were at a 50% leverage in the 90s and we’ve seen it decline to -- it got to as low as about 30%, so clearly we know that we have room for more debt in a more optimal capital structure.

In terms of additional financing, we have many options available to us. Historically, we’ve tapped the senior unsecured market because of the attractive rates that we have there but we can look at financing airplanes, ATCs, and a lot of other alternatives. We have not disclosed what we are going to do or what form of financing that we are going to pursue at this time.

Ray Neidl - Calyon Securities Inc.

Finally, the unit cost pressure is coming from operations, both fuel costs and non-fuel costs, but is one of the reasons why that Southwest is reluctant to take down the capacity growth is that it would put even more pressure on your unit cost? Is that correct?

Laura H. Wright

No, it’s not.

Ray Neidl - Calyon Securities Inc.

Okay, good. Thank you very much.

Operator

We’ll take our next question from Kevin Crissey with UBS.

Kevin Crissey - UBS

Good morning, everybody. Could you go into any strengths or weaknesses you are seeing by region? I’m not sure if I missed that or not, or by length of haul or however you would categorize it if there is a breakdown?

Gary C. Kelly

I think that the second quarter revenues were pretty much in line with what we would have expected historically, compared to the running rates, Kevin, that we saw in the first quarter and what we reported to you all in the first quarter is that the performance was pretty consistent around the system.

I did not detect, Laura, any particular strengthening or weakening across the system. Now, we were obviously showing declines in load factors from February through May and I think all of us were pleased with the improvement there in June. So now we worked, as we mentioned to you all before, we worked pretty hard to get that June traffic. But I do think that that is an -- I would interpret that the June load factor performance was some improvement from what we had been seeing February, revenue wise, February through May. I don’t think it was a remarkable improvement but I think overall it was an improvement and obviously what we’re hopeful is that we can build on that strength here in the third quarter.

Now, the only thing I would add to that is that we’re anticipating some changes in capacity by our competitors. I think that for the most part on balance, it will be some removal of flights and that should benefit us, and I think you’re aware of where those are. I mean, there’s some California service declines that should benefit us. On the other hand, we don’t know what Virgin America’s going to do, so -- but on balance, it does appear to us that in the near-term, we ought to see some boost by those changes.

Of course, we’ve got our own four quarter schedule changes planned that we think on balance will be a boost to our revenues and profits too. But the short answer to that is I don’t recall any particular change from where we were in the first quarter.

Laura H. Wright

I think across the board the weakness was everywhere, with the one exception is the Southwest region performed a little bit better because of the favorable impact of the amendment repeal. We had about $30 million of additional revenue in Dallas, so that was the only exception.

Gary C. Kelly

Yes, as we put in the press release there, that’s continued to be a real bright spot for us and we generated over $50 million in the first-half with the new Dallas itinerary, so we’ve been very pleased with that.

Kevin Crissey - UBS

Terrific, thanks. A couple other follow-ups; in terms of hedging, are you just rolling hedging, so you are hedging at these prices, or -- ?

Gary C. Kelly

I tell you what, that’s a hard decision and I’m glad that Laura and her team were as aggressive as they were in the fourth quarter/early first quarter when prices softened up a bit. That’s paying off handsomely for us, so -- we’ve got the hedging percentages reported out there.

Laura H. Wright

The only changes that you see just reflect the fact that capacity is down slightly, so a little higher hedge percentage but beyond that, we’re basically at the same position we had at the end of the first quarter.

Kevin Crissey - UBS

Okay, terrific and then the last is just a clarification; the $1 billion annually incremental revenue that you are looking to generate, that’s -- I’m right in saying that’s $1 billion annually, but you are not going to achieve the $1 billion annually until several years, or is it that it will take several years to accumulate $1 billion in additional revenue? That’s what I was kind of confused by.

Gary C. Kelly

Well, it is an annual target. It is an imperative, quite frankly, is the way we are viewing it, so I think what I’ve been trying to communicate is that we think we have adjustments planned for us to be successful. If we find that we’re still falling short, well, we’ll look for more adjustments on the revenue and the cost side. But I feel very confident about what we have planned.

Now, some things are being subtly implemented as we speak. You’re aware of our fourth quarter plans, at least, in terms of high level headlines. I realize that we haven’t provided you a lot of details of the things that we’ll be introducing in the fourth quarter, some of them are brand oriented and may take some time to ramp up. Some of them will be immediate, like fare structural changes and revenue management techniques.

Well, even having said that, some of the revenue management techniques may take a little ramp-up time in 2008 as well. I would hope that by the time we reach the end of 2008, that that is our running rate. But quite frankly, we don’t know. We know that we are introducing new sources. We are anxious for them to come online faster as opposed to sooner, but I don’t think it’s our expectation that we’ll see $1 billion plus incremental revenues for the full year of 2008. I would certainly hope that we’re closer to that in 2009.

Kevin Crissey - UBS

Terrific. Thank you, guys, very much.

Operator

We’ll take our next question from Gary Chase with Lehman Brothers.

Gary Chase - Lehman Brothers

Good morning, guys. I wanted to just ask you; I mean, I obviously understand the difficulty of the second quarter revenue compare versus last year but at least as I remember it, the third quarter is nowhere near as difficult and you mentioned as well, Gary or Laura, a number of things that are kind of working in your direction. It seems like the demand environment is improving, capacity is coming out. If you look at the same kind of sequential analysis that you’d pointed us to in the first and second quarter, it kind of suggests that things would be up.

I guess the question I have is, is there any way to give us a sense of magnitude on what the July decline is? I’m trying to get a sense of how hard would it be for RASM to be up year on year, given all those things that seem to be moving in a positive direction.

Laura H. Wright

Gary, so far in July, we are still trending down year over year to date but for all the reasons you mentioned, we do hope that we can turn the corner. Sequential trends, if you look at them from second to third quarter, they have been all over the board over the last five years but if you take a longer term average, third quarter RASM has typically declined, kind of in the 2% to 4% range. From a competitive capacity standpoint in our direct markets and indirect markets, our competition has taken about 1% of their seats out from second quarter to third quarter, and on a year-over-year basis it is going to be down about 6% in our direct market. So those are all good signs but again, we expect the year-over-year trends to be better in the third quarter and are hopeful that they can turn the corner.

Gary C. Kelly

I would just add a little bit different perspective than Laura’s insight there, which is we were surprised with the slowing demand this year, going back to late January. We’ve been I think not necessarily surprised but it has been a pleasant change to see demand strengthen but it is the peak time of the year and I’m a little concerned when you get to the second-half of August, based on what we saw earlier this year, when we get into the shoulder period of the year and then in particular, September.

So I think yes, we are just giving you a little bit of a cautious outlook there, knowing that it’s been a little bit of a rocky year. The other thing that we are doing that we’ve tried to be clear on is that we’re very aggressively going after traffic and we’re -- because we’ve tried other techniques in the first quarter and they did not work, as you saw load factors fall. So did RASM. So we do have a more aggressive approach to make sure that we get the traffic, to not underestimate perhaps the softening economy and if there is upside in the third quarter, I think we’ll all be happy.

We may well have a strong load factor comparison again in July. I’m hopeful that that will continue again in September, or rather in August and in September, it is much too early to give you that kind of a prediction but no question the comps get easier once you get into the August/September time period, and that’s just too far out for us to give you any real, precise input. But at least the comps are certainly better in July than they were in the second quarter.

Gary Chase - Lehman Brothers

Okay, so it sounds like there’s nothing you are particularly worried about, it’s just that you can’t see that far away and you just want to be on the cautious side.

Gary C. Kelly

I think that that’s fair. I think the old -- and I don’t like the word worry, anyway. I think we’re just a little cautious of how strong the travel demand will be once we get past this peak summer travel period and we felt like we got fooled a little bit in the first quarter and we’re just not taking any chances here coming into a softer period of the year.

Gary Chase - Lehman Brothers

Okay, great. I really appreciate the color, guys.

Operator

We’ll take our next question from Rob Barry with Goldman Sachs.

Rob Barry - Goldman Sachs

If I’m hearing correctly, just to add a little granularity hopefully to the PRASM outlook, it’s possible it will still be negative. You said it’s better but it’s better from a down 4%.

Gary C. Kelly

Well, I don’t think that’s what we’re saying. I think anything, of course, is possible but --

Rob Barry - Goldman Sachs

You expect it will be positive?

Gary C. Kelly

We’re just reluctant to give you a specific prediction and I think we’re admitting that it ought to be different than what you saw in the second quarter. I think it’s a matter of how much better is it going to be. But I’d be disappointed if we had down RASM again.

Rob Barry - Goldman Sachs

Okay, and when you mentioned just in answer to the last question about going after the traffic, I just wondered if you could add some clarity there. I know you raised fares so that might help revenue, but I’m wondering if there is any elasticity of demand impact that you are seeing.

Gary C. Kelly

None now but again, it’s just when we have an all-time record monthly load factor, that’s what we are basing those kinds of judgments on, is that if demand is strong, we’re hopefully that it will continue and I think it will be a while, Robert, before we know if there is any negative reaction to the fare increase.

I think you are going to see strong traffic in July. You’ll see strong traffic in the first-half of August, and as is typical with school starting, it’s the back-half of August and September that we’ll have to experience to really give you a better read on your question.

Rob Barry - Goldman Sachs

Could you break down that $1 billion, approximately how much you see it coming in through the passenger revenue line versus freight and other?

Gary C. Kelly

Well, Laura I’m sure has an exact breakdown of that number.

Laura H. Wright

We have not disclosed that for a lot of obvious reasons. We’ve got a lot of exciting things planned and we’d like to unveil them when they are ready. I don’t know if you want to add anything to that, but we really haven’t provided the breakdown.

Gary C. Kelly

We have not and I think it is much too early to, in fairness, to give you any real meaningful guidance there. The only thing that I would suggest is that we do see hundreds of millions of dollars a year and potential from expanding our codeshares, and that’s just based on the simple logic that we’re doing, with the little codeshare we have with ATA right now, we’re doing $40 million a year. So if we can expand that offering into the near international markets, we’re very hopeful that that alone will produce a very sizable increase in incremental revenue.

But beyond that, no, I don’t think we’re ready to give you any specific guidance. We’d like to see a little result from that in the fourth quarter and early first quarter before we start throwing out a bunch of numbers.

Rob Barry - Goldman Sachs

Finally, could you give us a percent of full fare tickets you sold in the quarter and how that changed year over year?

Laura H. Wright

Yes, we can. Our full fare coach mix was at 27% and that was down from 33% last year.

Rob Barry - Goldman Sachs

How would you interpret that, despite the fact that you’ve been implementing some initiatives to go after higher fare traffic? Is it --

Gary C. Kelly

I don’t know that I would -- I understand your insight there. I don’t know that the initiatives for “full fare” traffic are even close to being underway yet so I wouldn’t draw any conclusion from that.

I think it’s just a reflection of our view that demand is softer this year than a year ago and we’re being more aggressive. Now, Laura gave you the full coach mix and there are other fares, of course, that are close to that that are sort of business oriented. But I do think that the way she answered your question was pretty accurate, i.e. it gives you the same answer whether you include more fare categories or not.

But yes, it’s just a little bit softer environment this year for whatever reason, and it’s obviously not unique to Southwest Airlines. I think across the board the economy has slowed and domestic revenue has been harder to come by this year. Maybe post June we’ll see an improvement. We would all welcome that but we’re not ready to predict that yet.

Rob Barry - Goldman Sachs

I guess the reason I asked is people talk about demand being strong and loads being up but it seems like the planes are full of lower fare passengers, so --

Gary C. Kelly

Yes, I think you hit it on the head and again, I think the thing that if you want to be sure and understand, is that we tried that sort of stubborn approach in the first quarter and early spring to hold out for higher yields and it just didn’t work. So now we have been what I would consider to be more classic aggressive, get the traffic on Southwest Airlines. And the good things we’re having a party and people are showing up. We all wish they’d pay a little bit more but --

Laura H. Wright

And I think we saw not only demand but we just saw our competitors lower their fares and we had to, you know, we had to discount more to keep from being undercut.

Rob Barry - Goldman Sachs

Thanks very much.

Operator

We’ll take our next question from Bill Greene with Morgan Stanley.

Bill Greene - Morgan Stanley

I’m wondering if you could talk a little bit -- Gary, you mentioned you don’t want to have high leverage. How high is high?

Gary C. Kelly

Bill, I don’t know. I don’t know that there’s a bright line there. We are, and I thought Laura answered Ray’s question completely earlier but not to be too redundant here, if you go back, her point was our leverage has decreased over the past five plus years. So we’re trying to do everything that you all would expect us to do -- manage the cost of capital, hit our return on equity targets, more importantly hit our ROIC targets, and we’ve got an agreement with our board to keep the leverage at roughly -- and this is just a handshake, friendly agreement -- to keep the leverage below 50%.

Bill Greene - Morgan Stanley

And that’s gross debt, too.

Gary C. Kelly

Yes, that is gross debt and that is apples and apples to Laura’s 35% number. And that’s, and as you know, I’m not intending that you all interpret that to mean that we are going to go from 35% to 50%. That’s not the point but if you are thinking that we are comfortable at 60% leverage or 70%, we are not, so somewhere between 35% and 50% is just the range that I think that we’re comfortable talking about. But clearly we’re interested in boosting it up from 35%.

Bill Greene - Morgan Stanley

Okay, and then if we can talk a little bit just on the labor side, so you’ve got this buy-out in place and I realize you’ll try to replace some of these folks, but I would’ve thought that the buy-out would also be used as a way to improve productivity, so it is all intended to be flight crews or -- why would there be some --

Gary C. Kelly

No, no, it’s -- well, it is oriented towards operating groups where we have thousands of employees, in other words. Not all operating groups but many of them, and it’s just the arbitrage between senior rates and entry level rates is all it is, and we’re not making any secret about that. That’s all this is about.

Now, we are very productive and are more productive now, my point was, arguably than we’ve ever been in our history, given the service offerings that we have. So I’m not assuming that there is any tremendous benefit in terms of increased productivity but clearly there’s going to be a situation in an airport location or some department where we won’t have to replace everyone who takes this package but that is not the thrust of the program. It’s oriented towards replacing higher rates with lower.

Bill Greene - Morgan Stanley

Okay, and then the talk about reducing the capacity, has that created any challenges with any of your work groups?

Gary C. Kelly

No, not at all. Of course, we haven’t done it yet, if you know what I mean, so our schedule planning group, which deserves tremendous accolades for the work that they’ve done to run through changes as of October, they’ve done their part but now all of our operating groups will match up their staffing needs to this new schedule.

But no, we’re not -- all of that was well-orchestrated and very thoroughly vetted and discussed and -- now, we won’t have a very efficient schedule for us in the fourth quarter, so we will have some, what I will call some idle aircraft time and that will be squeezed out and optimized in our January schedule. So aside from those kinds of things, we are not perceiving any particular challengers there. We are actually kind of interested to see what benefits we might get from some, if you want to call it, some surplus airplane time in terms of on-time performance and minimizing cancellations and that kind of thing. But I wouldn’t want you to assume that that means that we think that we’ll continue to be sub-optimized because that’s -- we don’t think that that’s the right place to be.

Bill Greene - Morgan Stanley

All right, thanks for your help.

Operator

We’ll take our next question from James Parker with Raymond James.

James Parker - Raymond James

Good morning. I’d like to know about your plans for an enhanced fare structure and I guess better revenue management techniques. Are you catching up to the rest of the industry or do you have something that’s new and innovative, and could you elaborate on how you are going to achieve an enhanced fare structure?

Gary C. Kelly

Jim, I’m not going to give you a whole lot of insight, primarily for competitive reasons. We know what we want to do. We are building it now so it is not for a lack of details at Southwest. It is a desire to play our cards very close to the vest now.

I think we’ll have some innovation in there and there is always -- there are always things that we can do to improve but as you’ve heard us say, heard me say, and in 2001, we were not well-prepared at Southwest Airlines to offer the new kinds of things that we’re talking about today, and we have fully admitted that. So clearly there is some catch-up, if you want to describe it that way, that we will be undertaking, and especially with some of our structure.

But I would like to think that a lot of the things that we are doing are going to be innovative.

James Parker - Raymond James

Laura, did you say that competing capacity was going to be down 6% in the third quarter?

Laura H. Wright

Jim, if you look at our direct markets on a year-over-year basis, it’s down about 6%. From second quarter to third quarter, it’s down about 1% but year over year, down 6%.

James Parker - Raymond James

Okay, and one last question here; you recently raised fares and I believe that may be the third one this year.

Gary C. Kelly

Yes.

Laura H. Wright

That’s correct.

James Parker - Raymond James

But if you raise the fares, the fare buckets but if the seats don’t sell, then you move them down into lower buckets. My question is look like the first two, they didn’t sell and maybe in the high season, they are. I’m just wondering, why are you raising fares? Because if they don’t sell, you move them down into the lower buckets.

Gary C. Kelly

Well, I think that’s the art of the deal, is to try to raise fares productively. Up until this year, Jim, we’ve been able to do that very successfully. When you run into an environment that’s softer, like 2007, it is more difficult.

If you went back to the May timeframe, I was pretty skeptical about whether fare increases would be productive. Now we’ve got in June, an all-time record monthly load factor and we are hoping that the demand is going to be stronger and that we’ll be productive.

You understand like we do that until you try some of these things, you don’t know and I think that’s part of my answer to Gary Chase earlier and some caution about the outlook for the quarter. Right now it looks pretty strong. A lot of the demand, of course, is leisure oriented for low fares with or without a fare increase, so if we can get the leisure demand at a higher fare than we had otherwise, that’s better. But how the mix is going to change because of a weaker -- I think what you’ve got here this year is weaker business travel demand. I can’t prove it but I think that’s what’s going on and if that is the case, then it would certainly be wise to, if the leisure demand is strong, to try to raise leisure fares, period. And we think that that’s been working for us.

What we’ve not had is demand, in my opinion, as strong for business travelers.

James Parker - Raymond James

Thanks.

Operator

We’ll take our next question from Dan McKenzie with Credit Suisse.

Dan McKenzie - Credit Suisse

Yes, hi, everybody. The FAA is rolling out RNP technology across a number of airports and I’m just wondering if you could provide some perspective on the costs, the benefits for Southwest, where you are at with respect to that and the timing for it to be rolled out going ahead in particular airports that might be impacted.

Gary C. Kelly

Laura, do you want to answer that one?

Laura H. Wright

Yes, I’ll do my best. We’ve announced that we intend to move forward with RNP technology. I guess we announced in May that we had an agreement with Naverus, who we’ve hired to help us build some customized approaches into some of the airports.

In terms of timing, I think it’s ’09 -- first of ’08. I’m sorry, first of ’08 when we’ll start seeing the ability to use some of these approaches in some of our airports. By the time we enable the entire fleet or the majority of the fleet to have these capabilities, it is going to be probably around 2010.

From a cost perspective, we haven’t really shared the cost of that program but on a, as we’ve gone through the business case looking at it, the fuel savings are significant because of the shorter flight times with more direct routings and we’ve proven that the return on that capital investment more than adequately repays or the capital costs that’s going to be associated with it.

Dan McKenzie - Credit Suisse

I see. And then for the quarter, could you provide some perspective on the actual scheduled black hours versus -- or the actual black hours versus the scheduled black hours and how that impacted costs for the quarter?

Laura H. Wright

You know what, Dan? I don’t have that but just on a comparable basis, we did not have any excess costs really related to -- I’m assuming you’re looking at weather and all that. We didn’t really have any abnormality in our costs during the quarter.

Gary C. Kelly

I agree with Laura there, Dan. Now, our on-time performance hasn’t been reported yet for the month of June, but you all know I’ve been saying that our on-time performance this year has been very solid and year-to-date is actually better than a year ago, so I do remember that we had more flight cancellations, at least in some parts of the second quarter. I don’t recall overall whether we did, but in any event, we’re not holding out to you that we had any significant year-over-year cost penalty because of the weather. In fact, I was very proud of our operating groups and the performance that the airline had. We’re continuing, especially on the on-time performance side, to perform real well.

Laura H. Wright

Dan, we just looked at our numbers and compared to our budget for the quarter, we didn’t have any negative variance in our scheduled hours for aircraft time.

Gary C. Kelly

We’ve been real -- I think the bottom line on all of that is we’ve been very pleased with the operational reliability. It was quite good.

Dan McKenzie - Credit Suisse

Okay, good. Thanks a lot.

Operator

We’ll take our next question from Frank Boroch with Bear Stearns.

Frank Boroch - Bear Stearns

Hello, everyone. I wanted to follow up on the topic of productivity. If we look at Southwest FTEs per aircraft and maybe just compare them with someone like AirTran, is the AirTran network too different from Southwest to use that as a reasonable benchmark to where you could actually get the company around 60 FTEs per aircraft?

Gary C. Kelly

Well, I have to admit, I haven’t studied AirTran’s network compared to ours.

Laura H. Wright

I haven’t. What I don’t know, Frank, is -- we have a very different operation because they are very Atlanta district and fewer destinations in their out-stations. I don’t know how much they outsource, you know, ground service at their out-stations. That would definitely drive a lower FTE than the way we do it.

I’m like Gary. I don’t know if I know enough about their operation.

Frank Boroch - Bear Stearns

I guess even with -- without knowing that, does a number in the low 60 range seem even feasible with what you’ve seen modeled?

Gary C. Kelly

I think it’s feasible. Quite frankly, we’re sort of taking this one turn at a time and it feels to me like outside of our flight crews, we’ll continue to get more and more productive. We’ve got enough momentum and enough things planned that that improvement should continue.

Now, of course, what we’re hopeful of finding is some method of improving our flight crew productivity as well, since that’s just such a large, large component of our operation.

In any event, I think that the trends are quite good and will continue there. Our challenge on the cost side beyond fuel, under the assumption that we continue to do a good job of managing our unit labor cost, is with airports, and that is a real struggle. There’s inflation in the 2007 landing fees and rentals category that we wish wasn’t there and there are enormous spending programs planned around the country at airports that we serve, so that’s a constant battle. And of course, LAX has been a real high profile dispute in that regard.

That’s where I think we’ve got some work to do, but on the headcount side I think we’re having a great deal of success.

Frank Boroch - Bear Stearns

Last question, for the other 10 aircraft that you have to make decisions for for next year, if you wanted to defer those, how soon do you need to make that decision?

Laura H. Wright

When you mean defer, defer them with Boeing?

Frank Boroch - Bear Stearns

Yes.

Laura H. Wright

We will not dispose of those 10 additional airplanes through deferrals with Boeing. The alternatives that we’re looking at for those 10 aircraft do not include additional deferrals from Boeing in 2008. We’re committed to the 29 deliveries that we have with them, so we’re going to be looking at leases that come up for expiration. We’ve got about nine of them within the next 12 months and we’ve also got the ability to sell either new deliveries or owned airplanes. So we just have not made a decision as to which we are going to do yet, but it won’t include more Boeing deferrals.

Frank Boroch - Bear Stearns

Okay, great. Thank you.

Operator

We have time for one final question and it comes from Michael Linenberg with Merrill Lynch.

Michael Linenberg - Merrill Lynch

Good morning, Gary and Laura. This is Lily on behalf of Mike. My first question is regarding the markets that you guys compete with ExpressJet. I know there’s not a lot of information out there on them but just from your perspective, are you seeing any impact from them? How are some of those markets behaving given their entry?

Laura H. Wright

You know, the markets that ExpressJet is in are not direct non-stop markets that we serve. They are markets that we carry O&Ds in on a connecting basis. I think it was roughly about 1% of our O&Ds if you look at the markets that they went after.

I think somebody asked a question earlier about the performance of markets, if we saw differences across the system, there isn’t anything noticeable at this point. Again, they started ramping up throughout the quarter versus the rest of the system that’s distinguishable yet. I don’t know if you have anything else to add, Gary.

Gary C. Kelly

You know, it’s -- no, they are not on our radar at this point but as Laura was pointing out, those are more multi-stop O&Ds that we’re describing or that you’re asking us about. So we’re probably need to see the O&D revenue data via the DOT several quarters from now before we can give you real insight on that. But in any event, they are just not on our radar at this point.

Michael Linenberg - Merrill Lynch

Great, thanks. My second question is regarding whether you guys have switched on the GDS yet, and if you have, are you seeing any impact on mix because of it?

Gary C. Kelly

Lily, we have not. That, there is a technology construction effort underway to enable that and that was -- all that was announced back in May and that will be, assuming that we are on time with our project plan, that will be in December.

Michael Linenberg - Merrill Lynch

Thank you so much, guys.

Operator

That does conclude our analyst portion of today’s call. At this time, I would like to turn the call back over for additional or closing remarks.

Laura H. Wright

Thank you all for joining us today. The investor relations team stands by, ready to take your calls and I hope everybody has a great day. Thank you.

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Source: Southwest Airlines Q2 2007 Earnings Call Transcript
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