Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message| ()  

Executives

Gary Kelly – Chief Executive Officer

Laura Wright - Senior Vice President of Finance and Chief Financial Officer

Analysts

William Green - Morgan Stanley

Mike Lindenberg - Merrill Lynch

Ray Neidl - Calyon Securities

Jamie Baker – JP Morgan

Dan McKenzie - Credit Suisse

Gary Chase - Lehman Brothers

Jim Parker – Raymond James

Frank Roche – Bear Stearns

Southwest Airlines Co. (LUV) Q4 2007 Earnings Call January 23, 2007 11:30 AM ET

Operator

Welcome to Southwest Airlines fourth quarter 2007 earnings conference call. Today’s conference is being recorded. We have on the call today Gary Kelly, Southwest’s CEO and Laura Wright, the company’s Senior VP Finance and CFO.

As a reminder this morning’s call includes forward-looking statements. Such 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 do not relate strictly to historical or current facts. Actual results may differ materially from those expressed in forward-looking statements due to many factors.

For additional information regarding these factors, please refer to the company’s earnings press release, as well as its periodic filings with the Securities and Exchange Commission.

This morning’s call will also include references to economic results as well as certain other non-GAAP results. A reconciliation of these results with GAAP results is included in the company’s earnings press release, which is posted on Southwest.com.

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

Gary Kelly

Thanks a lot, Steve and we’re sorry to work you so hard there on that opening script, but it’s very important. Thank you all for joining us today as well.

First of all I want to thank all of our Southwest employees. We accomplished a great deal in 2007, especially in the fourth quarter. Excluding special items our fourth quarter 2007 was flat compared to 2006 at $0.12 a share. Comparatively, that was the best quarter of the year.

Of course, those results fall well below our goals and they must improve but given the financial challenges presented to us in the fourth quarter it was still a very significant accomplishment. Again, I’m very, very proud of our people.

It represents our 67th consecutive quarterly profit. 2007 represents our 35th consecutive year of profits. Both of those are unprecedented in the airline industry and truly remarkable in what has been the worst decade in the history of the airline industry.

First of all, I was pleased with our improved unit revenue trends in fourth quarter; we were up 3.7%. We had a little bit of softness around the holidays, but overall a really good performance. December showed the most improvement on a monthly year-over-year basis and it was also the best performing month of the year. Obviously we like those kinds of trends.

Excluding fuel I was pleased with our cost performance. Our employees deserve all the credit for that. Productivity continues to improve and at the same time our service levels remain very high. Of course, it is critically important that we continue to do everything we can to control our salaries and benefits cost to mitigate higher aircraft engine maintenance costs.

I was also very pleased with the performance of our fuel hedging. Laura Wright and our finance department did a fabulous job there. Our fuel hedging saved us $300 million alone in the fourth quarter and that helped limit our fuel cost per gallon increase to 10.3% year over year. Of note, without our fuel hedging gains we would not have made money in the fourth quarter.

Our customer service performance for the year 2007 was a real standout and once again Southwest Airlines is among the industry leaders. Our on-time performance was over 80% for the year, essentially the same as a year ago. Less than 1% of our flights were cancelled and that is a very story than the rest of the industry and I’m very, very proud of our 2007 operations.

Now given record energy levels, we put out the call in fourth quarter to find yet more ways to reduce our fuel burn. As usual, our employees have responded quickly and magnificently. Our fuel burn trends instantly began declining. Our operations folks have plans for more initiatives in 2008 which of course I hope will save us a considerable amount of money.

2007 was also a period of very significant transformation, and also adjustment for Southwest Airlines. We had slowing demand, rising energy prices so we decided to slow our capacity growth. We trimmed our flight schedule in October and November. That worked exceptionally well boosting our unit revenue, we think around 2%. Of course the overall results will attest to that.

Close to two years in the making, we have launched significant customer experience improvements in the fourth quarter with our enhanced boarding, an extreme gate makeover, Rapid Rewards frequent flyer program improvements and an enhanced fare structure, including a new Business Select product.

We’ve also launched new revenue management techniques and processes, procedures that we hope will boost yields and/or traffic and then obviously revenues. So collectively this was the biggest change at Southwest Airlines in decades. It involved virtually every department at Southwest Airlines. It was extraordinary team effort and a truly integrated effort.

As you can tell by looking back, the execution was flawless and that was despite the fact that it was very complex. But I just couldn’t be more proud of that performance. The feedback has been tremendous. Our employees love the changes, but I think more importantly our customers love these changes. We did extensive research and testing before we launched in the fourth quarter. We have continued to collect feedback from our customers extensively since then and the overwhelming majority of our customers really like the changes. So it’s early, but the early returns are very, very encouraging.

The work continues. We have a tremendous amount of new technology that’s been under construction and will be implemented in 2008. Much of this is foundational in nature. We’ll be replacing our point-of-sale system at the airport which includes boarding and baggage systems. We’ll be replacing our back office ticketing system. We’ll be replacing our revenue accounting system and of course, will be introducing international code share capabilities. So those are all very important and very important to our future.

In addition to that, we have a significant technology development underway for 2009 delivery including enhancements to Southwest.com, our Rapid Rewards frequent flyer program, and also more revenue management technology. All of these things collectively are designed to enhance our already industry-leading brand and customer experience, and also enable better revenue production per flight. Our goal is to improve unit revenue during 2009 by 10% to 15% from where we are today, or roughly $1.5 billion on an annual basis. That will bring our revenues in line with our higher cost structure, and enable us to continue profitably growing our fleet and route system.

Of course we’ve slowed our growth, but not stopped. With higher unit revenues in the future and costs under control, our low-fare growth opportunities are very significant. Denver, as an example, has shown very dramatic revenue growth in 2007 and that’s in response to more flights. So more flights are coming in Denver in April and May. By May 8th we’ll be at 79 daily departures.

We also recommence service in 2007 to San Francisco International in August. We started out with a record number of flights for a new market but the customer response there has also been tremendous. We are essentially matching our system load factors out of SFO in the fourth quarter already. So more flights are coming their way as well. In March we’ll be at 35 daily departures.

I just have to praise our schedule planning department also. They did a superb job in 2007 reacting to slower demand. They helped slow the growth, pruned out less efficient flight in October/November and another significant schedule adjustment is happening in May. They are overall reacting faster and more decisively to what is definitely a more challenging economic environment.

So we’re still adding flights and routes, we are pulling all the levers that we can to drive more revenues and more profits over the next 12 to 18 months.

Finally, today we’ve announced an agreement with Rove 44 to test satellite delivered broadband wifi Internet access on board the aircraft this summer and we will be the first U.S. carrier to test this service on multiple aircraft and of course the move fits in perfectly with our strategy to keep our costs and fares low, but also improve our customer experience and drive more revenues.

Again, a very satisfactory quarter, we’ve got a very cautious outlook for 2008 because of the economy and higher energy prices, but all in all we’re in superb shape.

With that overview I’d like to turn it over to Laura Wright, our CFO.

Laura Wright

Thank you, Gary and good morning, everyone including our webcast listeners. With what proved to be significantly more challenging year than anticipated, we’re pleased to report our 35th consecutive year and 67th consecutive quarter of profitability. Despite a softer domestic economy and rising energy costs which had a dampening effect on demand for air travel, we had a record annual operating revenue performance of $9.9 billion.

Although our 2007 unit revenues did not improve as much as we had hoped going into the year, we ended the year on an encouraging note with our fourth quarter unit revenues up year over year almost 4%.

Our 2007 cost per available seat mile, excluding special items, increased 3.3% over 2006 to $0.0904. This increase was driven largely by an 11.3% increase in our economic fuel prices which reflected $727 million and $675 million in cash hedging gains in 2007 and 2006 respectively.

Excluding fuel and special items our capital was up only 0.8%, to $0.0654 for 2007. We’ve done a great job managing our overall cost structure holding our unit costs relatively flat over the last few years.

With respect to our 2008 unit cost outlook, we are expecting some inflation, especially in our maintenance area and to a lesser degree our port costs.

Moving to our fourth quarter results, our GAAP net income was $111 million or $0.15 per diluted share compared to $57 million or $0.07 per diluted share last year. Excluding FAS 133 Out of Period Items, our fourth quarter 2007 net earnings were $87 million or $0.12 per diluted share. These results exceeded Wall Street’s mean estimate of $0.10 per diluted share and were flat with last year’s EPS.

Our fourth quarter 2007 operating revenues grew almost 10% to $2.49 billion. Passenger revenues increased 9% to $2.39 billion. Our traffic grew 4.2% on a capacity increase of 5.6%, resulting in a fourth quarter load factor of 69.3%, which was down almost a point from last years record fourth quarter performance of 70.2%.

Although our load factor declined, our passenger revenue yield per revenue passenger miles was up 4.6% year over year to $0.1364 which was the best year-over-year performance that we had during 2007. As a result of this strong yield performance, our operating revenue per available seat mile increased 3.7% to $0.0987.

On track with our plans, we began rolling our revenue initiatives and took the necessary steps to slow our capacity growth which all contributed to the nice improvement in our yield performance.

In November, we implemented our new customer boarding method, started rolling out our updated gate design at our airport, introduced our Business Select product, and unveiled enhancements to our Rapid Rewards program. We also launched a focused field campaign to win more large corporate accounts and travelers and are in the initial phases of implementing Galileo and Worldspan.

We slowed down our capacity growth in the fourth quarter to 5.6% versus our original plan of almost 8%. Our competitors also collectively reduced their seat capacity in our direct markets which was down an estimated 6%. Although we didn’t have the schedule fully optimized or our expenses right-sized, we estimated that we had a healthy revenue boost from our schedule changes.

As we discussed in our last earnings call, we also began enhancing our revenue management structure technologies, techniques and processes. We’re beginning to see the benefits from these efforts, including modest fare increases taken throughout the year. The benefit from the revenue management changes should accelerate during 2008 as we have been easing into our revenue management initiatives to mitigate risk.

We were also pleased with the improvement that we saw in our overall fare mix, our full fare mix was up 2 points for the third quarter to 27% which is a bit better than normal sequential trends.

Included in our full fare mix are our Business Select passengers and the estimated favorable revenue impact from Business Select for the fourth quarter was approximately $7 million. Considering the seasonality of our business traffic mix and the recent introduction on only November 8 of this product, we are very pleased with these early results which were in line with our expectations.

We also continue to benefit from service added to and from Dallas with the implementation of the Amendment Reform Act of 2006. Our right amendment revenue was $31 million and $113 million for the fourth quarter and full year 2007 respectively, compared to $11 million for the fourth quarter and full year 2006.

In summary, we have a lot of things impacting our revenue trends during the quarter and I’m quite happy to report that our collective efforts appear to be working. Our year-over-year unit revenue trends improved each month during the fourth quarter of 2007 and those favorable trends are continuing into January which is a seasonally weak travel period.

So far our January 2008 passenger unit revenue is steady, running up in the 4% range year over year. Although the trends are encouraging and we should benefit from an early Easter in March this year our outlook remains somewhat cautious as a result of the weak economy and credit crisis.

We also had a nice contribution from our freight and other revenues in the fourth quarter. Our freight revenues increased 9.4% year over year as a result of higher rates and we expect that favorable trend to continue into the first quarter of 2008.

Our fourth quarter other revenues increased 30.2% which was driven by a strong increase in our business partner income. We expect a similar year-over-year increase again in the first quarter of 2008.

Turning to costs, our fourth quarter unit cost, excluding the FAS 133 increased 4.1% to $0.0915. A significant contributor to this increase was fuel costs. Market prices for crude oil reached unprecedented levels during the quarter flirting with $100 a barrel and as a result our fourth quarter economic jet fuel costs increased 10.3% to $1.72 per gallon.

Despite the significantly higher increased prices our fourth quarter economic jet fuel costs came in lower than we originally anticipated due to higher field hedge cash gains resulting from better than expected hedge performance. Our fourth quarter cash hedging gains were $300 million and our full year cash hedging gains for all of 2007 were $727 million. Our unhedged fuel price per gallon was $2.52 in the fourth quarter.

Our fourth quarter 2007 gallons per flight hour of 721 was down 1.4% from last year thanks to the collective efforts of our flight crews, dispatchers and airport workers. With over 500 million in fuel headwinds estimated in 2008, our field consumption efforts are as important as ever and we have a number of ongoing initiatives which are driving continued improvement in our fuel burn.

Looking forward to the first quarter of 2008, we have derivative contracts on approximately 75% of our estimated consumption at an average crude equivalent price of $51 a barrel and we have converted the majority of our crude oil positions to refined products.

Based on this hedge position and current market prices, we do not expect the same amount of hedging gains in the first quarter that we had in the fourth quarter of ‘07. As a result we currently expect our first quarter ‘08 economic fuel price to approximate $2 per gallon.

Our premiums associated with the cost of our hedging program were in the same range as last year’s $16 million and this is recorded in other gains and losses. We expect similar premium costs in the first quarter of 2008.

The estimated fair value of our hedge contracts related to future periods was $2.4 billion at December 31 and looking forward, our hedging position is as follows: in 2008 we are over 70% hedged at approximately $51 a barrel; in 2009 we’re over 55% hedged at approximately $51.00 a barrel; 2010 is nearly 30% hedged at $63.00 a barrel and 2011 and 2012 are over 15% hedged at approximately $64 and $63 respectively.

Excluding fuel, our fourth quarter unit costs increased 1.7% to $0.0657. Even with anticipated maintenance and other operating cost pressures, our fuel unit cost performance was slightly better than we had expected driven by lower than expected fourth quarter airport costs.

Our landing fees and other rentals unit costs increased 7.8% during the fourth quarter to $0.55, primarily due to airport rate increases. Albeit a significant increase over last year, this unit cost performance was better than expected due to favorable airport audit assessments totaling approximate $17 million.

Due to continued rate inflation at various airports, and expectations that we will not receive a similar amount of assessments in the first quarter of ‘08, we expect our first quarter landing fees and other rentals or LSM to exceed fourth quarter 2007 $0.55 and we’re currently estimating a landing fee and other rental unit costs in the low $0.60 range.

Our fourth quarter maintenance unit costs increased 23% to $0.65. Although we anticipated inflation in our maintenance costs, the increase was more than we expected primarily due to higher engine maintenance costs. The inflation in our 2007 maintenance cost is due to a higher number of aircraft engine maintenance events. In addition, our airplane maintenance costs also increased as a result of the transition of our classic fleet to MSG3 airframe maintenance programs.

The escalation in our maintenance costs was due to the aging of our 737-700 aircraft which were first introduced into our fleet 1997. The timing of maintenance events is dependant on a variety of factors, but we are anticipating a significant increase in the number of maintenance events in 2008 versus 2007. There may be some variability from quarter to quarter, but we do expect a significant spike in 2008 and expect this cost pressure to ease over the long term. Over the long term, our maintenance unit costs should improve returning to the historical levels in the mid $0.60 range.

With respect to our first quarter ‘08 maintenance unit costs, we expect a year-over-year increase in the same magnitude as our fourth quarter 2007 year-over-year increase. Our salaries, wages and benefits declined 2.8% on a unit basis in the fourth quarter, primarily driven by lower health care costs. Our stock option expense in the fourth quarter was $7 million versus $14 million a year ago. Expense in the fourth quarter was $25.4 million, 401-K expense was $35.4 million and for the first quarter of 2008 our salaries, wages and benefit unit costs should not be up significantly from first quarter 2007’s $0.0324.

Our other operating expenses for ASM increased 5.4% to $0.0148. As expected, in the fourth quarter other operating cost pressures included the cost penalty from our sub-optimize reduced schedule, higher fuel taxes and a new advertising and marketing campaign and costs associated with our extreme gate makeover and our new boarding methods.

We currently expect our first quarter’s other operating expenses to be similar to fourth quarter 2007’s $0.0148. Based on our current operating cost trends we expect our year-over-year increase in the first quarter 2008 unit costs excluding fuel and any potential gains on aircraft sales to be up at least 3% from first quarter 2007 $0.0654.

The first quarter and full year 2007 income tax rates were both approximately 39%. In August of 2007 the State of Illinois as you remember changed the law and we had a charge. In January that income tax law was reversed by the State of Illinois and as a result we will have a decrease in our first quarter 2008 deferred tax liability of approximately $11 million and that will be classified as a special item in our first quarter earnings results.

Turning to the balance sheet, we ended the year with cash and short-term investments of $2.8 billion. At the end of the fourth quarter we held $2 billion in fuel hedge-related cash collateral deposit. Our capital expenditures during the fourth quarter were $350 million, they totaled $1.33 billion for the full year. We currently anticipate our 2008 and 2009 capital expenditures to be in the $1.3 billion and $1.4 billion range respectively.

We repurchased 66 million shares of common stock for $1 billion during 2007 which brings our total repurchases to 160 million shares or $1.8 billion since January of 2006. At the end of the year we had 735 million shares outstanding. Based on the stock price of $13 and taking into account a $500 million stock repurchase program that was authorized on January 17 we’re currently estimating our first quarter 2008 weighted average diluted shares to be approximately 736 million.

Our balance sheet leverage including our aircraft leases was approximately 36% at year end. During the quarter we acquired nine Boeing 737 700s and we added 39 aircraft during 2007 to end the year with a fleet of 520 aircraft. Our full year 2007 ASM growth was 7.5%.

Although we are taking a cautious approach to our 2008 growth plans in light of higher energy prices we currently plan to grow our 2008 ASM 4% to 5% over 2007. Furthermore, we are focused on optimizing our flight schedule to achieve increased efficiency and profitability and as always will continue to evaluate our growth rate and adjust accordingly based on the current environment.

During 2008 we’ll accept 29 new Boeing 737 700s. Our Boeing delivery schedule and our quarterly capacity plans for 2008 are as follows: In the first quarter we will have 12 aircraft additions and we’ll grow capacity by 6.2%. In the second quarter we will have nine airplane additions with capacity growth of 5%; third quarter, five additions, ASM growth of 2.8% and in the fourth quarter, three aircraft additions with the growth of approximate 4.2%. That gives us 29 new deliveries at a 4.5% annual growth rate.

Incorporated into these capacity plans is our intention to reduce our fleet during the year by 22 airplanes or a combination of lease returns and aircraft sales. We’re going to end up growing our fleet by a net seven airplanes.

While it is difficult to provide the precise timing of our aircraft disposals we have ten dispositions planned for the first quarter of ‘08 consisting of six 737 300 lease returns and four 737 700 aircraft sales. Since the third quarter of 2007 we have exercised three Boeing 737 700 options for delivery in 2009 bringing our ‘09 firm order and options to 21 and seven respectively. The remainder of our firm orders and options has not changed in the last quarter and please refer to the schedule and that is included in our press release with that information.

Our capacity by region for the fourth quarter was as follows: East had 14%, Northwest was 4%; Southeast was 16%; Southwest was 14%; Midwest was 17%; and the West was 36%.

In summary, it’s been a challenging year but we’re very proud of our accomplishments and we are excited about 2008. Throughout the company our employees have been working hard on our strategic initiatives and it’s really exciting to see their hard work start to pay off here in the fourth quarter.

Looking forward, we have some cost pressures but our revenue trends should continue to benefit from our diligent efforts to boost our revenue production. We will also continue to evaluate the efficiency of our balance sheet and maintain our preparedness to take advantage of any market opportunities.

While we can’t always predict the bumps in the road we have a clear vision of where we’re headed and we don’t intend to stop until we’ve achieve our financial targets.

With that Gary and I are ready to take your questions.

Question-and-Answer Session

Operator

Your next question comes from William Green - Morgan Stanley.

William Green - Morgan Stanley

I’m wondering if you can comment a little bit about some of the efforts in the industry recently to raise prices. I’m not sure with Southwest how you reacted to that, I know you are somewhat independent in how you approach pricing. I would have thought you might have matched some of it, at least, just given your cost pressures and the fact that your fuel is also becoming a bit more of a challenge now?

Gary Kelly

That’s obviously a question that we get often in this kind of an environment. Our objective is to raise our revenue production. We have launched some very significant changes for us and for our customers, so our objective right now is to try to prefect that. We have a new fare structure. We’ve got obviously the new Business Select product that you’re familiar with. We have new revenue management techniques that we’re using.

The environment, in our view, has been and continues to be a low fare environment. Obviously, the industry has slowed capacity growth and as Laura was reporting in markets that we serve, we’ve actually seen reductions in the supply of seats. So that’s obviously helping better match the demand but if we see opportunities to raise fares we’re going to do that. I think we’ve been pretty clear that our strategy going forward is to try our best to minimize that.

Again, I think the economic environment was softer in 2007 than we thought it would be. I don’t think anybody believes that they can raise prices in a recessionary environment. So we’re evaluating the demand and making those kinds of choices on an ongoing basis but prospectively I can’t give you much more. I can’t tell you when or whether we’ll increase fares in the future but pretty happy with what we’re doing on the revenue front since the changes were introduced in November.

William Green - Morgan Stanley

If I can shift to labor, do you have any updates that you can share with us? I’m particularly curious, we’ve seen some comments recently here from I think one of your unions about pushing for, it seemed to be compensation but maybe I misunderstood their point. I’m just curious if it’s realistic for us to believe that the contracts that you may be able to negotiate in the future, is there a way for you to get more productivity out of the folks who wish to get labor wage increases or have we really pushed to the limit on that? I don’t know how much productivity has left to go.

Gary Kelly

Great questions. Our company is very lean and very productive. One of the concerns that I have is that in some of our work groups we are too thinly staffed and we’re incurring too much overtime so we will need to make some adjustment in those cases and that’s not necessarily a new thought.

But overall we’ll continue to find opportunities to improve our productivity, Bill. I don’t know that they’ll be as dramatic over the next five years as they have been over the last five years. I don’t think any of us expect that; but there are clearly opportunities to continue to get better.

Just to give you a more specific answer to your question, we have two contracts under negotiation and our pile ups have been in negotiation for about a year-and-a-half so obviously I’m hopeful that we can get that wrapped up soon. Our TW555 union that represents our ramp operations and provisioning agents just started a week ago and that’s probably what you’re referring to, Bill, that you heard recently.

I think they have communicated what their desires in terms of negotiations but I want those negotiations to take place among our leaders at the bargaining table and not play that out through the media. We have a long history of working very, very well together.

I’m proud of the fact that our Southwest people are arguably the best compensated in the airline industry. We’ve never had a pay cut, we’ve never had a layoff and their job security is one of my top priorities. That’s been the case and that will continue to be so and that will be our guidepost here as we negotiate.

William Green - Morgan Stanley

Just one quick question for Laura. Can you just clarify, did you say CASM in the first quarter would be up 3% including or excluding fuel?

Laura Wright

That’s excluding fuel and special items.

Operator

Your next question comes from Mike Lindenberg - Merrill Lynch.

Mike Lindenberg - Merrill Lynch

Two questions just right off the top, when you think about some of the economic reports that are out there it seems like the prevailing view is that the States of Arizona, Nevada and California are three of the five states that are in a recession.

When you look at the traffic trends and demand in those states and I think, Gary, you guys probably carry more passengers within and probably to and from those states than any other carrier. Can you give us some color on what you’re seeing in demand trends in that part of the country versus elsewhere and your response to it as a proxy for if and when the entire US goes into a recession?

Gary Kelly

Sure, Mike. I think that we’ve done a lot to be better prepared for changes in the environment in 2007 than ever before. We’ve tried to move off of a fixed fleet schedule, if you will, and therefore a fixed flight schedule to something that is more quickly responsive to economic conditions. We made a lot of progress there, it may not be visible to the outside world but that’s one of the reasons that Laura and I think it’s important to point out that the schedule changes we made in the fourth quarter have turned out to be highly productive and that’s a little different for us.

We’re following that up with, for us again a very aggressive pruning of the May schedule and so what we’re talking about right now is what do we do next? Which will be our August 3rd schedule. We’ve got, I don’t know, five, six, seven weeks before we have to produce that.

With respect to what we’re seeing, I think our caution looking into 2008 is just more generic. I don’t know that we have seen anything like we did in the first quarter of last year where we saw pretty widespread trend changes that worried us. We’re not seeing that at all right now and that’s what Laura said and what I have said.

When we talked about Arizona and California in particular, there’s nothing to report there other than we’ve launched brand new service to San Francisco. We had a 69% plus overall load factor for Southwest Airlines in the fourth quarter and San Francisco matched that so that’s probably the only anecdotal evidence that I can think to offer you that I think is meaningful.

The only other thing to perhaps add some color there is we’ve growth Denver very aggressively because the demand has been there. We’ve recently added 14 daily departures at the outset of the fourth quarter. Our capacity, if I remember correctly, for our year-over-year in Denver was up about 67% and remarkably the revenues are up a like amount.

So again, all the anecdotal evidence Michael that I can think to offer would suggest we’re not seeing any weakness. The one cautionary note to add here is that as usual nothing stays the same. So while we are growing as Laura reported, our competitors are shrinking; they did in the fourth quarter year-over-year and they are again in the first quarter. I think they will yet again in the second quarter.

So to what extent capacity reductions are benefiting Southwest, we don’t know. It’s a little too early to make that call. But just reading what other airline CEOs are saying, I don’t see that there’s any fall off in demand, although we’re certainly watching for it. The only thing that I would comment that was a little, not alarming, but a watch out item for was the Thanksgiving and Christmas traffic didn’t seem to be as strong as it could have. I don’t know what to attribute that to.

You remember there was so much hype about the travel experience leading into Thanksgiving but that’s been my suspicion since then because the rest of the travel period has been pretty stable.

Mike Lindenberg - Merrill Lynch

Regarding the CapEx number, the $1.3 billion for 2008 presumably that’s a gross number and doesn’t reflect the net CapEx as airplanes are sold. If we look at the 22 airplanes, Laura, that you were planning to dispose of in 2008, what would be the mix of aircraft that are just coming off lease versus aircraft that you’re going into the market and selling? Should we anticipate any booked gains on the airplanes that are sold?

Laura Wright

Mike, the initial reduction was to reduce our fleet by ten airplanes and we’re in the process of that now and that’s going to be the six leased aircraft being returned and we’ve got four 700s that we’re selling.

The second decision to slowdown growth in December is an additional 12 airplanes and as it stands right now it will probably be a mix of about half 737 300 lease returns and half aircraft sales. So in total we are going to have about ten airplanes that will be sold this year between the first, second and third quarter.

We will generate pretty significant proceeds which will reduce our net CapEx for the year by $200 million to $300 million. We do anticipate booked gains when we sell those airplanes as well.

Gary Kelly

I hope they’re big gains too.

Operator

Your next question comes from Ray Neidl - Calyon Securities.

Ray Neidl - Calyon Securities

Yes, I want to verify a couple of things that you said. Laura, was the number of shares in the first quarter were they basic 736 million?

Laura Wright

The outstanding shares and then we had a diluted adjustment for the diluted share adjustment was about 7.5 million shares so I think it was 744 million total.

Ray Neidl - Calyon Securities

The $2 per gallon guidance you gave us for the first quarter, is that good for the whole year?

Laura Wright

Yes, I think you know our hedge position right now is relatively equal throughout the year, over 70% hedged at $51 a barrel and if you look at the forward curve throughout 2008, where it stands today it’s relatively pretty even across the year so I’d say with what we know today we are in that range.

Ray Neidl - Calyon Securities

The last thing, the tax rate was varying a little bit. What should we be using this year? 39% or 40%?

Laura Wright

About 39% but remember we will have an adjustment in the first quarter. We’re going to have an $11 million credit for the State of Illinois reversal of that tax that was enacted last August.

Ray Neidl - Calyon Securities

That’s one time, correct?

Laura Wright

Yes.

Operator

Your next question comes from Jamie Baker – JP Morgan.

Jamie Baker – JP Morgan

My math has $2 jet fuel and 3% ex- CASM depending on how you treat that tax issue. Does that imply the potential of a loss in the first quarter? Hardly shocking from an industry perspective but something a bit unusual for Southwest. Is this something you’d care to address?

Gary Kelly

I be happy to. I wouldn’t say that we aren’t at risk at all for a loss in the first quarter, obviously that’s not our goal, it’s not our plan. If indeed the results on the cost side $2 jet fuel plus CASM ex-fuel unit cost increases of 3% or more, then the obvious point is that we’re going to have to drive some revenues to offset that.

That’s harder for us to be precise with predictions on but clearly our goal for the year Jamie is as per usual, to drive earnings increases. It will be harder in the first quarter because of that cost hurdle, but we’re not telling you that we’re not going to strive to increase our earnings for the year 15%. So certainly it’s not a foregone conclusion that will have a loss in the first quarter, but yes, as the costs are going up the revenues will have to follow or we’ll be at risk there.

Jamie Baker – JP Morgan

That’s actually a good segue into the second part of my question, Gary. Despite the best fuel hedge in the business, you did appear to miss the targets for 2007 so I’m wondering if you’ve looked at any areas other than the traditional airline where you could potentially reallocate your capital?

For example, I’m assuming your aircraft purchase costs are the best on the planet and for argument sake, is there anything to keep you from going into the leasing business where fundamentals and returns at least for the moment seem to be stronger than the tradition airline model?

Gary Kelly

Well Jamie, I think that both Laura and I have allowed that that is something we’re considering, particularly in this environment where just walking through the logic with us; we’re trying to put our schedule planning function in a position where they have more flexibility. That has to start with, in other words, if we’re going to schedule the airline according to demand, well then we also have to be able to do something with surplus aircraft.

I think it leads very naturally into that kind of a thought process. I think Laura and I are indifferent as to whether we sell an aircraft versus lease it on a net present value basis, assuming that the result is neutral. So that’s part of what we’re exploring.

The other thing we’re not oblivious to is that business is cyclical as well but indeed it certainly makes sense for us to seriously consider that and we are seriously considering that.

Operator

Your next question comes from Dan McKenzie - Credit Suisse.

Dan McKenzie - Credit Suisse

Just looking at the income growth target in the first quarter, can you provide some more color on your confidence in reporting a profit in the first quarter here?

Gary Kelly

I don’t know if I said anything other than we are not planning for a loss but because costs are increasing and especially fuel I can’t completely discount the risk of a loss any more than we could last year. I think basically we had a pretty thin profit in the first quarter of ‘07 as well. So I don’t think we’re trying to alert or alarm anyone other than to say I can’t give you a guarantee that there won’t be a loss in the first quarter. What is clear and has been clear for years is that the costs are increasing which simply means that the revenues have to keep pace. So that’s what we are straining and striving to do and based on the January trends we’ve reported to you thus far we’re again not predicting a loss but at the same time I’m not going to tell you that we’re not at some risk here.

Dan McKenzie - Credit Suisse

It appears the industry is on the cusp of consolidation here and I was wondering if you could talk a little bit about how your fleet needs might change under that scenario?

Gary Kelly

That’s a perfect set up and I think a more thorough answer to Jamie’s question too which is, we would love nothing more than to keep all these airplanes and put them to good use and profitable service. So we don’t know what kind of opportunities will be unveiled where we’ll need more aircraft. As I mentioned in my comments, there is no lack of demand for more Southwest service, it’s just we’ve got to get it at the right revenue level.

So if we’ve get opportunities, Dan, that present themselves in 2008 the good news is if we don’t get too far down the line in committing these airplanes we’ll be in a very good position to take advantage of it. So obviously that’s our preferred route and our first priority will be to grow the airline as long as we can do it in a way we think will be incrementally profitable.

Operator

Your next question comes from Gary Chase - Lehman Brothers.

Gary Chase - Lehman Brothers

This is the first time I heard you reference $1.5 billion as the required revenue gain in order to meet the satisfactory level of return. I think I’ve heard you address that in the past in the billion-dollar range and I just wondered if you could elaborate a little on that. Is $1.5 billion the new official goal? Are there more initiatives that you are planning now as a result of what has happened with the fuel? Have you just had better take up? What’s driving that change?

Gary Kelly

I think the difference between $1 billion and $1.5 billion at this stage is arithmetic but the reality is since our New York Stock Exchange presentation in June, fuel prices have gone up dramatically. We’re not oblivious to that. Therefore for us to hit our profit target in 2009 our revenues are going to have to increase as well.

Now in fairness to this whole discussion, we’ve got a portfolio of revenue ideas that are well in excess of $1 billion, well in excess of $1.5 billion. I think that’s the only point I was trying to make with my comment which is we’ll just have to take this in incremental steps, launch our initiatives and see what they really produce and adjust accordingly.

But at this stage, I think the clear message is that our revenue targets will need to be higher than they were earlier in 2007 and right now we’ve pegged that at $1.5 billion.

Gary Chase - Lehman Brothers

So it’s well in excess of $.15 billion in the 2009 timeframe?

Gary Kelly

We don’t know. The other thing I was trying to illustrate this morning is that there is a tremendous amount of technology being deployed this year. That is pretty far along. Therefore I think you could say it has a lower risk of execution. Now the technology that’s being developed this year for next year is not as far along and really that’s where a lot of the more direct benefits will flow in terms of revenues:

Southwest.com enhancements, Rapid Rewards enhancements, additional code share partners, etcetera. We’ll just have to get from here to there before we can give you a lot more precision to answer your question.

Gary Chase - Lehman Brothers

What you’re trying to convey here -- because I think this is an important point -- is you think the opportunity set is large enough that you can deal with a change in fuel we’ve seen since you did your New York Stock Exchange presentation?

Gary Kelly

I absolutely do. I think what we have tried to consistently convey is that we are very confident of our ability to increase our revenues; we are not as confident as to the timing of when those benefits will flow or exactly what benefits will flow from each individual one; but collectively, I think we have a very large opportunity out there.

And again, there is nothing really new to report. I think we have been very transparent about the themes that we are pursuing. We have been obviously vetting out some of the details within those themes, but hopefully what we’ve done in the fourth quarter of last year gives you some indication that we have a lot underway and we are going to deliver and we are going to execute.

Gary Chase - Lehman Brothers

And just to be crystal clear, this is above and beyond industry, right? This is independent of industry revenue?

Gary Kelly

In fairness to us, we don’t know how these benefits are going to flow, so the best way I can think to describe it is from where we are, we need unit revenue improvements of 15% so if we can raise 15% and get them there, I think we ought to declare victory but we just don’t think that is going to be possible and we don’t think that is going to be the scenario. But in any event, we are looking for new sources of revenue in combination with what you might call more organic growth in RASM. It would all add up to be about 15% unit revenue.

Gary Chase - Lehman Brothers

Just to elaborate a little bit, if I walk through what you are talking about for the first quarter, it suggests that the revenue environment will get better than plus four in order not to have a loss. I may be doing that a little bit wrong. What I am driving at, is there something competitively that is changing or is it just that the comps get easier month by month? I am obviously cognizant of the Easter shift, I know that is a big deal for you.

Beyond that, is there anything we should be thinking is happening competitively through the course of the quarter that is going to be a tailwind?

Laura Wright

Gary, I think there are a lot of things. I think clearly initiatives we put out in the fourth quarter are just ramping up. We expect those to accelerate during the quarter. There are some new initiatives but clearly March will be very significantly impacted by a very, very early Easter this year as well.

The other thing is we have additional capacity with some of our competitors in the fourth quarter versus first quarter as well.

Gary Chase - Lehman Brothers

Laura, what is the spot fuel underlying $2?

Laura Wright

It is looking at the current [inaudible].

Gary Chase - Lehman Brothers

$89. Thanks very much.

Operator

Your next question comes from Jim Parker – Raymond James

Jim Parker – Raymond James

Good morning. Just looking at your fourth quarter increase of 3.7%, at the same time you had a 6% cut in capacity, competitive seats. Perhaps that is a little bit disappointing given that in ’06 I think your RASM was up 10% and the fleets that came out against you were either minus 7 or maybe 10.

So just in light of that, is this not a bit disappointing, a RASM increase of 3.7% on a 6% decline in seats?

Gary Kelly

I think so Jim, but in what context? So our disappointment dates all the way back to the first quarter. So relative to the first quarter we’ve actually done better by the time we get to the fourth quarter. I think we have been very open about that during all of 2007. We are just adjusted to that reality today. The bottom line is the domestic air traffic growth has been anemic throughout 2006 and 2007 and it has taken capacity adjustments by the industry to produce the kinds of results that we are all seeing.

We are in now way satisfied with that performance and obviously and again, there is a lot of work underway to improve it from there and we have not even the full 60 days worth of the new and improved features – and some of those are brand oriented which will take longer to win customers over to Southwest Airlines and the Business Select, we didn’t even promote or push. Still we are able to bring out $7 million.

The other thing I was very pleased with was from a trend perspective, the changes that were made to the flight schedule were very productive in October and November. This is a building process and we have to do better than plus 3.7%.

Jim Parker – Raymond James

With regard to ancillaries and the systems that you are putting in place perhaps to sell passengers something other than just the seat, it looks like some airlines are doing very well and realizing some very nice margins on marketing hotel rooms to passengers. What are you doing in this regard to increase that marketing of hotel rooms?

Gary Kelly

Our focus right now is on what was delivered in the fourth quarter and I want our company to perfect that. So we’ve got some follow-on that we will want to do with our fare structure, with our enhanced boarding process, with our advertising message. That is very, very important to get that right and that is where our emphasis is.

Now, in the background there is design work and construction work underway that is more on point to your question. We will need some significant enhancements to Southwest.com to generate the kinds of ancillary revenues that we want and I think you would also be excited about.

That will not come probably before 2009, although we will be doing what we can in the meantime to use what we’ve got, to find more partners, find better ways to sell. I am not ready to promise anything there yet.

That is clearly a goal and clearly something I am very excited about, but that is not the top priority today.

Operator

Your final question comes from Frank Roche – Bear Stearns.

Frank Roche – Bear Stearns

Gary, I was wondering if you could give us – you talked a little bit about potential consolidation and how Southwest would look at any assets that may come up. Have you had any discussions with anyone about any assets in the last little while?

Gary Kelly

Frank, you know I can answer that question. What I would say is we are trying to look at whatever opportunities become available here in 2008 and I think it is going to be a wild year. I think the industry is in terrible shape and we are in great shape. This is pure speculation on my part, whether it means we will have opportunities to buy assets, I couldn’t really say. All I can tell you is we are prepared for that and I think we have our fleet and schedule in a position where we can move pretty quick to take advantage of some opportunities.

But as to whether or not we will buy anybody or anybody is talking to us, I can’t comment directly on that, of course.

Frank Roche – Bear Stearns

Gary, I think you had said before in a press interview that for the full year ’08 you were thinking that unit costs ex-fuel would be up in the single digits. Is that – what is the latest thinking for full year ’08 and fuel?

Laura Wright

The guidance that we’ve given today is really what our ex fuel CASM and certainly we know that the pressure that we are going to have against higher [inaudible] based on what we think are events that are going to occur, but we do anticipate that we are going to be up ex-fuel ex-special items for the full year.

I thank you all for listening and if you have any questions, Tammy, Marci and I are available for calls. Have a great day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Southwest Airlines Co. Q4 2007 Earnings Call Transcript
This Transcript
All Transcripts