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Southwest Airlines Q1 2008 Earnings Call Transcript 15 comments

April 17, 2008 | about: LUV

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Southwest Airlines (LUV)

Q1 2008 Earnings Call

April 17, 2008 11:30 am ET

Executives

Gary Kelly – Chief Executive Officer

Laura Wright – Chief Financial Officer

Analysts

Duane Pfennigwerth - Raymond James

William Greene - Morgan Stanley

Jamie Baker - JP Morgan

Gary Chase - Lehman Brothers

Mike Linenberg - Merrill Lynch

Dan McKenzie - Credit Suisse

Frank Boroch - Bear Stearns

Kevin Crissey – UBS

Ray Neidl - Calyon Securities

James Higgins - Soleil Securities

Presentation

Operator

Welcome to Southwest Airlines’ first quarter 2008 earnings conference call. Today call is being recorded. We have on the call today Mr. Gary Kelly, Southwest CEO; and Ms. Laura Wright, the company’s Senior Vice President of Finance and CFO.

Before we get started, please be advised that this call will include forward-looking statements. Because these statements are based on the company’s current intent, expectations, and projections, they are not guarantees of future performance and a variety of factors could cause actual results to differ materially.

This call will also include references to non-GAAP results. Therefore, please see our earnings press release in the investor relations section of our website at Southwest.com for further information regarding our forward-looking statements and for the reconciliation of our non-GAAP results to our GAAP results.

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

Gary Kelly

Thank you, Tom and thanks everyone for joining us this morning. We are obviously very pleased to report a solid profit, excluding the special items in each year we earned $0.06 a share in the first quarter of ‘08 and that was a 50% increase from the year-ago period. We were of course especially pleased with the revenue performance. We had a record load factor as well as record revenues.

Our year-over-year growth was a very strong 15% and considering that our capacity growth was still pretty healthy at 6.4% our unit revenue growth of 8.2% was quite good; and in fact, that’s the best quarterly performance that we’ve had since the second quarter of 2006 and I believe very solid evidence that the changes that we made in the fourth quarter of 2007 are working and quite well.

Of course March and first quarter benefited from the Easter timing, but taking that into consideration, bookings for April, May and June, all three look strong. Nonetheless, we’ve got to be cautious in our outlook about the economy, but clearly the domestic capacity reductions by the industry are helping mitigate that concern.

Of course our obvious immediate concern is fuel prices. Fuel prices are soaring. They are clearly a very real threat, as well as we have a threat of a travel recession, so we decided to slow next year’s new aircraft deliveries to 14. That was down from 28, and we already have an agreement with the Boeing Company to do that. So my thanks to Laura Wright and the Boeing Company for really jumping on that.

But assuming no retirements next year -- which I want to emphasize we have not decided yet -- that means we’ll have no more than an annual available seat mile growth of 2% to 3%. We’ve also had to mitigate the fuel cost threat. We’ve taken two fare increases, one last night and one last week so we are taking what actions we think are necessary to deal with fuel costs.

For this year, on the other hand, we had previously planned to retire 22 airplanes. We’ve had some very dramatic events in the industry over the last couple of weeks. So we are revisiting our retirement plan for 2008. We’ve already retired or committed to retire six and we will likely retire some additional aircraft this year, but we just don’t know yet whether it will be all of the 22. But regardless, we’re continuing to prune our flight schedule with each new published schedule.

Finally before I turn it over to Laura we were fined, as you all know, $10 million by the FAA in March. That’s been accrued in the first quarter of 2008. According to the FAA, the fine is for allowing some planes to fly while they were being inspected to determine compliance with an airworthiness directive and naturally we’re going to work hard to resolve our issues with the FAA, which we hope and expect to do.

I would just repeat that there was clearly a mistake with our regulatory compliance. We’ve already made significant changes to ensure that Southwest maintenance processes are the very best that they can be. It’s important to also add, again, that this was a process issue. We have numerous overlapping and repetitive inspections. They were done on all of the aircraft that were involved. Safety of flight was never an issue, as confirmed by two outside experts and of course Southwest Airlines has the best safety record of any major airline over the last 37 years. So we’re devoting enormous amounts of time, energy and resources so that our customers and our shareholders know that we’re making a very safe airline even safer.

With that very quick overview, Ms. Laura Wright, would you tell everybody what they’re anxious to hear?

Laura Wright

Thank you, Gary and good morning, everyone, including our webcast listeners. In what proved to be another very difficult quarter for the airline industry, we’re pleased to report our 68th consecutive quarter of profitability. Our GAAP first quarter 2008 net income was $34 million, or $0.05 per diluted share compared to $93 million in the first quarter of last year, or $0.12 per diluted share. Excluding special items, our first quarter ‘08 net income was $43 million compared to $33 million in the first quarter of ‘07, which represented an increase of 30%.

The special items relate mostly to out-of-period FAS 133 items. We also had a special item which was a $12 million tax benefit which refers to the charge that we had in the third quarter of 2007 resulting from a State of Illinois income tax law change.

Our net income per diluted share excluding these special items was up 50% to $0.06 in the first quarter of ‘08, which was better than we expected and also exceeded Wall Street’s mean estimate of $0.01 per share.

Despite the weak economy, our business throughout the first quarter was solid. Our operating revenues for the first quarter were a record $2.53 billion, up 15.1% from a year ago on a capacity increase of 6.4%. Our operating revenues per available seat mile or RASM exceeded $0.10 and it was up 8.2% from a year ago.

The increase in unit revenues resulted from a record first quarter load factor performance of 69.8% and a 4.7% year-over-year improvement in our yield. Our PRASM growth for the two months ended February 29 was in the 6% range. Our PRASM growth for March was in the 9% range, which was boosted by Easter falling in March of this year versus April of last year. We estimate that the Easter benefited March favorably and represented about 1% of our first quarter ‘08 RASM growth.

We’re very pleased with these strong trends which reflect the encouraging results of our initial revenue initiatives. In November of last year we introduced enhancements to our overall product offering, including the new boarding procedure and Business Select product. The revenue increase from Business Select for the first quarter was almost $15 million. We continue to update our revenue management processes, techniques and procedures which also contributed favorably to the first quarter 2008 performance.

Our schedule adjustments in the overall reductions in competitive domestic capacity also contributed to our strong RASM growth. The impact from our October and November schedule changes represented at least 2% of the year-over-year first quarter RASM increase.

Looking ahead to the second quarter of 2008, the April comparisons will be more difficult due to the Easter mismatch. As a result of Easter falling in March of this year versus April of last year, we currently expect our April RASM to be in line with our year-ago performance. Barring a further slowdown in the domestic economy, based on the bookings for the remainder of the quarter and taking into account the impact of Easter, we expect solid increases in year over year RASM for both May and June. The remainder of the second quarter should also benefit from our modest fare increase on April 10th, and we also increased fares last night by $3 to $10, but this will not impact travel until June 15th.

As previously announced, we’re also adjusting our schedule again in May, which should benefit second quarter RASM. We’re eliminating 59 nonproductive flights and reallocating this capacity to focus markets such as Denver.

With respect to our ATA code share revenue, all code share arrangements have ended including any exclusivity provisions relating to any international code sharing. In the first quarter of 2008, we recognized approximately 6 million in code share and marketing-related revenues. We continue to build up the technology to code share internationally and we plan to explore code share opportunities with other airlines.

Our second quarter 2008 revenues, however, will reflect the loss of this code share revenue, and we will also incur a charge related to the cost of re-accommodating code share and ATA passengers who purchased a ticket on Southwest.com and we currently expect that to be in the $5 million range.

We also have significant revenue initiatives currently underway for 2009. They include evolving Southwest.com to provide more ancillary revenue opportunity; enhancing our Rapid Rewards frequent flyer program; providing in-flight connectivity, which we will begin testing on four aircraft this summer; and again we’re building capabilities for the international code share.

Turning for a moment to our freight and other revenues, we also had a strong first quarter performance. Our other revenues increased by $26 million or 46.4% compared to the first quarter of 2007. This growth was driven primarily by increased business partner income, and very strong charter revenues. We expect second quarter’s growth rate to be more in line with capacity growth.

Our freight revenue increased 13.3% to $34 million, primarily due to higher rates and we expect a similar increase in the second quarter. At this juncture, based on these trends and considering the Easter shift, we expect our second quarter 2008 RASM growth rate to be less than first quarter’s 8.2%.

I’ll now move to costs. Our first quarter unit costs excluding special items increased 7.3%, largely due to higher fuel costs. Even with $302 million in cash settlements from our derivative contracts, our economic fuel costs were up 20.7% to $1.98 per gallon. This was in line with our guidance of around $2 per gallon. Our fuel burn was down almost 2%, which was better than expected, due to continued fuel conservation efforts and focus by our flight crews and dispatchers.

We have derivative contracts in place for approximately 70% of our estimated second quarter fuel consumption, capped at approximately $51 a barrel. Based on this position and yesterday’s market prices, we expect our second quarter economic fuel price to be in the $2.35 range. This will result in headwinds of more than $140 million relative to first quarter 2008 fuel prices, which will make it very difficult to grow our earnings in the second quarter.

The estimated fair value of our hedge contracts increased to $2.8 billion at March 31st. We have $2.6 billion in collateral deposits, which represents 92% of the fair value of our hedge portfolio. Our premiums associated with the costs of our hedging program were $14 million in both first quarter ‘08 and ‘07 and these are reflected in other gains and losses. We expect similar premium costs in the second quarter of ‘08.

Our first quarter unit costs, excluding fuel, increased 2.4% to $0.067, which was a better performance than we had expected. Based on current trends, we expect our second quarter costs excluding fuel and special items, if any, to increase from first quarter 2008’s $0.067. We are currently estimating an increase in the 2% range from first quarter 2008 primarily due to higher than expected maintenance spending.

Although our first quarter maintenance unit costs declined 1.7% to $0.57, which was better than we anticipated, the timing of the initial engine overhaul for our F-700 engine is difficult to predict. We do not have a lot of history on the F-700 engine and we’re not currently under a MCPH contract for these engines. Because the direct expense method is event-driven, we experience more volatility from quarter to quarter.

Based on our current scheduled maintenance events, we expect a significant increase in year-over-year spending in the second quarter of 2008, possibly as high as $0.75. Our salaries, wages and benefits declined 2.2% on a unit basis, primarily due to lower share-based compensation expense versus first quarter of 2007. Our share-based comp expense was $5 million in the first quarter of ‘08, versus $13 million last year.

Our profit sharing expense for the first quarter of 2008 was $12.5 million, versus $9.4 million in the first quarter of last year. Our 401(k) contribution was $38 million versus $38.8 million last year. We expect that our second quarter 2008 total salaries, wages and benefits unit cost will decline from second quarter 2007.

The 6.3% decrease in aircraft rentals per ASM was driven by the retirement of five leased 737-300 aircraft in the first quarter of ‘08. Our landing fees and other rentals per ASM increased 17.2%, which resulted from various audit settlement charges paid to airports in the first quarter of ‘08. These true-ups are difficult to forecast and can go either way, but they are generally small as airports typically do a reasonably good job forecasting their rates.

However, we received a very large surprise audit settlement charge of approximately $13 million from the Maryland Aviation Administration relating to the Baltimore-Washington airport. Adjusting for these settlements, we currently expect our second quarter 2008 landing fees and other rentals per ASM to be in the low $0.60 range.

Our other operating expense per ASM increased 9.2%. The second quarter operating expenses included the $10.2 million fine assessed by the FAA. The increase was also driven by higher fuel taxes and advertising costs. With higher expected fuel costs, we expect fuel taxes to be even higher in the second quarter of 2008 and we’re currently estimating our other operating expense per ASM to exceed first quarter 2008.

The first quarter 2008 effective tax rate for our GAAP earnings was only 9% compared to approximately 38% for the first quarter of ‘07. The decrease again was primarily due to a decrease in our first quarter deferred state tax liability by approximately $12 million as a result of the January 2008 reversal by the State of Illinois of an August 2007 increase under the State of Illinois income tax law. We treat this credit as a special item in reporting our non-GAAP results. We currently expect that our second quarter 2008 tax rate will be in the 39% range and the full year tax rate will be in the 38% range.

Our cash and short-term investments were $3.1 billion at the end of the quarter, and that includes about $140 million in auction rate securities. At quarter end we held a total of $321 million of auction rate securities but we re-classed $181 million to other assets in the first quarter due to near-term uncertainty about liquidity in today’s market.

At the end of the quarter we held $2.6 billion in cash collateral deposits related to our fuel hedge. Our first quarter ‘08 capital expenditures were $364 million, and based on the reduced capacity plans we have for 2009 and 2010 resulting in lower progress and delivery payments to Boeing, we now expect our ‘08 and ‘09 cap expenditures to be in the $1.1 billion range for both years.

During the first quarter, we repurchased 4.4 million shares of common stock for $54 million. We haven’t been in the market repurchasing shares since the middle of February. We do not believe it’s prudent to repurchase shares at this time considering today’s unstable financial markets and unprecedented fuel prices.

At the end of the quarter, we had 732 million shares outstanding. Based on a stock price of $12.50, our current estimate for second quarter 2008 weighted average diluted shares is approximately 734 million to 735 million, assuming no more buybacks. Our balance sheet leverage including aircraft leases at March 31 was approximately 37%.

During the quarter, we acquired 12 F-700 aircraft from Boeing and we also returned five 737-300 off lease. We currently have one more lease return that is in the works.

Our first quarter ASM growth was 6.4%. Over the past year we’ve adjusted our growth plan three times and we continue to take steps to restore our profit margins. We’ve now made four adjustments to our schedule, eliminating nonproductive flights. We’ll continue our rigorous review of our flight schedule while balancing any strategic opportunities that may present themselves through possible industry consolidation or downsizing in this high fuel environment.

We will reduce our schedule again in August and we plan to eliminate 20 nonproductive flights, reducing our fourth quarter capacity growth to 1.4% versus previous guidance of 4.2%.

With respect to our 2008 fleet plans, our plan is to accept 29 new 737-700s, but we’re reviewing our previous plan to retire the 22 airplanes. We have flexibility to adjust our fleet plans including the remaining retirements planned for the year, and we’re well positioned to respond to a rapidly changing environment. Today we announced our plans to reduce our fleet growth for 2009 and our new plan is to grow our fleet by no more than 14 700 aircraft assuming no retirement. This represents half of our previous plan of 28, and it brings our 2009 estimated year-over-year ASM capacity growth to between 2% and 3%.

We deferred the 14 2009 deliveries to 2015. We also moved 12 of our 2010 deliveries into 2013 through 2015 and we exercised a total of 12 options with Boeing for delivery in 2010 through 2012. We now have 67 options with delivery positions in 2010-2015 and 54 purchase rights for delivery through 2018.

For the second quarter, we’ll take nine airplane deliveries and we’ll grow capacity about 5%. In the third quarter we have five aircraft additions with a capacity growth of 2% and our fourth quarter additions will be three airplanes with a near capacity growth of about 1.4%. We have provided the yearly breakdown of the new delivery schedule in the earnings release for your reference.

Our capacity by region for the first quarter was as follows: The Northeast had 14%; the Northwest was 4%; the Southeast was 16%; Southwest, 13%; Midwest, 17%; and the West was 36%.

In summary, it’s been a challenging quarter, but we are proud of our accomplishments. Fuel is obviously the biggest challenge that we have going forward, even with a great hedge. We’re pleased with our revenue momentum and we’re going to continue pressing our revenue initiatives. We’ll also continue our efforts to improve our productivity and maintain our disciplined cost control. Fortunately, we have a very strong balance sheet which will allow us to weather the economic climate and also allow us to take advantage of any market opportunities should they arise.

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

Operator

We’ll take our first question from Duane Pfennigwerth - Raymond James.

Duane Pfennigwerth - Raymond James

Thanks very much. I was wondering on the fuel line if could you just talk a little bit about your hedges between WTI and the actual price of jet fuel? How much of your refining margin is hedged and at what level should we assume versus 70% you’re hedged on WTI?

Laura Wright

Duane, the majority of our hedges are in refined products, you can clearly see that in the results we had for the first quarter. But with the guidance that we gave you in the 235 range for the second quarter, that takes into account our refined position, our refined hedges, the level we bought them at versus current market prices.

Duane Pfennigwerth - Raymond James

In terms of the RASM guidance, given you were tracking at 6% through the first two months of the quarter and you saw acceleration in March, if you exclude Easter from March, did you see acceleration above the 6% level?

Laura Wright

What we told you was that Easter contributed about 1% of the first quarter RASM gains. So we did see some benefits, Duane, from the enhancement initiatives with additional fare classes that became effective with our March 8 schedule but it wasn’t significant over that 6% trend that we saw in the first two months.

Duane Pfennigwerth - Raymond James

Keeping that trend in mind, coming into the second quarter ex the negative Easter effect, is that a similar rate we should expect minimally?

Laura Wright

I think what I said was that we expect our unit revenues in April to be pretty comparable to what we saw in April of last year due to the lack of Easter.

Duane Pfennigwerth - Raymond James

But based on current bookings, do you have a minimally 6% growth rate in the other months?

Laura Wright

We haven’t shared that with you.

Operator

We’ll take our next question from William Greene - Morgan Stanley.

William Greene - Morgan Stanley

Laura if I could ask you to give more color around these non-fare revenue issues? I know you mentioned the $15 million for Business Select but you have these other initiatives in place and I don’t know where you stand relative to your guesstimate of was it $300 million or so this year you thought you could get by year end?

Laura Wright

Let make sure I understand your question again, Bill.

William Greene - Morgan Stanley

I’m trying to get, you have the non-fare initiatives you highlighted last June for $1 billion to $1.2 billion through 2010 and that would suggest you need to get about $300 million for the year. You mentioned $15 million for Business Select; that obviously would be a very low run rate but you have other initiatives. So if you talk about the total initiatives you have in place, what’s the run rate?

Laura Wright

We gave you several of those. Initiatives that we saw during the quarter, Bill, were we had Business Select, we also had, in revenue management, we had the additional fare class, we went from 8 to 15 beginning with our March 8th schedule. We estimated the benefit from that was probably $20 million to $25 million in March from the AFC project. We also had as part of our initiatives our capacity adjustment where we culled out non-productive flights and we believe that contributed at least 2% to the RASM improvements that we saw during the quarter.

William Greene - Morgan Stanley

Gary, can I ask you to comment just a little bit about your evolving views on consolidation? I know in the past you’ve said we’d prefer if possible to look at assets when available, but you’ve also taken a new look at your overall business model, so maybe your thoughts on consolidation are changing as well? I’d just like to know what you’re thinking.

Gary Kelly

Well, our thinking is definitely evolving there, Bill. I think everyone is rocked a bit by $115 crude oil so you know, our best course of action could very well be to sit on the sidelines and let others combine, and we’ll look for opportunities to grow in this environment.

But you know that I can’t comment on anything that we might be considering or have in the works, but I don’t mind sharing with you that this is the kind of environment that I think you have to be a little bit risk-averse.

On the other hand, if there are some market opportunities that are created that we could expand into, I think that this is the time that we would want to take advantage of that. So that’s why it was important, I think, to share with you today that we have 16 more airplanes that we can either keep or we can retire this year, and we are in the midst of thinking that very thing through.

I think my view at this point is we just want to be sure that if consolidation does indeed take place that we have access to markets. I think that’s our primary interest at this point. Of course, if carriers combine and become so dominant in markets that you can’t get in, that would be a problem for us because we do want to continue to grow. That’s where our focus is at this point, Bill.

Operator

We’ll take our next question from Jamie Baker - JP Morgan.

Jamie Baker - JP Morgan

I don’t want to sound like a broken record but you’ve grown the airline in leaps and bounds in recent years. You have by far the greatest cost advantage in the industry. I suppose when measured relative to some of your peers, the fact that you never filed bankruptcy is an accomplishment. But still, earnings here are relatively stagnant. What’s not clear to me is what your absolute top priorities are.

I mean, if you were to identify the two most important items facing you and the board at this point, and let’s set aside safety because of course we know that’s a given, what would those two top priorities be?

Gary Kelly

Well, I think it’s real simple. We want to hit our earnings target. Then when you break that down, it has the two obvious components so we’ve laid out our revenue plan and coupled with that we have got, I think the best fuel price protection in the industry on the cost side. In addition to that we’ve got some very meaningful productivity improvements underway with regards to fuel burn and I’ve been very pleased with the progress that we’ve made in controlling our unit labor costs, so that productivity continues to improve each quarter as well.

We have major initiatives underway to control our costs. We have major initiatives underway to grow our revenues. We are slowing our growth rate in less than 12 months from what was 8% to what will soon be probably 2%. Whether we grow in 2009 even 2%, I’m still open to that. We may not want to grow our capacity at all in 2009.

So whether we need to reduce our capacity is something that we are open to. I haven’t seen anything to suggest that we need to do that at this point. But clearly we are in a mode which I mentioned earlier where every single schedule we’re pruning inefficient markets. We’ve done it in October, in November, we didn’t do much in the January schedule, we have done a lot here in the May schedule coming up. Laura just mentioned that in the August schedule that we’re planning to open here pretty soon, we’ll continue to prune out flights there.

So those are the big three drivers. I don’t know that there’s anything materially different to report other than we are continuing to slow the growth. The only thing that would vary from that direction is if there are some opportunities that are going to become available here in 2008 based on the last couple of weeks’ events, then we want to move on those. But I think that would be clearly the exception to the direction that we’re headed.

Jamie Baker - JP Morgan

But you think there’s still an argument for continuing to invest in the business, even just a dollar of investment here, even if the ROE isn’t rising?

Gary Kelly

The ROE needs to rise. The ROIC needs to hit our target and by 2009 we may not be growing the fleet. But you know, given the plans that we have for this year, no. I don’t think that we plan to have zero fleet growth for 2008. It is very possible though that from May of this year through the end of the year we may not have any fleet growth. That’s the assumption if we retire all 22 airplanes.

Operator

Your next question comes from Gary Chase - Lehman Brothers.